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The hotel REIT sector as a whole is drastically undervalued relative to other REITs. The sector trades at an FFO multiple of 11.7, as compared to the SNL Equity REIT Index, which on average, trades at a multiple of 15.1. What may have caused such a discount?

Factors Adversely Affecting Hotel REITs:

· Government spending on travel has been reduced, including a reduction in per-diem rates.

· Washington DC hotels have lost business due to an inactive Congress/lobbyist activity.

· Reduced travel from Europe has significantly hurt East Coast hotels.

· Hurricane Sandy has shut down travel, and may cause property damage to the region's hotels.

With each piece of news dropping on the market, investors' confidence was shaken, and as a result, the stocks have underperformed the broader REIT market. This discounting, however, is perhaps unjustified, as the sector indicators are continually showing strong reports.

Positive Factors:

1) RevPAR growth

In regard to the week ended October 20, Smith Travel Resarch reported: "In year-over-year comparisons, occupancy rose 1.9 percent to 67.3 percent, average daily rate was up 4.2 percent to $110.13 and revenue per available room increased 6.2 percent to $74.16."

This week was not an isolated incident. Equally strong reports have been coming out nearly every week for months. Industry fundamentals (point #2) suggest RevPAR will continue to rise.

2) Industry Fundamentals are promising

Demand growth is projected to outpace supply growth through 2015.

(click image to enlarge)

This supports further increases in RevPAR. More importantly, it allows for aggressive pursuit of ADR increases, which have a greater benefit to hotel EBITDA margins than do increases in occupancy.

3) Hotel values are rising

HVS (a major hotel appraiser) suggests that hotels will continue to grow in value through 2016 (referenced here). If this holds true, it will help these companies to naturally delever over time.

Why the positive sector indicators entirely outweigh the adverse factors

Most of these adverse factors (hurricane, lack of Congress/lobbyist activity, and loss of European travel) are micro in scale in the sense that only certain locations are affected. In contrast, the positive sector indicators bode well for hotels in the entirety of the U.S. Furthermore, RevPAR is an aggregate revenue statistic that factors in the events which have already occurred. Even including the losses associated with the aforementioned difficulties, revenue growth is materially and continuously positive. Hotel companies are clearly a great value, and it would be wise for investors to consider gaining some exposure.

Company (ticker)

Market Capitalization $

Price/ est. FFO

Price/Book value

Annual Dividend Yield %

Ashford Hospitality Trust (NYSE:AHT)

$586mm

5.9

0.64

5.12

Chatham Lodging (NYSE:CLDT)

$177mm

9.6

0.84

6.21%

Chesapeake Lodging (NYSE:CHSP)

$600mm

12.6

1.17

4.65%

Diamond Rock Hospitality (NYSE:DRH)

$1.63B

12.0

0.97

3.78%

FelCor Lodging Trust (NYSE:FCH)

$541mm

17.2

11.70

0.00%

Hersha Hospitality (NYSE:HT)

$913mm

12.2

1.12

5.06%

Hospitality Properties Trust (NYSE:HPT)

$2.84B

7.5

1.21

8.15%

Host Hotels & Resort (NYSE:HST)

$10.51B

13.8

1.55

2.16%

LaSalle Hotel (NYSE:LHO)

$2.07B

11.7

1.26

3.31%

MHI Hospitality corp. (MDH)

$37mm

n/a

1.20

3.26%

Pebblebrook Hotel (NYSE:PEB)

$1.28B

18.5

0.99

2.23%

RLJ Lodging Trust (NYSE:RLJ)

$1.87B

10.5

1.05

3.71%

Strategic Hotels (NYSE:BEE)

$1.12B

20

2.45

0.00%

Summit Hotel Properties (NYSE:INN)

$261mm

11.3

0.98

5.47%

Sunstone Hotel (NYSE:SHO)

$1.34B

10.1

1.19

0.00%

Supertel Hospitality (NASDAQ:SPPR)

$22mm

8.7

0.51

0.00%

As we can see, some of these stocks are massively discounted relative to a sector that is discounted to the broader REIT market. Specifically, the four companies trading at a price/FFO under 10: Ashford Hospitality Trust (AHT), Chatham Lodging (CLDT), Hospitality Properties Trust (HPT), and Supertel Hospitality (SPPR).

Ashford Hospitality Trust

Ashford Hospitality focuses on upper-upscale hotels in prominent locations. It recently purchased an entire portfolio of hotels (the Highland portfolio) and is currently finishing up renovations that were done to upgrade these hotels to the upper-upscale quality. Expect to see revenues increase significantly as this large portion of its portfolio opens up for business.

Ashford is differentiated from the other hotel REITS by its intentional use of high leverage. Montgomery Bennett, CEO, is extremely optimistic about the upside the hotel industry is heading into, and he personally owns a large portion of the company. He asserts that the use of leverage will propel Ashford to exceptional growth and set it ahead of the curve. If you would like more information, please reference this article I wrote, which focuses on Ashford in detail.

