Hotel REITs: Airbnb's WeWork Problem

Summary

• Hotel industry performance, inexorably linked to key economic indicators like job growth and corporate profitability, has softened over the last quarter amid signs of a clear slowdown in global growth.
• Industry forecasts for the rest of 2019 have been revised meaningfully lower by all of the leading research providers. RevPAR is now expected to grow just 1% this year.
• Guidance cuts were the name of the game for Hotel REITs in 2Q with more than half the companies in our coverage lowering full-year RevPAR and FFO expectations.
• Hiding in the shadows of the recent WeWork drama has been a similar venture-capital-backed "real estate technology" company, Airbnb, which shares more than a few parallels to WeWork.
• The dire projections of Airbnb crushing the traditional hotel industry have not come to fruition and we foresee Airbnb facing similar scrutiny as WeWork if it proceeded with IPO plans.
• This idea was discussed in more depth with members of my private investing community, iREIT on Alpha. Get started today »

REIT Rankings: Hotels

In our REIT Rankings series, we introduce and update readers with each of the residential and commercial real estate sectors. We focus on sector-level fundamentals, analyzing supply and demand conditions and macroeconomic factors driving underlying performance. We update these reports quarterly with a breakdown and analysis of the most recent earnings results.

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Hotel & Lodging REIT Sector Overview

Within the Hoya Capital Hotel REIT Index, we track the 15 largest hotel REITs, which account for roughly $50 billion in market value: Host Hotels & Resorts (HST), Park Hotels & Resorts (PK), Ryman Hospitality Properties (RHP), Hospitality Properties Trust (HPT), Apple Hospitality REIT (APLE), Pebblebrook Hotel Trust (PEB), RLJ Lodging Trust (RLJ), Xenia Hotels & Resorts (XHR), Sunstone Hotel Investors (SHO), DiamondRock Hospitality Company (DRH), Summit Hotel Properties (INN), Chatham Lodging Trust (CLDT), CorePoint Lodging (CPLG), Hersha Hospitality (HT), and Ashford Hospitality Trust (AHT).

Hotel REITs comprise roughly 5% of the broad-based REIT ETFs (VNQ and IYR). In the US, there are roughly 5 million hotel rooms across 50,000 individual hotel properties. The hotel ownership business is a highly fragmented industry with hotel REITs owning less than 5% of all hotel assets across the United States. Hotel occupancy tends to peak in August and bottom in January with guests paying an average daily rate of roughly $125 per night. Properties are typically segmented into "full-service" or "select service" categories and in general, public REITs portfolios tend to be concentrated in the higher-quality end of the spectrum and own primarily full-service hotels in coastal urban markets or resorts. As a result, hotel REITs are more sensitive to transient business travel and group bookings, which represent roughly 40% of the total hotel market with leisure travel representing the remaining 60%.

Hotel REITs tend to be one of the most economically-sensitive REIT sectors and despite their sector-leading dividend yield, tend to be among the least interest-rate sensitive REIT sectors. Generally, the companies that are ubiquitous with the hotel business - Marriott (MAR), Hilton Worldwide (HLT), Hyatt Hotels (H), Choice Hotels (CHH), and Extended Stay America (STAY) - don't actually own hotels but simply manage the hotel for the property owners. Because revenue from hotel operations does not satisfy the so-called "income test" for REIT qualification, hotel REITs generally utilize these third-party management companies for all owned assets. These hotel operators are typically structured as C-corporations and tend to operate in an asset-light model with higher margins and lower leverage.

The hotel ownership is a tough, capital-intensive business. In contrast to the hotel operators, hotel REITs operate under a relatively asset-heavy model and operate at considerably lower margins. A very labor-intensive business relative to other real estate sectors, the US hotel industry employs roughly 2 million people and workers earn an average of $15 per hour and wages account for more than 50% of total hotel expenses. After accounting for the estimated 25% annual cap-ex reserve, we estimate that hotel REITs operate at adjusted NOI margins of just 10-20%, the lowest in the REIT sector. Because of this operating profile, hotel REITs assume a high degree of operating leverage and are highly sensitive to marginal changes in supply and demand conditions. Hotel REITs tend to be less nimble and have slower growth rates than C-corp hotel operators, but have historically paid a sizable and relatively predictable dividend yield to investors.

