Remember When Airbnb Was Supposed To Kill The Hotel Business?

Summary

• From 2013-2015, the financial media wrote countless obituaries projecting the impending death of the hotel business at the hands of the sharing economy’s newest darling: Airbnb.
• At the time, Airbnb was raising capital at valuations that exceeded the market capitalization of the entire hotel REIT industry. We questioned Airbnb’s actual appeal to the mass market.
• Entering 2016, the consensus opinion on hotel REITs was overwhelmingly negative on fears of oversupply, weakening demand, and this severe threat from Airbnb.
• Over the last 52 weeks, hotel REITs have outperformed the REIT index by 20%. Q1 2017 was the best year on record for the industry and Q2 looks stronger.
• Using Google Trends data, we see that the growth of Airbnb is already decelerating. Regulation has caught up with the “illegal hotel” model of the commercial use of short-term Airbnb rentals.

REIT Rankings Overview

In our "REIT Rankings" series, we introduce and update readers to one of the thirteen REIT sectors. We rank REITs within the sectors based on both common and unique valuation metrics, presenting investors with numerous options that fit their own investing style and risk/return objectives. We update these rankings every quarter with new developments.

We encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Hotel Sector Overview

Hotel REITs comprise roughly 4% of the REIT indexes (VNQ and IYR). Within our market value-weighted hotel index, we track seven of the seventeen hotel REITs within the sector, which account for roughly $30 billion of the total $40 billion in hotel REIT market value: Ryman (RHP), DiamondRock (DRH), Host Hotels (NASDAQ:HST), LaSalle (LHO), Pebblebrook (PEB), RLJ Lodging (RLJ) and Sunstone (SHO).

Outside of our coverage, but among the top twelve largest hotel REITs, we also monitor Ashford (AHT), Apple Hospitality (APLE), Felcor (FCH), Hersha (HT) and Summit (INN).

Above we show the size, geographical focus, and quality focus of the seven hotel REITs we track. Like other REIT sectors, hotel REITs tend to have a specialized strategy focus. In general, public REITs tend to be naturally biased towards the higher-quality end of the quality spectrum and own primarily full-service hotels in coastal urban markets or resorts. Only one REIT we track, RLJ Lodging, owns primarily limited service hotels. The United States has the largest tourism industry in the world. On any given night, roughly 4.5 million Americans are staying in one of 55,000 hotel properties throughout the country. Of the five million available hotel rooms, roughly 60% of hotel stays are leisure-oriented, while 40% are business-oriented.

Hotels are typically grouped into segments based upon average room rates: budget, economy, midscale, and upscale. Alternatively, hotels can be segmented into location-oriented divisions: urban, suburban, airport, interstate, and resort or service-oriented divisions: full service, mixed service, limited service. Full-service hotels generally have restaurants, ballrooms, and fitness centers, while limited-service hotels typically provide only a room.

For real estate investors who are accustomed to simple business models, the hotel industry is a bit of an outlier and involves quite a bit of complexity. The companies that are ubiquitous with the hotel business - Marriott (NASDAQ:MAR), Hilton (NYSE:HLT), and Hyatt (NYSE:H) - generally don't actually own hotels. In October 1992, Marriott Corporation split into two parts: an asset-light hotel-management business and an asset-heavy hotel-ownership business, a model that remains the industry norm. These REITs own the assets, collect the revenue, and pay a set percentage to the management company.

As we always emphasize in our REIT Rankings, investors should be constantly aware of the supply and demand outlook for the sector. During the last cycle, hotel construction peaked at exactly the wrong time. Real construction spending on hotels doubled between 2006 and 2008, right into the eye of the recession. Construction essentially shut off in the immediate aftermath of the recession, bottoming in 2011. Supply growth as a percent of existing supply has risen from about 0% to 2% since 2012, which is roughly in line with long-term averages.

