An investment with a view

Hotel stocks are rebounding nicely.

Matt Biddulph/Flickr

Matt Biddulph/Flickr

If there was any one sector to avoid during the recession it was hotel companies. The hospitality industry in America in particular saw revenues take a nosedive as people spent their vacations at home and companies cut back travel. Occupancy rates dropped to record lows, and the industry’s key metric, revenue per available room (revPAR), took a significant hit too. What a difference a couple of years can make. Today, hotel occupancy rates are where they were pre-recession—about 65% full, versus 55% in 2009—and cash is once again rolling in.

Investors who stuck out those bad years have already been rewarded—the Bloomberg REIT hotels index is up 10.7% year-to-date—but as long as the economy continues to improve, there are still gains to be had. Compared to other real estate investment trusts, hotel REITs are “moderately cheap,” says Mark McAllister, a senior portfolio manager with ClearBridge Investments. He thinks many names will continue to see share prices rise over at least the next two or three years. “We’re in the fourth or fifth inning of this cycle, and we have at least until the eighth inning before we need to start taking things off the table,” he says.

Number of hotel rooms in the U.S.

Adding hotels to a portfolio isn’t for the faint of heart. It’s one of the REIT industry’s most economically sensitive sub-sectors. The fact that leases turn over almost daily (versus anywhere from a year to two decades for other commercial properties) makes these companies significantly riskier than, say, a business that holds office buildings. But with more risk comes more reward. If the U.S. economy keeps improving, then hotel stock prices should see above-average growth. “These are higher-beta stocks,” says Royal Sheppard, a REIT-focused equity analyst with S&P Capital IQ. “You’re playing the capital appreciation.”

Market share of economy chains

Besides a recovering economy, there are two reasons why some experts expect the sector to see higher earnings in 2013. The first comes down to supply and demand. One of the ways that hotels increase revenues is by hiking room rates. In a low-supply environment, they can bump rates up more than usual. The recession forced a number of companies to stop building new hotels, and it’s likely it will be another couple of years before many new properties open their doors. Sheppard says that new supply only increased by 0.5% in 2012 and will increase by 1% this year. That means hoteliers can increase rates without fear of new competition. Smith Travel Research, a company that tracks the hotel industry, expects U.S. room rates to rise by 4.9% in 2013.

The other plus is that the industry relearned a valuable lesson during the recession: too much debt can be deadly. Historically, hotel REITs have carried a lot of debt—more then six times debt-to-EBITDA (earnings before interest, taxes, depreciation and amortization) was common—but many have been diligently paying down that balance sheet. Lukas Hartwich, an analyst at Green Street Advisors, a real estate research firm based in Newport Beach, Calif., says that some of the better-managed operations have gotten their leverage levels down to a more manageable 4.5 times debt-to-EBITDA. He’s hoping that will fall even further. “Below three would be ideal, but no hotel REIT has yet reached that point,” he says.

Gross margin on full-service hotels

Thanks to low supply, increasing demand and more manageable debt levels, Ken Avalos, a real estate analyst with Raymond James, says that hotel earnings could grow by almost 20% in 2013.

Choosing which company to buy is a little like picking a place to stay on a trip, however. There are high-end hotels, budget properties, lodgings with conference rooms, and places with nothing but some beds and a breakfast menu. While it might be fun to splurge on a five-star hotel during a vacation, for investing purposes, the elevators may rise faster at two- and three-star properties.

Gross margin on limited-service hotels

Limited-service hotels, the industry term for lower-end properties, are a better buy because they have a lot less overhead than the luxury hotels, says McAllister. For the most part, these hotels provide a cheap place to stay and nothing else. They typically have better margins than the plusher hotels and, because revenues aren’t derived from conferences and big spenders, they’re less susceptible to economic downturns. McAllister points out that this part of the market has more supply risk—limited service hotels can be erected quickly in response to demand—but he doesn’t think we’ll see many new ones open up for a couple of years yet.

Also, buy companies with properties in urban areas. “You want to be in a market where there’s good fundamental demand drivers and at least some scarcity value to real estate,” says McAllister. High density areas have more people looking for places to stay and less space to build new hotels.

Average daily rate in New Orleans during the Super Bowl over regular rates

One key metric to pay attention to is revenue per available room. While it’s been consistently rising overall, it can vary between companies. Sheppard says to look at how a REIT’s revPAR is trending each quarter and whether it’s generating that figure from occupancy growth, room rate hikes or both. You want the number to be increasing.

Look at both enterprise value to EBITDA and funds from operation (FFO) too, says Avalos. The former ratio makes it easier to compare one REIT to another, as it accounts for differences in capital structure, while the latter is the REIT equivalent to the common price-to-earnings ratio. A lower-than-historical valuation for both metrics can signal that a company is undervalued.

As well, pay attention to a company’s debt-to-EBITDA ratio, says Hartwich. While the industry overall is paying down its debt, owning a company with four times debt-to-EBITDA is a lot better than buying one at six times. This metric is important because the sector is so economically sensitive. The lower debt a company has, the better it will be able to withstand any unexpected economic setback.

Dividend yield is a less meaningful metric in this space. Investors flock to REITs for their handsome payouts, but U.S. hotels tend to pay less than other REITs. McAllister points out that the hotel sector overall is paying around 2%, while non-hotel REITs are paying around 3.5%. While it’s nice to get something, these businesses typically use their cash to pay expenses, renovate rooms or expand. That said, McAllister does think some companies will raise their payouts as cash flows grow. But that’s just a bonus. “As a rule, this isn’t a great business model for high yields.”

This is not necessarily a sector that investors will want to stay in indefinitely. Consider a shorter-term visit. Rate increases will eventually slow, occupancy will level off and new supply will open up. If revPAR begins decreasing, then that could be signal to sell, says McAllister. Fortunately, that won’t happen for a while.

The CB Hotlist

Hospitality Properties Trust (NYSE: HPT)

P/FFO: 8.97

Yield: 6.65%

1-year total return (C$): 16.68%

This Newton, Mass.–based REIT is high risk but offers more reward, says ClearBridge’s Mark McAllister. It’s one of the few big dividend payers.

Hersha Hospitality Trust (NYSE: HT)

P/FFO: 22

Yield: 4.4%

1-year total return (C$): 5.85%

McAllister’s a fan of this Pennsylvania-based trust’s management, big exposure to New York and limited service model. Debt must come down, though.

Host Hotels & Resorts Inc. (NYSE: HST)

P/FFO: 18.38

Yield: 2.08%

1-year total return (C$): 9.12%

A Maryland-based REIT that’s done a good job of reducing debt levels. It’s also making smart acquisitions, says Green Street’s Lukas Hartwich.

Sunstone Hotel Investors Inc. (NYSE: SHO)

P/FFO: 12.84

Yield: 0%

1-year total return (C$): 29.34%

This California-based turnaround story replaced its management and is now doing things right, says Hartwich.

DiamondRock Hospitality Co. (NYSE: DRH)

P/FFO: 14.82

Yield: 3.48%

1-year total return (C$): -8.2%

This Maryland-based operation is trading at 10% discount to its NAV but isn’t much different from its peers, says Hartwich. A cheap but solid buy.