Hotel REITs: Another Record Year For Hotel Demand

Summary

• Powered by resurgent corporate travel, hotel demand set yet another record in the first half of 2018. The hospitality sector has seen more than 100 consecutive months of RevPar growth.
• Hotel REITs finally have their time in the sun. The sector has outperformed in 2018 and delivered solid results in 2Q18.
• 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.
• Business tax reform and the accompanying economic resurgence of 2018 has led to a jump in corporate and luxury hotel demand, more than offsetting the negative impact of supply growth.
• Expectations for the sector remain muted, however. Hotel ownership remains a tough, capital intensive business. Sentiment is much improved from 2017, but valuations still appear attractive relative to other REIT sectors.

REIT Rankings: Hotels

In our REIT Rankings series, we analyze each of the major 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.

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 5-7% of the REIT indexes (VNQ and IYR). Within the Hoya Capital Hotel REIT Index, we track the fourteen largest hotel REITs, which account for roughly $55 billion in market value: DiamondRock (DRH), Host (HST), LaSalle (LHO), Park (PK), Pebblebrook (PEB), RLJ Lodging (RLJ), Sunstone (SHO), Summit (INN), Ryman (RHP), Xenia (XHR), Chesapeake (CHSP), Ashford (AHT), Apple (APLE), and Hospitality Properties (HPT).

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 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 fourteen 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.

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 longer-term 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.

Recent & Historical Performance

While hotel REITs have indeed underperformed their "C-corp" operators over most measurement periods, their performance relative to the broader REIT over the post-recession period has been more favorable. Between 2009-2017, hotel REITs delivered an average annual total return of nearly 20% compared to the 14% average return on the REIT average.

This post-recession outperformance has widened so far in 2018. The hotel sector has climbed nearly 7% this year compared to the 2% decline in the REIT average. The S&P 500 (SPY), meanwhile, has jumped 9% so far this year. As the least interest-rate-senstive REIT sector, hotels have been relatively shielded from the otherwise negative effects on REIT sectors of the 68 basis point rise in the 10 Year Treasury yield.

The top performers this year within the sector have been LaSalle, Ryman, and Chesapeake, all of which have climbed more than 20% YTD. Summit, Apple Hospitality, and Hospitality Properties have been the laggards so far this year. Over the last two years, the sector has climbed nearly 25% compared to the 10% decline in the REIT averages.

Meanwhile, hotel operators have surged more than 80% 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 superior to that of asset-heavy hotel owning REITs.

Recent Fundamental Performance

Defying the headwinds of supply growth, the hotel industry set new records yet again through the first half of 2018, gaining on a stellar 2017. Average occupancy has continued it's seeming relentless climb through the post-recession period, and RevPar has climbed on a year-over-year basis in more than 100 consecutive months. Through August, RevPar has climbed an estimated 3.4%, continuing a reaccleration after bottoming in 2016.

Hotel REITs had underperformed the national metrics in recent quarters, but resurgent demand from the business and luxury segment has begun to reverse this trend. 2Q18 earnings were generally better than expected across the sector with all but four of the fourteen REITs topping estimates. The middle-tier segment of the REIT market were the relative outperfomers, seeing robust 3.6% RevPar growth over last year and a strong 100+ basis point rise in average occupancy.

While the performance gap has closed in recent quarters, hotel operators continue to see better overall RevPar performance compared to REITs. The "C-corps" saw an average 3.7% YoY rise in RevPar, led by luxury operator Hyatt at 4.6%. The lower-tier segments, which had outperformed in the prior two years, have lagged in 2018.

On the acquisition-front, hotel REITs have remained active in the transactions markets, but net external growth has been modest in recent years amid a period of neutral to slightly unfavorable cost of capital and NAV signals. Recent strong stock performance, along with rising interest rates, has made the cost of capital for many hotel REITs more favorable relative to their private market competitors. We expect the external growth spigot to re-open in the second half of 2018 as the NAV discount has turned into a modest NAV premium.

The major news of the first half of 2018 revolved around the drama surrounding LaSalle. The LaSalle Hotels (LHO) saga appears to finally be over. Hotel REITs Pebblebrook (PEB) and LaSalle agreed to merge this week in a $5.2B deal that concludes a months-long bidding war between Blackstone (BX) and Pebblebrook. Recovering share price valuations across the hotel REIT sector helped make fellow REIT Pebblebrook’s sixth offer more attractive relative to the Blackstone offer. The combined company will own 66 hotels and have a market capitalization just shy of $7 billion. The acquisition is expected to close in December.

Deeper Dive: 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. 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.

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 2020.

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.

Last update, we discussed an Oxford Economics report quantified the expected impact of the tax reform plan on the hotel industry. While the market consensus was that the projects calling for a significant acceleration in hotel demand were far too optimistic, it now appears that these optomistic projects were not too far off.

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. As discussed in the last update, 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.

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.

All ten of the fourteen 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. The smaller REITs including Apple Hospitality, Chesapeake, and Hospitality Properties have more Yield REIT characteristics.

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 4.5%. Hotel REITs pay out 83% of their available cash flow, so these firms have more modest potential for dividend growth than other sectors.

Within the sector, we note the differing payout strategies used by fourteen 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: Another Record Year for Hotel Sector

Powered by resurgent corporate travel, hotel demand set yet another record in the first half of 2018. The hospitality sector has seen more than 100 consecutive months of RevPar growth. Hotel REITs, persistent underperformers for much of the post-recession period relative to their "C-corp" operators, have finally had their time in the sun. The sector has outperformed in 2018 and delivered solid results in 2Q18.

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. Business tax reform and the accompanying economic resurgence of 2018 has led to a jump in corporate and luxury hotel demand, more than offsetting the negative impact of supply growth.

Expectations for the sector remain muted, however. Hotel ownership remains a tough, capital intensive business. Sentiment is much improved from 2017, but valuations still appear attractive relative to other REIT sectors. To see where hotel REITs fit into a diversified real estate portfolio, be sure to check out our full REIT Rankings series: Healthcare, Net Lease, Malls, Industrial, Single Family Rentals, Data Center, Apartments, Cell Towers, Manufactured Housing, Industrial, Shopping Center, Office, Industrial, Storage, Homebuilders, and Student Housing.

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.

Disclosure: I am/we are long VNQ, HST, 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.