Based solely on the supply growth of traditional hotel rooms, the supply outlook looks fine. While we can no longer ignore the impact of Airbnb as a source of supply, there is reason to believe the actual supply impact is less than originally feared. We wrote an article two years ago titled "Airbnb is No Uber" where we argued that calls for the death of the traditional hotel business at the hands of Airbnb are greatly exaggerated.

We were bombarded with criticism and charged with being “behind the times” of the newest economic innovation: the sharing economy. The crux of our outlook is that, given comparable prices, the vast majority of travelers will prefer the certainty, simplicity, and safety of a traditional hotel over an Airbnb listing. It is simply a better and more evolved business model than the barter-style Airbnb.

While this may be true, there is no doubt that Airbnb has added supply to the market at a time when construction of traditional hotels has accelerated, particularly in the New York City, Miami, LA, and San Francisco markets. In our last update, we estimated that Airbnb adds about 1-2% of new supply to the market each year that directly competes with traditional hotel rooms. We are revising this outlook down to <1% of new supply per year given the newly enacted laws in New York, LA, and San Francisco that limit or expressly prohibit the “illegal hotel” model of commercial use of short-term rental of apartment units.

In January, we estimated that supply growth would average 3-4% in 2017, with 2% coming from traditional hotel construction and 1-2% coming from Airbnb. We now estimate closer to 2.5% growth in supply in 2017 and 2018.

On the demand side, we note that hotel demand generally correlates closely with nominal GDP growth. We can further isolate the drivers of hotel demand by looking at air miles, vehicle miles, and corporate profits. If we assume that economic growth in 2017 will be similar to 2016, we estimate that demand growth will increase 2-4%.

At the start of the year, we estimated that 2017 would be the first year since 2008 that supply growth exceeds demand growth. We now believe that demand growth will outpace supply growth by a slim margin. RevPar growth can be roughly estimated as the difference between demand growth and the supply/demand imbalance. 2.5% demand growth combined with a positive 0.5% supply/demand imbalance should result in RevPar of roughly 3%.

While 3% RevPar growth would be the lowest since 2009, based on current valuations, it appears that consensus expectations are for zero or even negative growth. In other words, a repeat of last year’s 3% RevPar growth performance, however modest it may seem, could be equally rewarding to the share price of hotel REITs.

Recent Developments and Performance

Hotel REITs have declined 5% YTD, slightly underperforming the REIT sector average of a 2% decline. That said, over the past 52 weeks, REITs are still higher by 10%, outperforming the REIT average by 20%.

According to a data from STR, the hotel industry saw one of the best quarters ever in Q1 2017. RevPAR was up 3.4 percent to $75.92 as occupancy was up 0.9 percent and ADR was up 2.5 percent to $124.27.

Bobby Bowers of STR noted:

“This was the strongest first quarter on record in each of the performance metrics… Supply growth for the quarter was 1.9%, which was the highest for any quarter since Q2 2010. So as demand growth becomes more moderate, occupancy will decline, placing further pressure on pricing power. At any rate, muted ADR growth will continue to push modest RevPAR growth for the foreseeable future.”

Early indications are that Q2 performance was similarly strong. Based on STR data, RevPar will be around 2.6%, better than Q2 estimates at the start of 2017. While performance has been better than expected, the 2.6% RevPar growth will be the slowest growth since 2012, down from 9.2% RevPar growth in 2014.

Pebblebrook, Ryman, and Sunstone have been the best performers so far this year. RLJ has been the worst performer as investor scrutiny has ramped up on their proposed acquisition of FelCor Hospitality Trust.

Valuation of Hotel REITs

Relative to other REIT sectors, hotel REITs are among the cheapest based on current and forward free cash flow yields. At 15x, the sector trades at a significant discount to the REIT averages. When we factor in two-year growth expectations, though, the sector appears less attractive. Expected to grow FCF at just 1% over the next two years, hotel REITs are the slowest growing REIT sector, well below the REIT average of 6%.

