Hotel REITs: Winter’s Coming | Seeking Alpha

REIT Rankings: Hotels

(Hoya Capital Real Estate, Co-Produced with Brad Thomas)

Hotel REIT Sector Overview

Hotel REITs – along with the global leisure and tourism industry – have been decimated by the coronavirus pandemic, plunging more than 50% this year as “no vacancy” has quickly become “no occupancy.” Following a record year of occupancy and revenues in 2019, the hotel REITs recorded a mind-blowing 90% plunge in RevPar (“Revenue Per Available Room”) by mid-2020, forcing every hotel REIT to slash its dividend this year as the sector faces an ongoing existential crisis. Within the Hoya Capital Hotel REIT Index, we track the 18 largest hotel REITs, which account for roughly $25 billion in market value.

hotel REITs

Hotel REITs ultimately remain at the mercy of the coronavirus pandemic, which forced roughly half of hotels in the U.S. to temporarily close during the peak of the lockdown in April, though the majority of hotel properties have since opened – generally with reduced capacity. Hotel ownership is a tough, capital-intensive business even in the best of times, and hotel REITs tend to be “overweight” in the most affected segment of the lodging industry: corporate travel, group bookings, and international tourism. Demand from these segments is closely correlated with domestic air travel, which has exhibited a slow recovery from its lows in April according to TSA Checkpoint data. Airline travel bottomed in early April at just 4% of its prior-year levels but has rebounded to roughly 35% of “normal” by late September.

tsa travel data 2020

While leisure demand should bounce back relatively quickly when the pandemic subsides, business and group demand may take up to a half-decade or longer to fully recover. In terms of occupancy, suburban-focused and leisure-oriented properties have outperformed urban hotels that cater more towards the more affected business-oriented segments, resulting in significant underperformance by hotel REITs relative to the national averages. According to data from STR, hotel occupancy bottomed out at just 24.5% in April but has recovered to 48.6% in the week ending September 19th and has held onto recent gains despite the seasonal headwinds. Room rates, however, remain lower by 29% from last year, amounting to a total revenue per available room (RevPAR) decline of a whopping 51.6%.

hotel occupancy 2020

Hotel REITs are the single-most economically sensitive REIT sectors, and as we’ll expand on throughout this report, we view hotel REITs as a more “pure play” on the success of a coronavirus vaccine than even the pharmaceuticals themselves. A rebound in economic activity since April, led by resilient strength in the critical U.S. housing sector, has stabilized the macroeconomic outlook, but a significant “second-wave” of the pandemic and resulting economic lockdowns would be likely catastrophic for equity holders. Below, we present a framework for analyzing each property sector based on its direct exposure to the anticipated COVID-19 effects, as well as its general sensitivity to a potential recession. We note that hotel REITs fall into the “High” category in both direct COVID-19 sensitivity as well as general economic sensitivity.

covid sensitivity

Needless to say, hotel REIT earnings season was rather brutal with sharp declines in occupancy and RevPAR reported across the board, but interim updates over the last several months have painted a slightly less grim picture. Occupancy averaged just 16% in Q2 with the Upscale/Resort-focused REITs reporting just 5% occupancy rates, on average, as the majority of these hotels were temporarily closed. RevPAR dipped nearly 90% in 2Q20 from the prior year while average daily room rates (“ADR”) are lower by about 30%. Consistent with the national trends, occupancy rates have improved about 20-25 percentage-points from the pandemic lows, and hotel REITs have closed the underperformance gap over the last two months. Apple Hospitality (APLE), which owns a suburban-focused limited-service hotel portfolio, reported in recent weeks that the firm was again “cash flow positive.”

lodging REITs

Hotel REITs were a favorite of yield-hungry investors for much of the past half-decade, but it’s tough to pay dividends if hotels are sitting empty. Generally speaking, 40-50% occupancy is needed to “keep the lights on” for hotel REITs. Access to capital – aided by emergency stimulus programs by the federal government and Federal Reserve – has helped equity holders avoid an outright catastrophe, at least for the time being. Nevertheless, the pandemic has forced every hotel REIT to slash its dividend in an effort to stay afloat. We have now tracked 64 equity REITs – primarily in the economically-sensitive retail and lodging REIT sectors – out of our universe of 170 that have now announced a cut or suspension of their common dividend.

