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This article will highlight the use of higher risk REITs, specifically, Ashford Hospitality Trust (NYSE:AHT) and MHI Hospitality corp. (MDH) as a means to increase the average returns of a well-diversified portfolio. We will begin by showing the benefits of risk in general, then move on to the specifics of these companies and why they may be excellent additions to your portfolio.

Within the investment community, the benefits of risk control seem to be overstated. As an isolated variable, risk has no effect on the average returns of an investment. It simply refers to the spread between worst case and best case scenarios in terms of both the chance of occurrence and magnitude. A low risk stock has a greater chance of remaining within a small range of the expected outcome, while a higher risk stock may deviate further with greater frequency.

None of this is a new concept. Institutional investors are well aware of all the factors associated with risk, but between client's fears and the basic human preference for safety, low risk stocks are somewhat overbought. With the excess of investors using low-risk, agoraphobic portfolios, it opens a niche amongst higher risk stocks in which we can glean superior returns simply by being willing to assess and accept this risk. These greater returns serve as an alternative risk mitigating strategy as the profit cushions unexpected losses. In this sense, the higher yielding, "higher risk" portfolio can actually be the safer bet. Securities typically considered lower risk are in fact, steadier, but the difference is much smaller than would be expected based on the hefty price tag the market tends to place on them.

To illustrate this point, I ask that you suspend awareness of the variables of our economic reality and consider the following two hypothetical investment opportunities:

Investment A: Cost of $100/unit and after a year is worth $110/unit guaranteed.

Investment B: Cost of $90/unit and after a year is worth $110/unit 90% of the time and $0/unit 10% of the time.

Both investments, on average, provide 10% total returns, but investment B is clearly riskier with the possibility of losing the entire investment. While this is not always the case, risk averse market behavior will have the tendency to bring the average returns out of parity in favor of the riskier investment. Thus, in a real market scenario we may see something closer to this:

Investment A: cost of $102/unit and after a year is worth $110/unit guaranteed for a total return of 7.84%

Investment B: cost of $88/unit for a 90% chance of $110/unit and a 10% chance of $0/unit of total value after one year for a 12.5% return on average.

For most people or institutions, a 10% chance of total loss of capital is unacceptable. AHT and MDH are similar to investment B. While it seems unlikely that either would result in a total loss of capital, the span of potential outcomes between worst-case and best-case scenarios is relatively large for these companies as compared to the average. These securities also resemble B in that the market significantly undervalues them with extraordinarily low price to FFO ratios of 5.2 and 6, respectively. Fortunately, there is a way in which we can reduce this risk while still collecting the market enhanced returns of higher risk investments -- diversification.

Instead of comparing individual investment opportunities as we did above, we will now compare two portfolios.

Porfolio A is comprised of 10 different investments similar to investment A, resulting in approximately the same average total annual return of 7.84%. As a portfolio, A is even safer than the individual investments since a single anomalous event will be partially out-weighed through diversification.

Portfolio B is comprised of 10 different investments similar to investment B, resulting in approximately the same average total annual return of 12.5%, but with a very different risk profile. Assuming each investment has an entirely independent chance, the individual investments will form a Gaussian random walk about the midpoint of 12.5%, for an overall total return distribution resembling the normal bell curve. Consequently, the chance of complete loss of capital has been reduced to 10%10 or approximately 1 in 10,000,000,000. As the number of investments in the portfolio increases, the distribution more heavily favors the midpoint making returns almost certain to be near 12.5%.

While the assumptions above and the chance of each investment failing being completely independent are wildly untrue in a real world situation, we can begin to see that across an entire portfolio the risk associated with a single security is significantly washed out. Consequently, we should focus less on stability and more on value.

Not all risks are created equal

Credit worthiness:

For many small-cap REITs, it is simply not worth the cost to get rated by the appropriate credit agencies. While these companies are sometimes categorized alongside those with poor credit ratings the clear difference is that these small-cap REITs could, in fact, be highly credit worthy. Investors who can accurately estimate the stability of one of these companies independently becomes part of a much smaller pool of investors who can viably purchase such stocks. In this smaller pool, the great deals stick around longer without masses of investors to immediately consume them. While unrated small-cap REITs may add perceived risk to a portfolio, the investor capable of choosing the right ones is at a great advantage.

Long-term vs. short-term:

REITs operating under the triple net lease model will often sign long-term leases with tenants. This is usually seen as a way of locking in a spread at very low risk, but it too carries the burdens of chance. With such long contracts, even tenants with high credit ratings can have trouble guaranteeing payments. Seemingly strong companies like the now-defunct Borders Books and Best Buy (NYSE:BBY) can go from being the most reliable tenants to struggling, when events (in this case, the economy and mostly the Internet as competition) undermine their businesses.

