Factors That Make An Attractive Hotel REIT

By on May 5, 2014

Hotels are everywhere these days. Not only are they prominent in city centre and fringes, they can also be found in quieter local neighbourhoods as well. This is hardly surprising as the hotel business is one of the most profitable operations around when you do it right.

Operating costs are not highly volatile. While room availability is like a running tap. It will run no matter what. Any additional guest is additional cash since the costs will remain more or less the same.

It is then no wonder why hotels are very attractive propositions to investors. But buying and taking over one is not as easy as switching on the television. So experts came up with the idea of packing them into Real Estate Investment Trusts (REITs). This makes hotel investments within the reach of almost every individual with money to spare. Even better, all you need to do to be an owner of a $500m hotel is get on one of those online stocks trading platforms and click a few attention grabbing buttons from a list of REITs.

But surely there are winners and losers with every type for investment trust. Even treasury bonds can be considered risky when there are better returns elsewhere which are just as safe. What would make a good hotel REIT?

Asset quality

Just like the fundamentals of any REIT, a good hotel-focused on needs to have high quality assets in it’s portfolio. This does not mean that only big brands or prime locations will make the cut. When we talk about investments, we think about numbers that make sense instead of words that come with bragging rights.

An industry performance metric that is commonly used to measure the earnings strength of such assets is the revenue per available room (RevPAR). It is “calculated by dividing a hotel’s total guestroom revenue by the room count and the number of days in the period being measured” – Wikipedia. Remember that even though the most luxurious hotels tend to command the best rates, they don’t necessarily have the best RevPAR because a low occupancy rate can pull down this metric.

Because the hospitality industry is very much a seasonal or cyclical business, how much a hotel is able to combat earnings volatility and manage it’s earnings as consistent as possible throughout the year can reveal how attractive it is to other players and investors.

This means that even if a REIT has a huge branded hotel in it’s portfolio, it can look like a lemon if the asset is too correlated to economic performance movements. Booms will mean record profits and crashes will mean bust. Not very attractive for long term investors.

high quality hotelMaster lessee

Because managing a hotel is a world apart from managing retail malls and residences, hotel REITs are managed by experienced hotel operators. They are also referred to as the master lessee. This puts the operator in direct control of the destiny of the REIT. With this in mind, the quality of the master lessee is a critical factor. Even cruise ships owned by MNCs can get into troubled waters when the Captain is incompetent.

The attention given to avoiding mismatches in communication will then be of utmost importance.

Leverage

Since a high portion of profits are required by regulations to be distributed to investors, it will always be a challenge for hotel REITs to manage cash flow even for just working capital. A lot of that money will come from debt. This makes leverage and gearing ratios a particular concern for investors who have a liking for numbers.

The thing with leverage is that different parties can have very extreme opinions on what is best. One may feel that an investment should be geared to the maximum for peak returns. While another might feel that it is too dangerous to be highly leveraged. But in view that REITs are meant to be less risky, a low comfortable level of debt is best.

Calculated acquisitions

The corner stone for growth in any fund is acquisitions. Acquisitions create much more buzz in the market than record earnings announcements. This is not surprising as the market is more emotionally charged than pragmatically.

With this in mind, REIT managers might always be on the lookout for acquisition opportunities to appease owners and to make a name for himself. Given the risk-adverse nature of REITs, acquisitions must be meticulously scrutinized so that it does not stray from the initial goals of the trust.

Buying a highly-prices upscale hotel is not necessarily overpaying when the investment can be quickly recouped in a booming market. And buying a cheaper hotel chain is not necessarily finding good value when it would take ages just to get back the initial capital outlay.

Capital expenditure (CAPEX)

The big drawback of hotels is that they have to constantly innovate to draw the crowd. Innovation comes in the form of aesthetic improvements, enhance decorations, upgrade technologies that pamper guest, etc. It will feel weird to enter a quality hotel in December without seeing Christmas decorations on the building exterior and interior.

These capital expenditure will have to come from retained profits or from borrowing more debt. How these financial requirements are met can greatly determine the performance of the assets.



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