Hotel Industry Booming, But REITs Didn't Get The Memo

Apr. 09, 2018 2:11 PM ETCHH, DRH, H, HLT, HST, INN, IYR, LHO, MAR, PEB, PK, RHP, RLJ, SHO, SPY, STAY, VNQ20 Comments

Summary

  • Defying the headwinds of supply growth, 2017 was a stellar year for the hotel industry. Revenue Per Available Room rose 3% and annual average occupancy reached a new record high.
  • Leading economic indicators suggest that 2018 may be even better for the industry, highlighted by improving corporate demand. Meanwhile, international tourism remains one of the most compelling secular growth stories.
  • Supply growth continues to hang over the sector and is most acute in the business travel segments and urban markets. REITs hold a disproportionate amount of hotels in this segment.
  • Hotel ownership remains a tough business. While hotel operators are up 40% over the past year, hotel REITs are flat. As supply growth cools, REITs may finally join the rally.
  • Despite commanding a higher valuation than every hotel REITs combined, Airbnb’s impact on the industry remains relatively modest. The dynamics of the broader online travel industry, however, profoundly impact hotels.

REIT Rankings: Hotels

In our REIT Rankings series, we analyze one of the 15 real estate 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.

REIT Rankings Hotels

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 6% of the REIT indexes (VNQ and IYR). Within the Hoya Capital Hotel REIT Index, we track nine of the largest hotel REITs within the sector, which account for roughly $40 billion in market value: DiamondRock (DRH), Host Hotels (HST), LaSalle (LHO), Park Hotels (PK), Pebblebrook (PEB), RLJ Lodging (RLJ), Sunstone (SHO), Summit (INN), and Ryman (RHP).

hotel REITs

For real estate investors who are accustomed to simple business models, the hotel industry is an outlier. Generally, the companies that are ubiquitous with the hotel business - Marriott (MAR), Hilton (HLT), Hyatt (H), Choice (CHH), and Extended Stay (STAY) - don't actually own hotels but simply manage the hotel for the property owners. These hotel operators are typically structured as c-corporations and tend to operate in an asset-light model with higher margins and lower leverage.

hotel operators

Hotel REITs, on the other hand, operate with an asset-heavy model by owning the assets, collecting the revenue, and paying a set percentage to the management company. Hotel REITs tend to be less nimble and have slower growth rates than c-corp hotel operators, but have historically paid a sizable dividend yield to investors. Simplistically, hotel operators are the growth side of the business, while asset owning REITs are the income side.

Hotels are typically grouped into segments based upon average room rates: budget, economy, midscale, upscale, and luxury. We simplify these categories into high, average, and low quality. Above, we show the size and quality focus of the nine hotel REITs we track. In general, public REITs portfolios tend to be biased towards the higher-quality end of the spectrum and own primarily full-service hotels in coastal urban markets or resorts. More than the average hotel, these REITs generally cater more to transient business travelers and group bookings.

Bull and Bear Thesis For Hotel REITs

Tourism is one of the largest and fastest growing sectors of the global economy. Fueled by the rise of the global "middle class," tens of millions of new consumers each year are entering the global tourism market. According to Deloitte, international arrivals in the US surged to 76 million in 2017, up from 55 million in 1997, and 2018 is expected to be another record-breaking year. Total global travel is expected to grow 5% this year, supported by a 6% rise in corporate travel. US hotel demand grew nearly 3% in 2017, and occupancy reached another record high at nearly 66%. Over the past decade, middle-income consumers have allocated an increasing percentage of their disposable income towards experiences rather than goods. Below, we outline the five reasons to be bullish on the hotel REIT sector in 2018.

bull thesis hotel REITs

Hotel ownership is a tough business, however. Despite trading at persistent discounts to the REIT averages, hotel REITs have underperformed the broader REIT index (and their C-Corp counterparts) over most recent measurement periods. At just 25-30%, Hotel REITs operate at the lowest EBIT margins across the real estate sector, which averages 65%. These REITs have had some success in recent years controlling rising labor costs, property taxes, and other expenses. As a percent of NOI, hotels also have the highest capex requirements in the real estate space at 30%, well above the sector average of 15%. Below, we outline the five reasons to be bearish on hotel REITs in 2018.