Under the typical hotel operating agreement, operators run all aspects of the hotel operations and pass the revenues and operating costs onto the owner. For that service, operators receive 3-5% of revenues plus an incentive fee of around 10% of Gross Operating Profits (GOP). Operating agreements typically last for up to 20 years with subsequent renewal options. As part of the agreement, both parties are typically held to certain standards related to profitability, minimum capital expenditures, and other operating performance metrics. Below, we define key industry-specific terminology that we use throughout this report.

RevPar	Revenue per available room (RevPAR) is a performance metric calculated by multiplying a hotel's average daily room rate (ADR) by its occupancy rate.
ADR	Average daily rate (ADR) is a metric widely used in the hotel industry to indicate the average realized room rental per day.
GOP	Comparable to NOI, Gross Operating Profit (GOP) represents hotel profits after subtracting all of their operating expenses.

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US Hotel Industry Fundamental Performance

A decade after emerging from the depths of the financial crisis, and despite calls for the demise of the hotel industry at the hands of Airbnb (AIRB) and other online travel agencies, the national hotel industry has been remarkably resilient throughout the economic recovery, although the industry prosperity has not been shared equally across all segments which we will discuss in more detail below. Before turning negative last September due to tough comparisons to 2017's Hurricane Harvey-impacted data, RevPAR rose on a year-over-year growth for 102 consecutive months dating back to 2010.

Hotel industry performance, inexorably linked to key economic indicators like job growth, consumer confidence, and corporate profitability, has softened over the last quarter amid signs of a clear slowdown in global economic growth. Since our last update in June, industry forecasts for the rest of 2019 have been revised meaningfully lower by all of the leading research providers. Notably, STR, PWC, and CBRE revised their most recent RevPar projection down to 1.6%, 1.1%, and 0.9%, respectively, each lower by 40 basis points or more from the most recent projection. For full-year 2019, occupancy is now expected to be flat (after record-highs set in 2018) while ADR is expected to rise by just 1%, which would be the lowest rate growth since the beginning of the recovery.

While demand growth continues to be strong, supply growth has heated up considerably since 2014 and continues to pressure industry fundamentals, particularly in the categories seeing the most significant supply growth, many of which the REITs have the highest degree of exposure to. After seeing moderating growth from 2015 through 2018, construction spending on hotel assets has unexpectedly picked up in recent quarters, forcing the major forecasting firms to raise the supply growth forecasts for 2019 and into 2020. The pick-up can likely be explained by the upward inflection in growth in 2018 and we expect to see more modest growth or negative growth in spending going forward given the clearly less favorable macroeconomic conditions.

While the new supply pipeline essentially shut down after the recession, it roared back in recent years and is expected to remain elevated through 2020, matching demand growth of 2% this year. Demand for hotel room-nights is conservatively projected to rise another 2% this year and 1.7% in 2020 while supply growth is expected to average around 2% per year during this time. As supply growth has caught up with demand growth, the favorable imbalance has been largely erased, dragging down RevPAR back towards inflation levels. Supply and demand are expected to be balanced over the next three years.

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 so. 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.

Hotel REIT Fundamental Performance

After a relatively strong first quarter for the hotel REIT sector in which it appeared as though the REIT sector may be finally turning the corner in a positive direction, second-quarter earnings results were quite weak across the board. Guidance cuts were the name of the game with more than half the companies in our coverage lowering full-year RevPAR and FFO expectations. On a market-cap weighted basis, the REIT sector delivered negative RevPar growth for the first time of the recovery, declining by 0.1% as a result of a 56 basis point decline in occupancy and a modest 0.4% rise in ADR. A reversal of past industry trends, the upscale segment was the relative outperformer, seeing an average 1.2% rise in RevPAR while the economy segment experienced a 1.6% decline in RevPAR.

Hotel operator performance in 2Q19 revealed similar trends of moderating growth with the upscale and midscale segments seeing the strongest relative rate of growth. On average, RevPAR rose 0.9% from the same quarter of 2018, which was roughly in line with the average in Q1. Hyatt and Hilton reported 1.4% and 1.3% growth in RevPar compared to a 0.1% decline from Choice Hotels. Occupancy was slightly higher on a year-over-year basis in the second quarter.

