Pebblebrook Hotel Trust: Market Has It All Wrong, 35% Upside For This REIT

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About: Pebblebrook Hotel Trust (PEB), Includes: H
by: Michael Boyd
Summary

Pebblebrook's equity value has tanked as the growth story fizzled, and the company booked impairment charges on asset sales.

The sell-off is overdone, and the company is priced well below private market valuations of its assets.

Management agrees the hotel market appears toppy, and is committed to selling off non-core properties to reduce debt and realize book value gains.

Thus far, management has concentrated on selling weaker assets first. The market is applying these weaker valuations across the entire portfolio.

Asset sales are only half done. Expect the next round to include several properties that are sold substantially above GAAP book value.

Pebblebrook Hotel Trust (NYSE:PEB) is a company that was designed to have a finite life, and appears to have just started its slow decline into old age. Founded late in 2009 to acquire distressed hotel assets in major coastal metros, the apparent timing of the company's deal-making borders on prescient, given we now have the benefit of hindsight. Chairman and CEO Jon Bortz, who left LaSalle Hotel Properties (NYSE:LHO) after 11 years at the helm to start this venture, clearly has an eye and an appetite for this type of activity.

From 2010 to 2015, Pebblebrook acquired 37 properties, with purchase activity slowing as the economy stabilized itself and deals becoming harder to come by. Management's eye turned towards property improvement instead of acquisitions to drive return on capital, implementing various efficiencies at a property level, such as right-sizing staff, implementing best practices when it comes to product sourcing, and refurbishing rooms and rehabbing on-site hotel services like restaurants, clubs, and bars.

The market seemingly took offense to the slowing growth story despite results that largely met expectations, along with a 35% increase in the distribution. Management has reacted swiftly, putting into place a plan to take advantage of the disconnect between its own valuation of assets ($38-42/share) and the stock price ($29.75/share). Management notes this represents a cap rate of 6.8%, which it believes is low to the true value of the property portfolio. I can see where the market is coming from in practice; 6.5-7.0% cap rates are the norm for valuations within the domestic hotel and lodging industry. However, those rates are not the norm for Northeastern and West Coast major metropolitan markets like Philadelphia, Atlanta, Seattle, and San Francisco. The three most recent asset sales (excluding the Manhattan JV sale) are very supportive of that case (pricing in millions):

Redbury LA and DoubleTree Bethesda did not see the EBITDA growth that other properties have seen since acquisition, and the Viceroy Miami represented a speculative buy in Florida for management that it doesn't view as integral to the portfolio it wants to build as a long-term hold. Pebblebrook spent $138M acquiring these properties, but received $156M in proceeds as a result (while also benefiting from mortgage amortization). Notably, these properties did not receive much in the way of capital investment (unlike the West Coast properties). Beyond that, these were underperforming or weak properties for Pebblebrook, so the multiples received here are telling. On the Q3 2016 conference call, CEO Jon Bortz stated quite assuredly that Pebblebrook had no other properties where fair market value was below acquisition cost plus investment. The recent impairment charges are therefore quite unlikely to be repeated.

Not mentioned in the sales data above, the impact of the Manhattan Collection asset exchange, joint venture dissolution, and sale of the Manhattan NYC hotel are less clear given the complicated structure of the deals, but realized cap rates are strong nonetheless (4.1% blended). Overall, I'm pleased to see the company reduce a lot of exposure to the New York City market. Several large players (Hyatt (NYSE:H) and the sale of Andaz 5th Avenue as a recent example) are starting to trim stakes here as well, given solid increases in new hotel supply, coupled with lighter business travel traffic as New York begins to lose some of its appeal. The sale here is representative of management's ability to recognize when it has made a misstep in making a long-term investment and should step away and reallocate capital. Expect continued focus on the Western United States, where city regulations limit the potential for outsized growth in available hotel capacity.

The Game Plan

Overall, management feels hotel fundamentals are positive through next year, but more downside risk is present than upside opportunity. Supply growth has not been as robust as management has expected, which has allowed occupancy rates to reach an all-time high.

Management has targeted $500M to $1B of asset sales (~$463M complete after the NYC asset sale closes), with the company marketing additional assets currently. To play the speculation game, expect the Westin Colonnade Coral Gables to be on the chopping block, which is the weakest remaining asset on the company's book. A sale here would cement the company's move out of the Florida market, and the timing couldn't be better given the completion of $17.5M in renovations this year. $80M appears to be an appropriate price. Another potential sale target (especially given the company's coastal focus) is the Grand Hotel Minneapolis to be put up for sale, which was one of its first purchases, and a strong success story. Acquired for just $33M in 2010, the property will easily fetch $70M in an asset sale to the right buyer.

What will management do with this capital? Sales proceeds are targeted towards being used to pay down debt, issue special cash dividends to shareholders from taxable gains on asset sales, and repurchasing stock (management threw "up to $150M" out there as a potential number). While Pebblebrook does have some debt coming due in 2017, this is all mortgage debt that should be easy to refinance at attractive rates if management wishes. Historically, it has paid down mortgages as they have come due rather than refinancing (InterContinental Buckhead Atlanta, Skamania Lodge, etc.), but capital could be deployed towards the term loans as well.

Valuation

Pebblebrook has historically traded between 14x and 16x Property EBITDA, which is generally in line with private market net asset valuations, and realized gains on sales (Viceroy Miami sold at 17.7x, Redbury LA 15.5x, with DoubleTree Bethesda selling at 11.6x, an outlier given the suburban market exposure).

The company now trades at just 11x its forecasts for 2016 same-property EBITDA. The net asset value case is a strong one by itself, particularly given investor appetite, particularly from foreign buyers, is quite strong. Bolstering the case, management believes it can drive same-property EBITDA incrementally higher over the next few years, namely by increasing RevPAR, squeezing out incremental margin expansion, but most substantially by capturing value from its redevelopment and capital investment projects, many of which were started recently and are just now starting to add value.

I really like the story here. Most investor opinion continues to focus on this as a growth story gone awry; a company that saw share price gains simply from lucky timing on acquisitions, rather than skilled management. Sure, there are headwinds here, as Pebblebrook deals with declining business and international visitor traffic at the same time as many view the hotel market as overheated. But that is more than priced in.

If this was trading over net asset value, I would tell you to stay away - but it isn't. There is substantial upside here, and management is committed to creating value in the best ways it can, including via shareholder returns. The spike in short interest that occurred in 2016 (now 20% of float short) seems misplaced at current prices, which is confirmed by strong buying moves by real estate-focused 13-F filers, including Cohen & Steers which built a 10M share stake (14% ownership) between June and September of this year in some of its real estate funds.

Fair market value here on the common equity is $40/share, or 35% upside, with the potential for incremental increases if management delivers on its promised EBITDA growth initiatives. While the preferreds are fine if you are keen on playing it safe, I think you lose out on some substantial upside taking that route. Expect strong realized pricing (and reports of healthy demand by buyers) on asset dispositions to help the market shift its viewpoint and push the stock higher into 2017.

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Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in PEB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.