A gloomy landscape

Capital markets are skeptical of the lodging industry outlook

July 18, 2016

About the author

Noam Ganel, CFA is the founder of Pen&Paper, a value-oriented, contrary-minded journal of the financial markets. Between 2010 and 2020, Ganel worked for Silvergate as Vice President in Capital Markets. He provides advisory services to family offices,  private companies, and financial advisors.

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“The Company and industry are forecasting a low to mid-single digit percentage increase in revenue for 2016 compared to 2015,” notes Justin Knight, boss of Apple Hospitality REIT. “As of December 31, 2015, the Company had outstanding purchase contracts for four additional hotels, with a total gross purchase price of $81.1 million.” But the market is oblivious to the optimistic message and the buying frenzy. In past year, hotel REITS have been losing value.   

Hotel REITs have two objectives: first, to provide income through operating cash flow; second, to increase the value of its common shares. To achieve these objectives, the hotel REIT will seek to enhance return and the value of the hotels that it owns.

But the value creation is often by capital allocation and not by hotel management per se. Typically, unrelated companies, such as Driftwood Hospitality and GFManagement, manage the hotel portfolio on behalf of the Hotel REIT. Common terms between the parties include Base Management Fee between 1 to 4 percent and Incentive Management Fees between 10 to 20 percent of gross operating profit. Working Capital Provision requires the hotel REIT to fund the cost of supplies. In addition, sale of a hotel provision may limit the hotel REIT’s ability to sell or transfer the hotel unless the transferee assumes the related management agreement.

Airbnb, an online marketplace that enables people to list, find, and rent vacation homes, is just one of the behemoths the earnings of a hotel REIT faces. The cyclical nature of the lodging industry is another, notes Ridzwan Rahmat of REITsWeek, a newsletter. There is also refinancing risk associated with debt. In a tight credit environment at loan maturity date, the ability to extend debt is unpredictable.

Room revenue per available room (RevPAR), average daily rate (ADR), and occupancy are key measures of operating performance. RevPAR is calculated by dividing the annual revenue by the number of rooms and the number of days. ADR represents the average income per room. Occupancy is the number of rooms occupied divided by number of rooms.    

The bleak outlook of the lodging industry is concerning investors. Despite a five-year growth in performance metrics, hotel REIT’s valuation declined in all hotel REITS listed in the NAREIT index in the past year. It is not unwarranted.