bear thesis hotel REITs

Recent Performance

Despite a highly favorable economic and secular backdrop, hotel REITs barely beat the REIT benchmark in 2017, finishing the year essentially flat compared to a 20% rise in the S&P 500 (SPY) and an 85% rise in Marriott, the largest hotel operator.

hotel REIT 2017 performance

2018 hasn't been too kind to hotel REITs, either. Whether it is fundamentally justified or not, the entire REIT sector has traded as a de-facto bond proxy since the passage of tax reform last December. Even hotels, the least interest-rate-sensitive sector, are not immune from the broader REIT weakness. Hotel REITs have dipped 5% so far in 2018, slightly outperforming the 9% decline in the broader REIT index.

Meanwhile, hotel operators have surged nearly 90% over the past two years, led by Marriott and Hilton. As discussed above, hotel operators have outperformed hotel REITs over nearly every long-term measurement period. Historically, the profitability and efficiency profiles of the asset-light hotel operators have been vastly superior to that of asset-heavy hotel owning REITs.

Quarterly Results

Boosted by a stellar fourth quarter, 2017 was another strong year for the hotel industry. As we projected in our report "Hurricanes May Revitalize Stumbling Hotels," storm-related demand help to push annual average occupancy and RevPAR to new record-highs, topping the levels set in 2016. National hotel performance has been strong over the past several years, driven by solid leisure and individual "transient" business demand, which has risen nearly 40% since 2007. Group bookings, which account for as much as one-third of revenue at these REITs, have been flat over this time. For the year, RevPAR rose an estimated 3.0%, accelerating from the 2.0% growth last year.

hotel REvPar occupancy

While the good times continue to roll for the average hotel operator, hotel REITs continue to underperform the national trends. 4Q17 earnings were generally stronger than expected as eight of the ten REITs exceeded consensus FFO estimates. Most REITs, however, provided cautious guidance for 2018. Consistent with the prevailing trends of 2016 and 2017, high-quality urban markets (in which REITs are concentrated) underperformed the national averages as supply growth continues to impair fundamentals.

REIT hotels quarterly performance

In the fourth quarter, occupancy rose an average of 1.5% across the REIT space while Average Daily Rates (ADR) rose 1.0%. Together, these metrics combined to raise Revenue Per Available Room by 2.6% over 4Q16. While the quarter was the strongest of the year for REITs, the 2.6% RevPAR growth still came up significantly short of the 3.9% national average. EBITDA margins remain stubbornly below 30% for hotel owners compared to the 52% margins for operators.

RevPar hotels

Hotel Fundamentals

At more than 1.2 billion room-nights sold in the US representing 2.7% growth over last year, 2017 set a new record for hotel demand. Supply growth, too, set a new record-high at more than 1.8 billion room-nights available representing a 1.8% rise over 2016.

hotel supply and demand

While the new supply pipeline essentially shut down after the recession, it has roared back in recent years. Supply growth has averaged 2% over the past couple years, but as much as 6% in the urban markets in which most REITs operate.

hotel supply demand

As supply growth has caught up with demand growth, the favorable imbalance has been erased, dragging down RevPAR. Supply and demand are expected to be balanced over the next three years. With a balanced outlook, and with demand expected to be in the 2-3% range, it is reasonable to expect 2-3% growth in RevPAR through 2019.

hotel fundamentals

Over the past several years, supply growth has been most acute in the middle and upper-quality segments, the segments most commonly owned by hotel REITs. These quality segments continue to underperform the national averages, and as a result, hotel REIT performance has lagged the industry-wide performance. Strong demand in these segments has been able to keep RevPAR in positive territory, but barely. Supply growth has been low in the resort and ultra-luxury segment and nearly non-existent in the economy segment, where demand growth has also been sluggish.

2018 Outlook

With supply growth peaking in 2018 and tailing off into 2019 and 2020, performance in 2018 will be largely dictated by the demand-side of the equation. Hotel demand can be forecast using several leading and coincident economic indicators, including GDP growth, corporate profits, wage growth, employment growth in the leisure and hospitality sectors, and airline/ vehicle miles. These indicators suggest that hotel demand should continue to be robust in 2018, growing 2-4%.

hotel demand

There is considerable optimism within the hotel industry that the tax reform package will materially increase hotel demand, particularly in the business and group travel segments. The plan cuts corporate tax rates from 35% to 21%, equating to a roughly $1 trillion tax cut to US corporations. As REITs are most exposed to the business and group travel segment, we see this as an opportunity for REITs to "catch-up" with the broader industry.