On the acquisition front, hotel REITs remain significant net-sellers of assets as the sector continues to grapple with steep discounts to Net Asset Value. With REIT trading close to NAV parity at the end of Q1, we expected that the sector may actually become net buyers in 2019. Weak share price performance over the last quarter, however, has reversed any positive momentum on the acquisition-front. Hotel REITs reported the most significant TTM rate of net sales on record in Q2, disposing of more than $2.6 billion in assets over the last twelve months.

Recent and Historical Hotel REIT Stock Performance

On the topic of share price performance, despite another record year for the hotel industry in 2018, hotel REITs significantly lagged the broader REIT averages last year, delivering a total return of -13% compared to a -4% return on the NAREIT All Equity REIT Index. Despite the stumble in 2018, in the post-recession period, hotel REITs have delivered strong results relative to the REIT averages, returning an average of 16% per year compared to the 13% average annual return on the REIT index through the end of 2018.

Hotel REITs have significantly lagged the broader REIT averages again in 2019. Concerns over the impact of trade tensions and slowing global growth have weighed on the sector, which has climbed 7% this year compared to the 25% gains on the broader REIT average. Hotel REITs have outpaced only the flagging mall REIT sector so far this year.

Hotel REIT YTD performance briefly dipped into negative territory earlier this month, but the 8% gains over the past month have pulled the sector out of the doghouse. Ryman Hospitality, Xenia Hotels, and Summit Hotels have been the standouts so far this year while Ashford, Hersha, and CorePoint have been the relative laggards.

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. Powered by data from the iREIT Terminal, we see that hotel REITs trade at an average AFFO multiple of just 11x, far below the 20x REIT average. Looking at historical five-year FFO growth data, we note that the hotel sector has achieved just 0.1% FFO growth over the past half-decade. Hotel REITs trade at an estimated 15-25% discount to NAV, making external growth nearly impossible.

Hotel REIT Dividend Yields

One of the most attractive investment attributes of the sector, hotel REITs pay dividend yields significantly above the broader REIT average. Hotel REITs pay an average dividend yield of 5.9%, ranking towards the upper end of the REIT universe. (Note that our REIT Average is skewed lower by our coverage universe which generally excludes externally-managed and small-cap REITs under $1B in market capitalization.) Hotel REITs pay out roughly 54% of their available cash flow based on our estimates, leaving a capital cushion for external growth or future dividend increases.

Within the sector, we note the differing payout strategies used by 15 REITs, which opens an opportunity for investors to be selective depending on their tax situation. Historical evidence suggests that taxable accounts may see a better after-tax return by investing in companies with consistently lower payout ratios. The outperformance of lower-yielding and lower-payout REITs may apply to both taxable and non-taxable accounts, however. Since the dawn of the Modern REIT Era in 1994, our research suggests that investors selecting the REITs in the lower two quadrants of dividend yields have actually outperformed the REITs in the higher two quadrants of dividend yield on a total return basis.

The Bull and Bear Case for Hotel REITs

Fueled by the rise of the global middle class, tourism is one of the largest and fastest-growing sectors of the global economy. Tens of millions of new consumers each year are entering the global tourism market, aided by historically inexpensive airfare and the rapid development of travel accommodation technology. 2018 was another record year for US hotel fundamentals with occupancy and RevPAR both hitting new record-highs. Levered to a growing economy, hotel REIT performance has historically correlated with job and income growth and is one of the few real estate sectors that has historically responded favorably to rising interest rates. Below we discuss five reasons that investors are bullish on hotel REITs.

Despite strong underlying hotel fundamentals at the national level, hotel REIT ownership is concentrated in the weakest-performing hotel segments over the past several years. The luxury-focused asset class in coastal markets has seen robust supply growth since 2015, compounded at the margins by the "shadow supply" created by home-sharing sites including Airbnb. 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 25-30%, well above the sector average of 15%. Below we outline five reasons that investors are bearish on hotel REITs.

Is Airbnb The Next WeWork?