reit dividend cuts

Before the outset of the pandemic, the national hotel industry was actually performing quite well with record-high occupancy and revenues last year, particularly in the mid-tier and economy segments of the market following more than 100 consecutive months of job growth, a record-long economic expansion at the time. Hotel REITs, however, had lagged the broader industry due to their focus on upper-tier markets that have been pressured by oversupply issues in recent years. It won’t get any easier in the months – or years – ahead, as industry forecasters expect a roughly 55% decline in RevPAR this year, driven by a 40% decline in average occupancy and a 20% decline in average room rates, with a full recovery not expected until at least 2024.

hotel industry performance 2020

As if the coronavirus pandemic wasn’t a big enough concern, these headwinds have been magnified by the sky-high leverage levels of many of these hotel REITs. As of the end of August, 13 of the 18 REITs operate at Debt Ratios above 60%, according to NAREIT, while 6 hotel REITs operate at levels over 80%, prompting questions about several of these REITs’ ability to continue to operate as a “going concern” including Ashford Hospitality (AHT) which remains engulfed in an increasingly ugly battle between equity holders and its external manager, Ashford Inc. (AINC). As we’ve highlighted in various other reports, including “REITs: This Time Was Different,” while most commercial equity REITs entered the COVID-19 crisis on a solid footing following a decade of conservative decision-making and prudent balance sheet management, a handful of the small-cap hotel REITs were an exception to the rule.

hotel REIT balance sheets

Hotel REITs Slammed Amid Pandemic

Hotel REITs are now the second-worst performing property sector in 2020 behind only the regional mall sector, declining by 50.6% so far in 2020, compared to the 18.6% decline on the broad-based Equity REIT ETF (VNQ) and the 3.8% gain on the SPDR S&P 500 Trust ETF (SPY). Glimmers of hope began to emerge in late summer amid signs that the worst of the coronavirus pandemic was finally behind us, but choppiness has emerged over the last month, fueled by concerns over the reimposition of lockdown measures in the U.K. amid an uptick in coronavirus cases in many European countries and dwindling expectations of a new round of fiscal stimulus.

hotel REITs

There haven’t been many places to hide within the sector, as all eighteen REITs are lower by at least 39% this year. The larger and more well-capitalized REITs, including Apple Hospitality, Host Hotels (HST), and Sunstone Hotels (SHO), have been spared the worst of the declines faced by the small-cap and higher-levered names, including the aforementioned Ashford Hospitality, as well as Condor Hospitality (CDOR), Southerly Hotel (SOHO), and Braemar Hotels & Resorts (BHR). Despite another record year for the hotel industry in 2019, hotel REITs significantly lagged the broader REIT averages last year as well, delivering a total return of 15.7% compared to a 28.7% total return on the NAREIT All Equity REIT Index.

hotel REITs 2020 1

While normally a relative “safe haven” for investors during drawdowns, investors using the “preferred route” haven’t fared much better in 2020. Nine of the eighteen REITs offer preferred securities. Three of the nine REITs have suspended their preferred distribution: Ashford (AHT.PF, AHT.PG, AHT.PH, AHT.PI), and Sotherly (SOHOO, SOHOB, SOHON), and Hersha (HT.PC, HT.PD, HT.PE). Besides the convertible issue from RLJ, all of the issues are standard cumulative redeemable preferred securities, so all missed payouts must be paid to preferred stockholders before any common dividends are paid. On average, hotel REIT preferreds are lower by 43% in 2020, the second-worst performer behind mall REITs.

hotel REIT preferreds bonds

Our partners at iREIT on Alpha recently published a deep-dive in the preferred issues of Hersha Hospitality in Rising From The Ashes, concluding that the rebound in occupancy rates and high degree of insider ownership bode well for the prospects of a preferred dividend resumption in the relatively near future. With the preferred trading at a deep discount to par value, the iREIT team concluded that the roughly 11.5% current yield presents an attractive speculative opportunity.

Deeper Dive: Hotel REIT Fundamentals

One of the largest and most important economic sectors, the leisure and hospitality industry employed 16.8 million Americans before the pandemic but had temporarily shed 40% of these workers in April, before recovering about half of these job losses in May and June and now stands at 12 million workers. There are roughly 5 million hotel rooms across 50,000 individual hotel properties in the United States, and the hotel ownership business is a highly fragmented industry, with hotel REITs owning less than 5% of all hotels across the United States. The companies that are ubiquitous with the hotel business – Marriott International (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.

hotel REIT overview

In contrast to these hotel operators, hotel REITs operate under a relatively asset-heavy model and operate at considerably lower margins. We estimate that during “normal” times, hotel REITs operate at adjusted NOI margins of just 10-20%, the lowest in the REIT sector. Because of this operating profile, they 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 dividend yield to investors.hotel REIT operating