An Oxford Economics report quantified the expected impact of the tax reform plan. Oxford Economics sees a 1.4% boost to hotel demand RevPAR in 2018, followed by a 0.3% rise in 2019, and then gradually tailing-off into 2022. With supply growth peaking in 2018, a resurgence in demand would again create favorable supply/demand conditions and lift RevPar higher by 2% per year over the next five years.

We view hotels as the real estate sector that stands to gain the most from the tax cut and as an effective hedge against the downside risks related to the tax cut. We believe that the downside risk is that the economy enters a period of "overheating" characterized by rising inflation and higher interest rates. Hotel leases are the shortest in the real estate sector (1-2 days per lease) and would serve as a hedge to the potential for rising inflation. As we'll discuss shortly, hotel REITs are the least interest rate sensitive real estate sector.

Valuation of Hotel REITs

Relative to other REIT sectors, hotel REITs are among the cheapest based on current and forward free cash flow (aka AFFO, FAD, CAD) multiples. When we factor in two-year growth expectations, however, the sector appears less attractive. Expected to grow FCF at just 3% over the next two years, hotel REITs are the slowest growing REIT sector, well below the REIT average of 6%. That being said, the growth rate for these REITs is highly leveraged to economic growth, so upward surprises to GDP could result in far stronger growth rates than our base-case expectations.

hotel REIT valuation

Across the sector, all nine names appear cheap based on free cash flows but expensive based on FCFG.

Sensitivities to Equities and Interest Rates

As a sector, Hotel REITs are Growth REITs and are the single most equity-like REIT sectors. Hotel REITs actually exhibit a negative correlation to changes in interest rates, a rarity among income-oriented investments.

We separate REITs into three categories: Yield REITs, Growth REITs, and Hybrid REITs.

growth REITs

All nine REITs in the sector are classified as Growth REITs and should be used by investors seeking REIT exposure that is leveraged to a growing economy and exhibits low interest-rate sensitivity.

hotel REITs Dividend Yield and Payout Ratio

Unlike most Growth REITs, however, many hotel REITs pay healthy dividend yields. Based on dividend yield, hotel REITs rank in the upper-end of the REIT universe, paying an average yield of 4.2%. Hotel REITs pay out just 73% 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 nine 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. It should be noted that, on the most recent earnings call, LaSalle announced that it is considering a 50% cut in its dividend by the end of 2018.

hotel REIT dividend

Bottom Line: Hotel Industry Booming, REITs Left Behind

Defying the headwinds of supply growth, 2017 was a stellar year for the hotel industry. Revenue Per Available Room rose 3%, and annual average occupancy reached a new record high. Leading economic indicators suggest that 2018 may be even better for the industry, led by improving corporate demand. Meanwhile, international tourism remains one of the most compelling secular growth stories.

Supply growth continues to hang over the sector and is most acute in the business travel segments and urban markets. REITs hold a disproportionate amount of hotels in this segment. Hotel ownership remains a tough business. While hotel operators are up 40% over the past year, hotel REITs are flat. As supply growth cools, REITs may finally join the rally. Despite commanding a higher valuation than all hotel REITs combined, Airbnb's impact on the industry remains relatively modest. The dynamics of the broader online travel industry, however, profoundly impact hotels.

Hotel REITs have unique investment characteristics that may be attractive to many investors. First, despite their high dividend 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 Ranking. 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.

hotel REIT rankingsWe currently view Host Hotels as the most attractive name in the sector followed by Sunstone and Summit. To see where hotel REITs fit into a diversified real estate portfolio, be sure to check out our full REIT Rankings series: Office, Healthcare, Industrial, Single Family Rental, Cell Tower, Apartment, Net Lease, Data Center, Mall, Manufactured Housing, Student Housing, and Storage sectors.

Please add your comments if you have additional insight or opinions. 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.

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