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Hotel REITs are a deeply cyclical sector. In economic upswings, profits are great, but in downswings, occupancy, room rates, and RevPar all suffer greatly. This sensitivity is a result of the industry's short "lease" structure. Unlike retail, commercial or residential where leases span years, hotel leases are counted in days and therefore, must be constantly "renewed."

The positive effect of short leases is that hotels are an excellent inflation hedge. Average daily rate (ADR) can easily be adjusted and is highly correlated with inflation. In fact, over the past 20 years, annual nominal ADR growth rate has been around 3.5%, while annual CPI was roughly 3.1% (Source: 2010 Smith Travel Research, Inc., U.S. Bureau of Labor Statistics).

The negative effect is that if the economy goes south, visitors do not renew, and that makes hotel stock prices particularly sensitive to economic concerns. Therefore, when doom and gloom are predicted, hotels have often been an effective way to short the economy. An example of this occurring is the third quarter of 2011.

Leading into the second half of 2011, hotels were poised to continue a strong recovery. June 2011's RevPar at $68.90 was the highest since August 2008, driven by a 3.5% increase in ADR and a 4.2% increase in occupancy from June. This healthy growth was occurring despite an anemic first half year GDP growth of less than 1%.

But concerns about the economy tipped the market into a significant retraction, with the S&P 500 sliding 17.95% between July 1 and October 3, 2011. The bad news in July and August 2011 was wide ranging -- from the debt ceiling crisis, to the U.S. credit rating downgrade, to the increasing likelihood of countries like Italy joining the ranks of Greece and Portugal. Stocks were hit hard, REITs were hit even harder, sliding 21.23%, and hotels were hit almost twice as hard, falling 38.12%.

Hotel REITs are hit extra hard in times of economic concern because of the immediate affects a slow economy can have on this sector. Here's a sample of what REIT professionals were saying in 2011 about the dive:

What's happened is that during the late summer [of 2011] when we had so much turbulence in the equity markets and in the financial markets in general, primarily because of what was happening in Europe, but also what was happening with the U.S. congress, there was a great deal of concern about where the economy was headed and a lot of that spilled over into lodging because everyone knows how sensitive we are to how the overall economy performs.

- Ed Walter, President and CEO of Host Hotels and Resorts

There's been a huge disconnect between Wall Street and Main Street when it comes to hotel REITs

- Ken Cruse, President of Sunstone Hotel Investors

Commenting on how he did not think the drop in hotel stock prices had much to with hotel fundamentals, "It was just overall global markets, the impact of the European recession, and there was a broader pullback in the market," [Jay Shah] says. "I think hotels and real estate stocks took it may be worse than others because they are financials and highly volatile."

- Jay Shah, CEO of Hersha Hospitality Trust

The hotel's sector sensitivity to economic news has, in turn, made hotels more volatile. In the first half of 2012, the highs are higher, and lows are lower:

(click images to enlarge)

Hotels could not recover in 2011 after the extra severe slide in July and August:

This volatility has contributed to Hotel REITs either being a big leader or big loser over the past six years:

While the hotel sector has led the nosedive in dividends over the past four years:

Outlook

Fundamentals for hotels look great. Through August 2012 RevPAR is projected to grow by 7.2% for the year. The lack of near-term supply should help the industry continue to raise rates, with ADR predicted to grow by 4.6%, while hotel demand is surpassing its pre-recession peak. Construction of new hotels has historically grown at an average of approximately 2% per year, but growth has been less than 1% over each of the past two years, and that rate is expected to continue.

But as we saw in the third quarter of 2011, rosy fundamentals will only support hotel stocks to a point, so I may shift my "hold" to a "sell" in this sector within the next 60 days if we begin to see new cracks in the economy or the beginning of a market correction. I believe we are entering a particularly high risk three- to four-month period. Some of my concerns are: (1) a S&P 500 negative third quarter earnings season after 11 consecutive quarters of gains; (2) an unemployment surge after the recent, possibly too good to be true, drop to 7.8% -- the largest move since 1983; (3) an unresolved fiscal cliff; (4) a return of European debt crisis headlines; and (5) a post-election market slide. These are concerns that all market participants must be cognizant of -- and deserved or not -- that often have an amplified effect on hotel REIT stocks.

Preferred Alternative

An alternative to owning hotel REITs outright is to purchase preferreds. Preferreds have historically yielded between 6.3 and 9%, but most rates have recently dropped to a 5.6 to 6.5% range as investors' appetites for REITs grow.

There are solid hotel REITs with preferreds that have significantly higher yields. I like Chesapeake Lodging Trust's new preferred (CHSP-PA), with a coupon rate of 7.75%. CHSP is profitable with a healthy cash flow -- the most important factor to consider when purchasing preferreds. The trust's holdings consist of 14 upper-upscale hotels (a sector less prone to market swings). Additionally, the trust has a promising outlook, and has recently experienced significant insider buying. You can read more about CHSP here, here, here, and here.

Note: Most hotel stocks are particularly sensitive to economic concerns, but I focused on hotel REITs and their performance because of my interest in REIT investment management.

Source: Hotel REITs: Particularly Sensitive To Economic Concerns