- Lodging REITs are the most sensitive to the overall economy’s health. A decrease in tourism and travel directly has a direct effect on Hotel REITs' FFO;
- COVID-19 is spreading rapidly outside of China. After Korea, infections are increasing at a fast pace in most European countries (not only Italy).
- PEB shares look cheap on a P/FFO basis, but if occupancy starts to plunge, so will FFO.
- The elevated debt load may put Pebblebrook's operations under heavy pressure: don’t fall for the high yield and avoid the whole sector for now.
A bit of catching-up
Before start, let me remind you this is my second article about Pebblebrook Hotel Trust (NYSE:PEB) on Seeking Alpha. I already covered the company in this article last November, when I had a bearish outlook on the stock. Since then, the S&P 500 has returned 3% and PEB -25% (dividends included). I made my call based on the unfavorable macro trends I foresaw for the whole lodging sector rather than problems at the company level. Fast forward a few months, and the spread of the COVID-19 infection has been the catalyst dramatically accelerating the awaited downturn. PEB has been the worst performer within the peer group, which includes Park Hotels & Resorts (PK), Host Hotels & Resorts (HST), Hersha Hospitality Trust (HT), DiamondRock Hospitality Company (DRH), and Sunstone Hotel Investors (SHO). Still, the performance of the entire upper-upscale lodging sector has been abysmal in light of the virus spread.
On February 21, the company also released its FY2019 results. The numbers came in ahead of expectations, with beats at both revenue and FFO levels. Same-Property RevPAR for the fourth quarter increased 2.0% YOY to $196.34, thanks to an occupancy increase of 2.5% to 79.4%, although the company had to sacrifice on the rate side (0.5%) to achieve this result. The company continued managing its portfolio with one additional disposal, bringing the number of owned properties down to 56. Since the integration of the LaSalle portfolio, Pebblebrook completed a total of $1.33 billion of hotel sales, with most of the proceedings used for deleveraging. The D/EBITDA ratio at the end of December stood at 4.7 times, much higher than the more conservatively managed Host but not dissimilar from other names in the lodging space. The leverage employed on a D/EBITDA basis stood at 4.2 times for Park Hotels & Resorts and 4.4 times for Ryman Hospitality Properties (RHP).
The provided outlook for 2020, which forecasts same-property total RevPAR growth to be between -0.6% and +1.0%, was underwhelming, especially as Pebblebrook explicitly warned that the outlook excludes any adverse effect from coronavirus. The flattish revenues, when combined with a 2.2% increase in expenses, are expected to drive a considerable negative impact on the EBITDA margin for 2020.
How bad could this coronavirus get?
For those who wish to read a well-balanced, thoughtful view amid all COVID-19-related noise, legendary Bridgewater founder Ray Dalio just weighed in with his opinion, stating a few interesting things about the coronavirus epidemic. Dalio expects the virus to “provide interesting opportunities for investors” and that “markets should focus on companies with insufficient capital to weather the downturn rather than short-term revenue hits. But they are likely to do the opposite.”
Regardless of what the market will focus on, in the case of lodging REITs, investors are looking at choppy waters ahead. REITs are highly leveraged entities (with the possible exception of HST) but also among the industries widely expected to take a massive short-term revenue hit because of coronavirus. Hotels, cruises, and airlines seem the worst places to be for investors over the next months when the full-scale impact of the virus will unravel on the markets. Of course, all these sectors are also set for the most significant rebounds when the scare will subside, but it’s far too early to tell when this might happen.
In the meantime, after the cruises sector debacle, Jeffries was the first one to put out a note expecting negative earnings revisions for the hotel sector. Hyatt (H) was the first to point to decreased transient bookings and increased group cancellations in North America and Europe. Names such as Marriott International (MAR), Hilton Worldwide (HLT), and InterContinental (IHG) are likely to follow. The revisions will directly affect REITs such as Host and Park Hotels & Resorts but not PEB, whose portfolio focuses on owning independent and boutique hotels. However, I do expect the same level of disruption to hit Pebblebrook’s properties. PEB’s assets are not immune to an economic slowdown, they are located in popular destinations, and any interruption of tourism will profoundly affect demand.