Hotel companies, such as Ashford and MHI Hospitality, are on the other extreme of contract duration. With "leases" that last only a night or two, hotels are perpetually facing the possibility of vacancy, but also enjoy the upside of being able to jack up rents during times of high demand. Large events which draw travel to the area can drive massive amounts of profit over a single weekend.

With this in mind, the differences between high credit rated triple net lease REITs and small unrated REITs may not be as large as we had thought. Each carries a set of risk and reward that, overall, averages to approximately the same profitability. For some comparisons the risk profiles will be astronomically different, but I urge you to compare the risk company by company using their inner-workings rather than the categorical generalizations.

Building a risk adjusted portfolio

Many investment portfolios are doubled up on risk protection with both strong diversification and exclusive use of steady stocks. With sufficient diversification, through both sector and performance in each stage of the economic cycle, the exclusion of companies with poor credit or unrated credit is unnecessary. Similarly, we can open our portfolios to the possibility of companies with less predictable income or shorter contracts. A broader spectrum of possible securities affords shifting emphasis toward value and creates more opportunities for micromanagement as disparities arise. We will now examine the previously mentioned higher risk stocks in greater detail.

Ticker

Recent market price

Yield%

Price/est. FFO

Price/book

AHT

$8.36

5.39%

5.2

0.62

MDH

$3.85

3.22%

6

1.21

Ashford Hospitality Trust

Most hotel REITs operate under fairly similar models, but AHT has a few characteristics that set it apart from the pack: Management, value, and use of leverage.

Ashford uses an affiliate, Remington, to manage its hotels rather than a franchisee. Historically, the hotels managed by Remington have outperformed, so it has given AHT the ability to glean higher cashflows on the same assets. Additionally, the strange precognition of Monty Bennett has given rise to numerous accretive transactions. During the crash of 2008, AHT used its superior liquidity to repurchase a significant amount of both common and preferred shares at extremely low prices. Since then, it has reissued shares at peak market times to essentially net the difference.

Over the past 12 months, AHT has delivered total returns of -19.4% against a market that produced a 16.7% average amongst equity REITs. This underperformance of the stock coinciding with strong performance of the company is the root of its astronomically low FFO multiple. Trading at only 62% of its book value, AHT is a clear value.

While other companies strictly adhere to targeted debt to equity ratios, AHT takes a more dynamic approach in which it adapts to the current and expected market environments. In the past three company presentations, AHT went into detail about the cyclical nature of RevPAR (revenue per available room), and how they perceive that we are only in the early stages of the upward part of the cycle. In preparation for this, AHT has been intentionally taking on leverage to take full advantage of the boom. Similarly, we can expect AHT to significantly delever as RevPAR approaches its peak. Herein lies the risk and reward. If Ashford can correctly predict the cycle, its extra assets from the leverage will slingshot it into exceptional returns, but if there is a large crash before AHT gets chance to lower its leverage, it could be in a rough spot. Given the long history of cyclicality and a year over year increase in RevPAR of 8.2% as of 7/28/12, we can say that it is probable that AHT will perform very well. If purchased as a small portion of a portfolio, the risk is minimized, and we can enjoy the increased average potential returns.

MHI Hospitality Corporation

MDH got hit very hard by the recession and its stock price fell accordingly. It became a value, however, when the company's recovery outpaced the stock's recovery. Its largest problem was debt both in amount and rate, but it has made tremendous progress in reducing this. Some of its costly preferred was paid down, and multiple new mortgages with a weighted average interest rate of around 4.5% have been obtained to reduce its overall cost of debt to 6.07% as of the 2Q earnings conference call.

This stock's risk profile, much like AHT's, is largely dependent on the economy and RevPAR maintaining or improving. A crash could halt the remaining portion of MDH's debt restructuring, but between an upcoming surge in demand for its Tampa hotel due to the Republican convention and the current trends in RevPAR, it seems MDH is well positioned to become very stable. A few more quarters of strong performance would create an amplifying effect in which the debt restructuring could be completed and the increased cashflows may spur further dividend bumps.

Of course, the risk profiles for either company are not as dichotomous as I have described them, but the general idea is that barring a crash, these companies are positioned for exceptional returns. Risk is ubiquitous: Banks can fail, stocks can depreciate. There is no such thing as an entirely safe investment. Even an uninvested portfolio can lose value to inflation. In a world with risk lurking around every corner, embrace it, and outperform the market.

Disclaimer: 2nd Market Capital and its affiliated accounts are long MDH and AHT. This article is for informational purposes only. It is not a recommendation to buy or sell any security, and is strictly the opinion of the writer.

Source: Embrace Risk With Ashford Hospitality And MHI Hospitality