Perhaps the only silver lining of the pandemic, the hotel development pipeline is finally showing signs of cooling after a half-decade of above-trend growth, and if the past recession is any indication, developers will be slow to resume activity even after the dust settles. The new supply pipeline essentially shut down after the recession, but it roared back in recent years, driven by a record 100-plus months of positive RevPAR growth from March 2010 through late 2018. Over the past several years, supply growth was most acute in the middle- and upper-quality segments, the segments most commonly owned by hotel REITs. Supply growth has been low in the resort and ultra-luxury segment and nearly non-existent in the economy segment, which have been two of the outperforming categories over the past several years.

hotel construction spending

Hotel REIT Valuations

Hotel REITs may be a case of “you get what you pay for.” As they have for much of the past half-decade, hotel REITs screen as one of the “cheapest” sectors, trading at persistent discounts to the broader REIT average based on consensus forward FFO (“Funds From Operations”) multiples. With significant downward revisions in FFO estimates, hotel REITs currently screen as only marginally cheap relative to other REIT sectors. With a highly uncertain outlook, particularly if we indeed face a “second wave” of the coronavirus pandemic in the colder months, value-seeking investors should be wary of equating recent price declines with true “value.”

hotel REIT valuations

Despite the nearly 50% decline in equity value, hotel REITs continue to trade at roughly the same Net Asset Value (“NAV”) discount that they have for much of the past half-decade due to the concurrent decline in private market values. Using publicly-available transaction data and Green Street Advisors’ Commercial Property Price Index, we estimate that private market hotel values have declined by roughly 15-30% over the past year with the declines more significant in the urban-focused markets. Symptomatic of this decline in property value, Sunstone permanently closed a 44-story hotel in midtown Manhattan, writing down the value of the flagship Hilton hotel to $61 million, less than the $77 million outstanding mortgage on the property.

commercial real estate values

Hotel REIT Dividends

Once one of the highest-yielding REIT sectors, all eighteen hotel REITs slashed their dividends, and the sector is now in the basement of the yield tables. In our recent report, “The REIT Paradox: Cheap REITs Stay Cheap,” we discussed our study that “more expensive” REITs with lower leverage profiles have historically produced better total returns, on average, than their higher-yielding and higher-leveraged counterparts.

hotel REIT dividendsService Properties (SVC), RLJ Lodging (RLJ), and Pebblebrook (PEB) continue to pay a nominal $0.01 quarterly dividend. While many of the 64 equity REITs that suspended or reduced their dividend since the start of the pandemic may resume payouts by the end of 2020, we believe that hotel REITs will be among the last to reinstate distributions. On that point, iREIT on Alpha recently interviewed Chatham Lodging’s (CLDT) CEO Jeffrey Fisher, who discussed the priority of reducing leverage before reinstating the dividend, which will think may take up to 2-3 years for the more highly-levered lodging REITs, assuming industry trends progress as expected.

hotel REIT dividends

Key Takeaway: Hotel REITs: A Pure-Play on Vaccine?

“No vacancy” becomes “no occupancy.” Hotel REITs – along with the global leisure and tourism industry – have been decimated by the coronavirus pandemic, plunging more than 50% this year. Following a record year for the industry in 2019, hotels REITs reported occupancy rates below 20% in Q2. Occupancy has recovered to roughly 45% by late summer, but winter is coming and a “second wave” of the pandemic could be the death knell for several highly-levered REITs. Perhaps a more “pure play” on the success of a vaccine than even the pharmaceuticals themselves, the balance of risks for the better-capitalized hotel REITs may be skewed to the upside, however, with dozens of vaccines and therapeutics in the pipeline led by Moderna (MRNA), Pfizer (PFE) and BioNTech (BNTX) and AstraZeneca (AZN).

vaccine pipeline 2020

Every hotel REIT slashed its dividend since the start of the pandemic in a dividend cut bloodbath not seen before in the REIT sector. While leisure demand should bounce back relatively quickly when the pandemic subsides, business and group demand may take up to a half-decade or longer to fully recover. In general, we continue to see better opportunities elsewhere in the REIT sector – particularly in the “essential” sectors, including technology, housing, and industrial REITs where valuations remain attractive and where the long-term outlook is relatively unaffected by the course of the pandemic.

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Disclosure: I am/we are long HST, PKB, SHO, HOMZ. 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.

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