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Hotel REITs: Opportunity Is Still There

In a period of just two months, we have experienced the end of the longest bull market and a severe bear market followed by yet another bull market.

I think it is safe to assume that almost nobody expected such a roller coaster going into 2020. Before the outbreak of COVID-19, the consensus indicated for an elevated risk of having a notable economic slowdown either at the end of 2020 or beginning 2021. Plus, there was this notion of recency bias that many prominent analysts kept referring to in order to make a case for relatively minor stock market drawdown in case of some shock in the economy. The idea was that the consensus is falsely assigning too high probability for such a severe event as in GFC because we people tend to associate some things (e.g. the nature of bear market) with our most recent experiences/memories.

Well, we all know what happened...

In March, COVID-19 caused a global pandemonium. VIX, a proxy of the market's vol, just exploded sinking almost all major indices.

In the chart above, we can see that almost all equities have responded in a synchronized manner - both to the downside as well as to the upside.

However, there are two important deviations which are worth highlighting:

  • Large cap, technology, and growth stocks have showcased the strongest downside resistance and have already reached a positive return level on a YTD basis.
  • Small cap, lower quality, and real estate have experienced a completely different pattern. When the overall fear was peaking, the price drop was way larger than for other names (e.g., QQQ). The recovery phase has not been as pronounced either.

Now, we all are familiar with the famous quote from Warren Buffet:

Be fearful when others are greedy and greedy when others are fearful

So, if we put our contrarian investor hats on, real estate is one of the first candidates for profitable bets. This is a perfect opportunity to finally look at ourselves and answer whether we have the guts to actually be a contrarian or all the talks during the bull run were just a theoretical exercise.

Now, as you know, Vanguard Real Estate ETF (VNQ), which tracks the overall real estate market, consists of many sectors. There are sectors, which have already recovered and/or exhibit modest volatility since the COVID-19. Data centers, warehouses, and some constituents in the specialty sector have performed relatively well.

Nevertheless, there are some sectors, which have lagged behind and thus, per definition, offer still a chance for a huge upside. According to NAREIT April data, hotel REITs were the worst-performing asset class (even worse than for malls) - losing on average 60% of the market cap.


In the chart above, you can see how the share price (including dividends) of the two largest hotel REITs - Host Hotels & Resorts (HST) and Apple Hospitality REIT (APLE) - have moved since the beginning of the year. 50% decline...

Similarly, there is reflected share price development of two smallest hotel REITs - Ashford Hospitality Trust (AHT) and Sotherly Hotels (SOHO). Here, the total return decline has reached ca. 75% on a YTD basis.

To introduce another important aspect, have a look at the table below:

The key takeaway here is that the more leveraged the company is (i.e. high debt ratio), the more severe decline it has experienced.

All this makes sense that (a) smaller cap REITs have exhibited relatively higher declines; (b) more indebted REITs have significantly underperformed peers with healthier balance sheets; and (c) hotel REITs, in general, have been taken to the woodshed. The last point becomes quite understandable in the context of the following facts (which I outlined in my most recent article on Sunstone Hotel Investors):

Shock to travel (including hotel) industry 9 times worse than 9/11. Eight out of 10 hotel rooms were empty in April. 2020 is projected to be the worst year ever for hotel occupancy rates - worst than in 1933. Around 70% of hotel employees have been laid off or furloughed so far.

So, to get an exposure to potentially very attractive returns that would be driven by some mean reversion or the economy returning back to a state of normalcy, you have to pick hotel REITs with relatively small market cap and high leverage.

However, to respect the risk side of the equation and limit the probability of suffering permanent capital losses, there are three critical prerequisites to consider before initiating a position here.

  1. Liquidity. Important to understand how many months or quarters a company can survive such periods as late March, April - without taping new credit lines, selling assets, or diluting equity. Debt maturity profile is also a vital part of the overall liquidity assessment. For instance, if there are significant amounts of debt maturing in the near term, and the company is already breaching the existing loan covenants, the probability is quite high that either new debt will cost a lot more or in the worst case, there will not be any subscribers to the necessary re-financing amount.
  2. Operating leverage. Determining the level of fixed and variable costs as well as the degree of how the cost structure has historically responded to the rate of change in the top-line allows one to arrive at the expected cash burn figure. During these times, when hotels face drastically depressed occupancy rates, significant pricing headwinds, and elevated financing costs, the underlying going-concern becomes questioned. Looking at the operating leverage, one should also get the necessary break-even point in which the company can fully offset the costs with its top-line. The lower the cash burn figure and break-even point, the higher probability for a relatively quick and notable rebound in the market cap.
  3. The consequences of deferred expenses. Since late March, almost all hotel REITs have suspended their capex programs and some of them have paused distributions to the preferred stockholders. Here, one has to assess the potential effects on the ensuing quality of the properties and services and the pent-up costs, which should be covered first before making any distributions to the shareholders (e.g., cumulative preferred stocks, yearly maintenance, renovations, etc.).

All these three items above are critical to understand. You have to be really on top of them and factor into your expectations when making bets on hotel REITs now. This will help you avoid a permanent loss to your capital via e.g. massive equity dilution and permanently subdued performance due to significantly deteriorated competitive advantage.

Finally, here you can have a look at how this approach looks like in practice.

  1. Ashford Hospitality: Headed For Bankruptcy. Hotel REIT with clear insolvency around the corner.
  2. Sunstone Hotel Investors: Immediate 25% Upside With Relative Alpha Ahead. Hotel REIT with low equity dilution risk and strong upside potential.

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