Has any company had a worse month than WeWork (WE)? Last month, following news that "office sharing" company WeWork was planning a since-delayed IPO, we published Office REITs: WeWork's Reckoning where we argued that while we believe that co-working is a legitimate and potentially profitable business model as illustrated by the relative success of the incumbent co-working firm Regus, we have continued to question the valuation ascribed to WeWork which we believe is many multiples higher than warranted. We noted that WeWork’s upcoming IPO could be a moment of reckoning for the highly-valued but fast-growing co-working sector, whose growth has been fueled by a seemingly limitless pool of venture capital funding.

(Source: Recode)

In subsequent weeks, WeWork has seen its projected valuation slashed, its IPO delayed, and its CEO forced to step aside. Hiding in the shadows has been a similar venture-capital-backed "real estate technology" company, Airbnb, which just last week announced that it plans to delay its potentially imminent IPO. Sharing an abundance of similarities with WeWork, the home-sharing website was valued at more than $30 billion in its latest funding round earlier this year and analysts from Morningstar project that the firm may fetch a valuation as high as $65 billion in the public markets. Sound familiar?

Like WeWork and the office REIT industry, a valuation of this magnitude would value Airbnb at more than the entire hotel REIT industry combined. And like WeWork, competition from within the industry has intensified dramatically over the last few years. Early this year, Marriott announced its own home-sharing program while Expedia has ramped up its home-sharing offerings through a series of acquisitions of short-term rental startups. Also like WeWork, the home-sharing firm punches far above its weight in garnering media attention relative to its actual share of industry revenues. A recent study showed that in the 10 cities with the largest Airbnb market share in the US, the entry of Airbnb resulted in 1.3 percent fewer hotel nights booked and a 1.5 percent loss in hotel revenue. Citing increased local regulations on home-sharing and issues surrounding privacy and safety, Morgan Stanley (MS) notes that home-sharing has yet to make significant inroads into the business travel segment. The researchers estimate that home-sharing contributes a rather modest 20 basis point drag on national RevPAR.

Like WeWork, a significant percentage of incremental home "home/office sharing" demand has come from outside the traditional marketplace. In the case of Airbnb, this demand is largely replacing room-nights that were otherwise listed on private marketplaces like Craigslist for hostels and long-term vacation home rentals. Nearly a decade into the home-sharing "revolution," the impact on the traditional hotel industry remains minimal and a recent report from Morgan Stanley revealed that growth in the home-sharing business may be slowing. Data from eMarketer reveals that Airbnb user growth has slowed from over 100% growth in 2015 to less than 15% growth in 2018 and is projected to slow to a single-digit growth rate this year.

Sharing more than a few similarities to WeWork, we think the Airbnb will face similar challenges and scrutiny entering the public markets. Given comparable prices, the vast majority of business travelers continues to prefer the certainty, simplicity, and safety of a traditional hotel over an Airbnb listing and it's difficult to see that changing in the foreseeable future. While this may be true, there is no doubt that Airbnb has added supply to certain segments of the leisure and lower-priced accommodation markets and may marginally weaken hotel pricing power around busy "compression nights."

Bottom Line: Tough Fundamentals, But Decent Outlook

Hotel industry performance, inexorably linked to key economic indicators like job growth and corporate profitability, has softened over the last quarter amid signs of a clear slowdown in global growth. Industry forecasts for the rest of 2019 have been revised meaningfully lower by all of the leading research providers. RevPAR is now expected to grow just 1% this year.

Guidance cuts were the name of the game for Hotel REITs in 2Q with more than half the companies in our coverage lowering full-year RevPAR and FFO expectations. Hiding in the shadows of the recent WeWork drama has been a similar venture-capital-backed "real estate technology" company, Airbnb, which shares more than a few parallels to WeWork.

As domestic growth at Airbnb moderates, the dire projections of Airbnb crushing the traditional hotel industry have not come to fruition, and the implicit "Airbnb discount" applied to hotel REITs appears unwarranted and Hotel REITs appear attractively valued within the REIT sector. We expect construction spending on hotels to finally begin to cool in late 2019 after several years of double-digit growth. On the demand side, we continue to view the global tourism industry as a compelling secular growth with benefits that will, over time, extend to the hotel REIT sector despite the industry's near-term challenges with oversupply.

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