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Supertel (SPPR) has a portfolio of 95 hotels mostly located in the Midwest at prominent locations on major highways. It ran in to serious financial trouble during the recession and got bailed out by Inversiones y Representaciones Sociedad Anonima (IRS), who purchased the convertible Preferred C which gives them a strong foothold in the company. Since then, SPPR has been recovering well, reporting strong FFO in 2Q12. Many factors contributed to this recovery, but the decision I believe to be most crucial to its long-term success was a restructuring of the contracts with its hotel operators.

Like most other hotel REITS, SPPR contracts external management to operate its hotels. Unfortunately, the nature of the contracts was contributing to an excessively high cost of operations. As evidence, let us take a look at Supertel's Income Statement from its 2Q12 10-Q. As per the norm, numbers represent dollars in thousands.

Revenues

3 Mo. Ended June 30, 2012

3 Mo. Ended June 30, 2011

6 Mo. Ended June 30, 2012

6 Mo. Ended June 30, 2011

- Room rental + other services

21,562

20,433

38,243

36,703

Expenses

- Hotel Operations

15,269

14,878

28,810

28,366

- Depreciation/Amortization

2,226

2,313

4,350

4,559

- G&A

921

1,001

2,014

2,104

- Acquisition expense

162

0

162

1

- Termination cost

0

0

0

540

- Total expenses

18,578

18,192

35,336

35,570

Net Operating Income

2,984

2,241

2,907

1,133

For the 6 months ended June 30 2012 and 2011, the cost of operation of the hotels consumed 75.33% and 77.29% of revenues respectively. As compared to peers such as Ashford Hospitality (AHT) or Pebblebrook Hotel (PEB) this expense is very high (respective 10-Qs linked here and here). Many different factors could have caused the large expense ratio, but the nature of the contracts with operators certainly contributed. What was the contract and why was it bad? The details can be found in this excerpt from SPPR's 10-Q.

The hotel management agreement, as amended, between TRS Lessee and Royco Hotels, the previous manager of 95 of the Company's hotels, was terminated effective May 31, 2011. Under the agreement, Royco Hotels received a base management fee ranging from 4.25% to 3.0% of gross hotel revenues as revenues increased above thresholds that ranged from up to $75 million to over $100 million, and was entitled, if earned, to an annual incentive fee of 10% of up to the first $1.0 million of annual net operating income in excess of 10% of the Company's investment in the hotels, and 20% of the excess above $1.0 million.

Essentially, the problem was that management fees were tied to gross hotel revenue. Thus, hotel operators were incentivized to spend money for even small returns. The emphasis was on revenue at the expense of profit. SPPR terminated this contract on May 31, 2011 and replaced it with the following:

On April 21, 2011, the Company, through TRS Lessee, entered into separate management agreements with HMA, Strand and Kinseth as eligible independent operators to manage 95 of the Company's hotels (two of which were subsequently sold) commencing June 1, 2011. Each of HMA, Strand, Kinseth and Cherry Cove receives a monthly management fee with respect to the hotels they manage equal to 3.5% of the gross hotel income and 2.25% of hotel net operating income ("NOI"). NOI is equal to gross hotel income less operating expenses (exclusive of management fees, certain insurance premiums and employee bonuses, and personal and real property taxes).

These new contracts are based on income rather than revenue and create far better alignment. This improvement is evidenced by the fact that hotel operation expenses as a portion of revenues dropped to a much healthier 70.8% in 2Q12. Financial maneuvers like this show that management is taking Supertel in the right direction.

Supertel as an investment

At its current price of $1.05 Supertel trades at a price/book of 0.50 and a price/est. FFO of 8.8. It is clearly a great value, but it comes with some risk. SPPR is still fragile and an economic downturn could undo some of its progress. In my opinion, it serves as an excellent value play when bought as a small portion of a portfolio for risk tolerant investors.

Those looking for a safer play should look into its 10% Preferred B (SPPRO). While it is redeemable on 06/03/13, I suspect it will be far longer before SPPR has the financial strength to execute the redemption. In the mean-time, we can enjoy the phenomenal dividends and the security that comes with the preferred's superiority in the capital structure.

2nd Market Capital and its affiliated accounts are long SPPR, SPPRP, and SPPRO. 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: Supertel Makes Great Strides With Restructuring Of Hotel Operator's Contracts