To have a flavor of what will likely happen over the next few months, one shall look no further than the current news from Korea and Japan. In the case of South Korea, though overall infections in the country stand to pass 6.000 soon, as of March 5, there are only 104 recorded cases of coronavirus in the capital city Seoul. Of course, this is not a small number, but in a city of over 10 million people, the infection rate stands at a meager 0.001%. Nevertheless, high-end properties in Seoul are experiencing a terrible drop in occupancy rate. The fall is so bad that Lotte Hotels & Resorts executive board members are returning 10% of their pay to contribute mitigating the crisis. Other luxury hotels in Korea are suffering similarly, but have been reluctant to speak up about their losses. Once a super popular destination among Chinese tourists, Chinese are now fleeing Seoul en masse, to the point that a coworker of mine rushed to relocate her family back to China last week. In a healthcare crisis, priorities change quickly. People might be willing to stay in a place (potentially) less safe but that they call home, where they can find the comfort of relatives, friends and their family doctor.
The same goes for Japan. The country has hit the headlines for CV because of the Diamond Princess, but the overall infection rate is still relatively low. Yet, the country’s lodging sector is experiencing a plunge in occupancy rates, and hotels are responding the only way they can: slashing prices aggressively. Popular tourist destinations of Kyoto and Fukuoka are offering discounts of up to 25% during an ordinarily busy season, and the situation is even more desperate for business travel. In Tokyo, budget accommodations are seeing rate discounts of up to 70%. The virus is such a severe threat that officers are even considering to cancel the summer Olympics, although the event is still months from now. The country is bracing for the worst, and there is a mounting feeling that the COVID-19 may have an impact lasting well over the next couple of weeks.
The US is not immune from the COVID-19 threat
Despite what President Trump may tweet, coronavirus cases are rising steadily in the US as well. Chances that America will escape the severe impact that the virus already had on Asia and Europe are growing thinner by the hour. The Fed has already acted with a 0.5% rate cut, which had a temporary soothing effect on the markets. We will see how long that lasts, but I guess that, at the latest, the last relief rally will fizz with the upcoming earnings season, when the severe disruption impact seen in February and March will start to be digested by the markets.
Ironically, Pebblebrook has substantial exposure to California, which has just declared a state of emergency over the novel coronavirus. Out of 56 properties, over half of PEB’s portfolio is located there: 12 hotels in San Francisco, 1 in Santa Cruz, 9 in Los Angeles, and 7 in San Diego. Such exposure to California may also be part of the reason why PEB seems to be underperforming its peer group over the last few trading sessions.
Source: Pebblebrook website
Shares cheap on a P/FFO basis, but this could change
PEB currently trades at 8.5x forward FFO and a steep discount of 50% to the management-sponsored NAV of $38.25. I already contended in my previous article that NAV discount is a compelling argument, but not a sufficient reason to go long the shares. Once the market perceives a sector as embattled, even wilder discounts may show up without enticing any buying interest. Self-assessed NAV measures rely on cap rates for comparable transactions, and this type of pricing does not come without shortcomings.
During a slowdown, much fewer transactions are observed in the first place. These are, usually, fire sales that liquidity-hungry entities must push forward regardless of the cap rate to raise capital to repay debt maturities and stave off bankruptcy. Such deals tend to push cap rates higher in a fast and disorderly manner. Secondly, there is always a margin of error (and discretion) with these appraisals. Management certainly has an interest in showing investors how undervalued the company is, up until it isn’t anymore. Beauty lies in the eyes of the beholder, or in this case, of the appraiser. However, things can go south fast when fundamentals do not appear as sound anymore. The Dutch shopping-centers REIT Wereldhave (OTCPK:WRDEF) knows a thing or two about all this, having slashed its independently assessed NAV by over 25% in the last year. Such extreme haircuts are uncommon, but investors should be aware this is a possibility, especially for the REIT sub-sector with the most fickle FFO: lodging.
It is hard to hypothesize how severe the impact could be under a worst-case scenario. Still, in case Pebblebrook is to experience a decline in occupancy and RevPAR similar to what Japanese hotels are experiencing now, numbers would be hideous (we are talking about negative FFO bad-level hideous). Of course, such a tsunami wouldn’t probably last for very long, but a problem remains: even when travel picks up again, you cannot fill the same room twice in the same day to make up for what has gone lost.
Verdict: stay on the sidelines
While I would like to love Pebblebrook, the current circumstances force me to reiterate a sell recommendation on its shares. Despite my bearish stance, I believe PEB’s President and CEO Jon Bortz is one of the masterminds of this industry, and his track record demonstrates that he has the right skills to create significant shareholders’ value over the long term. Unfortunately, the timing just doesn’t look right, and I believe investors should tactically position more defensively in light of the COVID-19 ongoing threat, shying away from leisure stocks for the time being.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.