Across the sector, all seven names appear cheap based on free cash flows but expensive based on FCFG. Within the sector, Pebblebrook and Diamondrock are the two names that screen as attractive at these valuations.

Sensitivities to Equities and Interest Rates

Using our Beta calculations, we see that hotel REITs are the most equity-like REIT sector. The sector is the least sensitive to interest rates and most sensitive to movements in the equity markets. For more detail on these calculations, we highlighted the dynamics of bond-like and equity-like REITs in our previous articles, "Are REITs Bond Substitutes" and "REITs Without Interest Rate Risk."

Within the sector, we classify the seven names as either Yield, Growth, or Hybrid REITs based on our calculations. All seven REITs are Growth REITs, which means these REITs should be relatively immune from movements in interest rates but are more exposed to broader economic growth conditions.

Dividend Yield and Payout Ratio

Based on dividend yield, hotel REITs towards the top of the REIT universe pay an average yield of 4.0%. Hotel REITs pay out just 67% of their available cash flow, so these firms have greater potential for dividend growth than other sectors.

Within the sector, we note the differing payout strategies used by seven firms, which opens an opportunity for investors to be selective depending on their tax situation. Taxable accounts may see a better after-tax return by investing in companies with consistently lower payout ratios.

Bottom Line

From 2013-2015, the financial media wrote countless obituaries projecting the impending death of the hotel business at the hands of the sharing economy’s newest darling: Airbnb. At the time, Airbnb was raising capital at valuations that exceeded the market capitalization of all the entire hotel REIT industry. We questioned Airbnb’s actual appeal to the mass market.

Entering 2016, the consensus opinion on hotel REITs was overwhelmingly negative on fears of oversupply, weakening demand, and this severe threat from Airbnb. Over the last 52 weeks, hotel REITs have outperformed the REIT index by 20%. Q1 2017 was the best year on record for the industry and Q2 looks stronger.

While financial data on Airbnb is notoriously opaque, we used Google Trends to estimate a projected growth rate. We believe the growth of the Airbnb concept is already decelerating. We revised down our estimates for annual supply growth from Airbnb from 1-2% per year to <1% per year. It took a few years, but regulation has caught up with the “illegal hotel” model of the commercial use of Airbnb.

Hotel REITs have investment characteristics that are rather unique and may be attractive to a lot of investors. First, despite their high current yields, hotel REITs are the single least interest-rate sensitive sector. Few other high-yield investments exhibit nearly zero correlation to interest rates. Second, while the REIT sector as a whole is rather defensive, hotel REITs are highly pro-cyclical, which can add balance to a portfolio that would otherwise underperform during good economic times.

We aggregate our rankings into a single metric below, the Hoya Capital REIT Rank. We assume that the investor is seeking to maximize total return (rather than income yield) and has a medium to long-term time horizon. Valuation, growth, NAV discounts/premiums, leverage, and long-term operating performance are all considered within the ranking.

After the sharp sell-off so far this year, we view RLJ Lodging Trust as the most attractive name in the sector, followed by Host Hotels and Sunstone Hotels.

Let us know in the comments if you would like us to expand on any part of the analysis. Again, we encourage readers to follow our Seeking Alpha page (click "Follow" at the top) to continue to stay up to date on our REIT rankings, weekly recaps, and analysis on the REIT and broader real estate sector.

Be sure to check out our other sector recaps: Data Center, Manufactured Housing, Single Family Rentals, Healthcare, Industrial, Apartment, Student Housing, Net Lease, Mall, Self-Storage, Shopping Center, and Office.

Analyst’s Disclosure: I am/we are long VNQ, SHO. 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.

All of our research is for educational purpose only, always provided free of charge exclusively on Seeking Alpha. Recommendations and commentary are purely theoretical and not intended as investment advice. Information presented is believed to be factual and up-to-date, but we do not guarantee its accuracy and it should not be regarded as a complete analysis of the subjects discussed. For investment advice, consult your financial advisor.