Chatham Lodging

Chatham's portfolio of hotels has a very interesting story, which explains how it has been able to get such a strong footing despite being rather new. Jeff Fisher founded Innkeepers USA Trust, which he took public in 1994. It grew nicely to an enterprise value of $1.5B, at which point it got bought out by Apollo Investment Corp. (NASDAQ:AINV) in 2007. Or course this was the peak of the market before the crash, so the debt associated with the transaction sent Apollo into bankruptcy. Consequently, Jeff Fisher was able to use his new company, Chatham Lodging, to buy many of the same properties back at deep discounts. It acquired five independently, and the rest through a JV with Cerberus Capital Management. In all, the properties, which were originally sold for $1.5B, were almost entirely repurchased for just over $1B.

This process set Chatham up with the strong position it maintains today, with low leverage and the highest operating margin in the hotel REIT business. The downside of Chatham is its fairly high cost of debt at a weighted average of 5.8%, and the fact that nearly all of it comes due at once in 2016.

Hospitality Properties

At a price to FFO of 7.5 and a whopping 8.15% dividend, Hospitality Properties looks very tempting, but be careful of this value trap. It is run by RMR, the management team that took down CommonWealth (CWH). This team repeatedly makes decisions that indicate a preference for fee collection over what is best for the company. For additional reasons why I advise staying away from HPT, please reference this article by fellow SeekingAlpha contributor Hype Zero, or my previous focus piece on CWH.

Supertel

Supertel Hospitality has an entirely different exposure to the hotel industry. It has small properties with an emphasis on road travel rather than air. It was hurt simultaneously by the economic downturn and the higher gas prices, both of which discouraged this sort of travel. Supertel was on the verge of bankruptcy, but Inversiones y Representaciones Sociedad Anonima (NYSE:IRS) bailed it out with the negotiated purchase of a newly issued convertible preferred. Usually, when a company is struggling, it will be forced into very unfavorable terms, but Inversiones took a different approach, obtaining a large controlling share of the company.

Today, Supertel has stabilized and is even beginning to make acquisitions again. At a market price of only 51% of book value, Supertel is an excellent way to gain exposure to the other side of the hotel REIT business. The high-rise, big-city hotels may be more glamorous, but Supertel fills a niche with excellent potential for profit.

These companies have not yet released their third quarter results, so we may see some increased activity as these reports roll in

Company

3Q Release Date

When

AHT

October 31st

After Market Close

CLDT

November 6th

After Market Close

HPT

November 6th

Before Market Opens

SPPR

November 6th

Unannounced time

Some hotel companies have reported, however, and we can use their reports for insight.

Hyatt Hotels Corporation (NYSE:H), a non-REIT hotelier, released its 3Q earnings this morning (October 31). It showed strong growth in both EBITDA and RevPAR, with increases of 14.1% and 4.6%, respectively, as compared to the prior year's third quarter. Perhaps this is not quite representative of our focus companies, as its international portfolio is more extensive. Instead, we can look at Hyatt's managed and franchised hotels in the North American portion of its portfolio, which showed RevPAR increases of 4.2% among full service and 6.0% for select service. These numbers are mostly expected based on the RevPAR growth we have seen these past few months, but it is the composition of the growth that I find particularly important. In the full service portion, ADR rose 4.9% while occupancy decreased 1%, and for select service, ADR increased 5.5% with occupancy up 0.4%. The improved RevPAR came overwhelmingly from ADR, which drastically improves operating margins. It is this ability to charge higher prices that will launch hotel companies into a period of flourishing.

Host Hotels & Resort (HST) released its third quarter earnings on the 10/10/12 with similar results. AFFO increased 31.3%, driven by RevPAR increases of 7.6% as compared to 3Q11. Once again, its gains were primarily the result of rising ADR, as elaborated on in this excerpt from its Press Release:

The increase in comparable hotel RevPAR was primarily driven by improvements in average room rates coupled with continued occupancy growth. For the third quarter and year-to-date, average room rates improved 4.7% and 3.9%, respectively, while occupancy improved 2.1 percentage points to 78.4% and 2.0 percentage points to 75.4%, respectively. The improvements in revenues led to strong margin growth as comparable hotel adjusted operating profit margins increased 285 basis points and 170 basis points for the third quarter and year-to-date 2012, respectively.

I feel the results from HST, the largest domestic hotel REIT, foreshadow what we will see from Ashford, Chatham, and Hospitality. Supertel is a very different story due to the nature of its hotels, so unfortunately, we do not have evidence to help predict its 3Q.

In conclusion, the hotels sector represents a great value, as its market prices have been battered down by a series of hardships, which the companies have largely overcome. The sector's greatest values are Ashford or Supertel, and the lower leveraged, safer alternative which still has solid return potential is Chatham.

2nd Market Capital and its affiliated accounts are long AHT, HT, and SPPR. 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: Hotel REITs Look Promising With Strong Industry Fundamentals