It's obvious that investor sentiment toward lodging REITs is negative. Despite solid and improving operating fundamentals, stock prices have steadily drifted lower throughout 2011. Investors are spooked by the increasingly grim global economic outlook, and they believe — with good reason — the hospitality sector is particularly vulnerable. However, industry analysts say investors have overreacted to macroeconomic concerns and that it's one of best times to invest in lodging REITs.
“We met with 23 different groups at the NYU Lodging Conference in mid-September, and no one is seeing any sign of a slowdown,” says David Loeb, a managing director covering lodging REITs for Robert W. Baird & Co. “Demand for hotels is still strong enough that there's occupancy growth, and we're at a point where occupancy is high enough that operators have some pricing power to increase room rates. Risk is already built into the stock prices, and we think investors should overweight the sector.”
Lodging stocks fall into two main categories - operators such as Marriott International (Ticker: MAR) and hotel REITs such as Host Hotels & Resorts (HST). Lodging operators tend to own very few properties and generate the bulk of their income from franchise fees and operating agreements.
Lodging REITs, in contrast, own hotel properties and generate most of their income through leases with hotel operators and franchisees. In some cases, however, lodging REITs also operate their own properties. Lodging REITs own some of the highest quality hotel assets in the world. Host Hotels, for example, owns the St. Regis Houston, along with the W New York, while Ashford Hospitality Trust (AHT) owns the Ritz-Carlton Atlanta.
Today, there are 17 publically-traded lodging REITs with a total market cap of $19.2 billion. Host Hotels & Resorts is the largest with a market cap of roughly $7.9 billion, according to SNL Financial. On the non-traded REIT side, there are two hotel-focused REITs currently raising money: Apple REIT Ten and Carey Watermark Investors. A number of other non-traded REITs invest in hotels, albeit not exclusively.
The past five years represent the worst operating environment for the lodging sector since the early 1930s. Occupancy peaked in 2006, while revenue per available room (RevPAR) and average daily rae (ADR) peaked in 2007, along with lodging REIT stocks. In fact, the Baird/STR Hotel Stock Index, which is comprised of 15 publicly traded lodging companies and hotel REITs, shed nearly 85 percent from July 5, 2007 to March 6, 2009. In contrast, the RMZ lost 65 percent and the S&P 500 lost 55 percent during the same period. The five-year total return for the SNL US REIT Hotel Index was a negative 48.19 percent — the worst performance of all REIT sectors. Year-to-date (as of Sept. 27, 2011), the index was down 32.39 percent — once again a laggard compared to other REIT sectors.
Indeed, most publicly traded lodging REITs have posted a negative total return so far this year. But the returns, as with any industry sector, are not uniform: InnSuites Hospitality Trust (IHT), for example, achieved the highest total return of 31.63 percent, and FelCor Lodging Trust (FCH) is getting punished, recording the lowest total return of a negative 60.6 percent, according to SNL Financial.
Perhaps the equities needed a little rest. Loeb points out that lodging REIT stocks nearly tripled from March 2009 to February 2011. But, from February 2011 to the present, stocks have decreased more than 30 percent. “Investors were clearly concerned that the recovery in hotel stocks happened a little too soon,” he says. “It's been a pretty spectacular sell off.”
The average dividend yield for the hotel REIT sector — 2.34 percent — is relatively unimpressive compared to those offered by other sectors. However, there are several REITs within the space that didn't pay a dividend for the last quarter, which drags down the entire sector. Most of them offer a dividend yield in the 3 percent to 4 percent range, according to SNL Financial.
Most investors view hospitality as the riskiest of all commercial real estate sectors because of its close ties with the overall economy and the short-term nature of nightly rentals versus multi-year lease agreements like those seen in retail and office properties.
While PwC's report forecasts that some people will shorten or cancel their trips during the remainder of 2011 and into 2012, the firm still expects that most leisure travel plans will remain unchanged and corporate and group travel will continue to expand. As a result, its outlook anticipates ADR gains of 3.6 percent in 2011 and 5.1 percent in 2012. Likewise, it predicts RevPAR increases of 7.5 percent this year and 6.2 percent next year.
“The economy is not in great shape, but the nature of the economic weakness has not led individuals to cut back on leisure travel or businesses to cut back on corporate travel,” Loeb contends. “Groups are booking for the next three months to a year. These are indicators that things are pretty good.”
Expecting the Worst
Although operating metrics, management commentary and supply/demand dynamics all point toward positive growth through 2012, the market is pricing hotel REIT stocks as if the world is ending. For example, current 2012 EV/EBITDA multiples for the REITs in Baird's coverage universe are trading at 11.2, essentially pricing in a 15 percent decline for the firm's 2012 EBITDA forecast. That decline corresponds to flat RevPAR growth in 2012, a scenario that Loeb finds unlikely.
“We believe it would take a substantial change in travel patterns, like the one seen following the 9/11 terrorist attacks or the sharp decline in business travel during and after the 2008 financial crisis for [RevPAR to be flat or negative],” Loeb says. “While the risks of such a change in travel patterns now appear to be higher than they seemed to be a few months ago, we still see that risk as low.”
Loeb contends that current valuations are attractive for risk-tolerant investors. “When sentiment turns positive, we believe relative outperformance could be achieved, hence our overweight recommendation of hotel stocks,” he says. “Investors willing to shoulder heightened economic risks have a buying opportunity in high-quality lodging stocks, given the potential for several years of occupancy gains.”