A few weeks back I wrote an article discussing the New York City real estate market, and which sectors I thought presented to best opportunities for investors. In that article I noted that the hotel sector presented the best opportunity because it had the most constraint on supply, and I also noted which hotel REITs had the most exposure to the NYC hotel market, thus allowing investors to play my theory.
In this article I will explore the topic of how to play this theory in more depth. I will present and analyze both the key operational and financial metrics used in the hotel industry today, and through them try to gain a deeper understanding of the risks and rewards each of the hotel REITs offer.
Before I dive into this discussion a word about definitions:
- Operational Performance - the ability of the REIT to extract the most profit from its customers.
- Financial Performance - the ability of the REIT to manage its debt and efficiently deploy capital.
Also, you can find the sources for the information I use in this article in all of the company's most recent 10-Ks.
In my opinion, looking at a REIT's hotel revenue and expense presents a much better way for investors to examine a hotel REIT's performance over the commonly used RevPAR metric. Simply put, RevPAR can range wildly within two companies, and only because some companies have higher-end luxury hotels, and some have limited service budget hotels. However, if we want to see a company's operating efficiency from its hotel operations, looking at the margins mentioned above provide a much more accurate perspective.
Operating Revenues (in millions)
In terms of performance the numbers speak for themselves, but I would like to make one point. When I looked at the particulars of DRH's performance, I felt struck by the huge management fee expense the company incurs, something not found in the income statements of any of the above competitors. I tried to do some research into this subject, but have come up empty. I will continue to look into this issue, and write about it if I come up with a credible theory.
These numbers provide a critical assessment when deciding which companies operate most efficiently but, they only make up one part of the story. As I said in the introduction I will also examine the financial performance of these REITs. Considering they all have a fairly complex capital structure, with large amounts of debt and preferred equity, I think in order to get a full picture of the risks and rewards of these stocks, we should take a close and hard look at this area as well.
In order to look at the financial performance of the above REITs I will examine two sets of data:
- EBITDA/Interest payment ratio and EBITDA/interest payment and preferred payment ratio to examine the company's debt management.
- FFO/dividend payout ratio to examine the company's capital management.
The following table, using the same order as the one above sets forth the first set of data.
EBITDA: Interest Payments
EBITDA: Interest payments and preferred payments.
EBITDA: Net debt
NB Host Hotels and Diamondrock don't have any outstanding preferred shares; as such they don't have a difference between the two types of ratios.
I just want to make a few short points regarding this table. On an extremely elementary level the lower the ratio the more vulnerable to company defaulting on their debt. Second, both LaSalle and Pebblebrook issue a fair amount of preferred shares as you can see from the above chart. Preferred shares, as you probably know, have the characteristics of both debt and equity, and some will quibble with my lumping them together with regular debt. I hear the argument both ways, and I decided to include the ratios with and without preferred shares. I am inclined to include preferred equity because while they don't have the same level of claim as regular debt, their coupons put actual pressure on the companies to pay the preferred shareholders, thus limiting their ability to reinvest in the business.
The following table shows FFO/dividend payout ratio:
FFO: Payout Ratio
All of these companies either make a nominal amount of net income, or lose money on a net basis, so the above companies prefer to use FFO, which excludes most non-cash charges (a practice sanctioned by the self -governing REIT board). I felt struck when I first saw the tremendous variance between these different REIT's in their payout ratios. Clearly, these variations speak to the difference in company goals. The higher the payout, the more the company focuses on providing income for shareholders, and the lower the payout the more the company wants to reinvest back into the business.
Putting It All Together
I think these sets of data give us a good vantage point for trying to play the NYC hotel market. In order to come up with a way to play my theory we must put a lot of data together; as such different people will come to different conclusions. However, I would like to add my two cents here in terms of a risk/reward of some of the different REITs presented in this article.
In my last article, I said that Hersha, because of its high concentration of NYC hotels, and its diversification of different type of hotels within that location, gave investors the best shot at capitalizing on my theory. As you can see from the data presented in this article, from a performance perspective, that theory definitely holds true. However, financially we must take pause. Hersha operates with the highest levels of EBITDA/debt, and the highest levels of EBITDA/Net debt. These both leave Hersha more vulnerable than the other REITs to a financial downturn. Additionally, Hersha has the highest dividend payout ratio of all the REITs mentioned in this article. This arrangement might work well for investors seeking income, but for investors who want the company to reinvest their cash into their business, especially if you think the business can produce huge returns because of the underlying economics, this arrangement might not work.
Bringing this whole discussion home, considering I believe in the incredible fundamentals of the NYC hotel market, I also believe that investors would be better served if the companies put their cash back into the business as opposed to paying it out in dividends. HST, has the lowest dividend payout ratio, but it also has the lowest percentage of its hotels - 9.17% - in NYC. LHO has the second lowest dividend payout ratio, and a fair amount - 12.75% - of its hotels in NYC. Additionally, it has the second highest operating margin - 36.58%, and an extremely healthy level of debt that puts it square in the middle of the pack (see above) relative to the other player in the market. Therefore, when considering all of the factors I think LHO gives investors the best way to play the NYC market profitably.
In this article I didn't look at the effect of any markets besides NYC on the hotel sector. Obviously, a more complete understanding of the hospitality sector, and its effects on specific companies would have to take into consideration other markets, which might have better fundamentals than NYC, and a host of other factors as well. In this article, I wanted to give what I believe investors could use a substantial guide to examine the major players that traffic in the NYC hotel space.