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Lodging REITs Positioned For Upside Through 2016

|Includes: BX, DRH, FelCor Lodging Trust (FCH), HT, LHO, MAR, RHP, SHO

TWST: If you would, please start with a quick snapshot of your coverage universe.

Mr. Bhalla: I cover a total of 17 companies including nine lodging REITs. My focus is really on the lodging sector here. By way of background, I came to Wall Street from the industry. I used to work for Host Hotels & Resorts (NYSE:HST), which is the largest hotel REIT in the world, before I came to FBR, and I have a master's from Cornell Hotel School. So I have a lodging background, and that's why I do what I do right now.

TWST: What's your overall sentiment and outlook on the lodging REIT space right now and why?

Mr. Bhalla: I think the space is very well-positioned for the next several years of growth. At least for the next two to three years, as far as one has some visibility, the space and the stocks should continue to grind higher, barring any exogenous macroeconomic events. There are a couple of reasons for that. One is, lodging at the end of the day is tied to economic growth. If you believe the projections that are put out by noted economists right now, the thought process is that there is some acceleration in economic growth coming in 2014 and even more so in 2015, and beyond that some economists are calling for peak employment in 2016. So that represents good three years of runway ahead of us, which is a very positive backdrop for the lodging industry and relates well to the demand growth for hotels.

The other signpost we always look for is supply growth or new room construction growth. What we've always found is, at least in the last three cycles spanning 20 to 30 years, we have had supply growth starting to ramp up midcycle, and peak at a point where the demand growth starts to fall off. Taking a closer look at the cycle that we are currently in, we've had three years of successive RevPAR growth, or revenue growth per room, and we haven't really seen any material ramp up in supply growth.

Fortunately we have a lot of visibility when it comes to new hotel construction growth looking out, and when you look out for the next three years, it's still quite benign. It's about 1% in 2013, a little over 1% in 2014, and in 2015 it starts to get closer to 2%, and I would imagine that you really start to see new construction growth come in line with demand growth in the industry sometime in 2016. So we can see that far out, at least right now, and unless there is an issue from an economic standpoint, like something happens where there is an exogenous event and we start to see the economic growth taper off, there's really no reason in our industry for the fundamentals to deteriorate. That's a very good environment for lodging REITs overall.

The other positive is that when you look at industry occupancies in the lodging sector, they are at peak levels we experienced in the last up cycle. So we're already pretty much there in terms of occupancies, now the rates have to catch up, and that's really good. When you start to increase rates and when more of your RevPAR is coming from rates rather than higher occupancies, that's great for margin expansion. Given that lodging REITs typically have very high fixed costs, when you have incremental positive dollars or growth in your rates, that helps your margins a lot more than if you're just a manager of hotels. So that's another reason why I'm positive on the REITs.

And finally, when you think about the multiples in the space, I think we're at midcycle multiples here, and I wouldn't call them overly expensive at this point in time. I think they reflect the uncertainties and the cautious environment that we're in, but they also reflect the multiyear growth that I think investors in the space are looking forward to.

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