Hotel REITs Have Room to Run
- Sep 19, 2012
Tim Southard, Senior Vice President of Jones Lang LaSalle Hotels
As the lodging industry emerged from the downturn caused by the banking crisis of 2008-2009, investors discovered that there was virtually no debt to be had for hotel acquisitions.
Cash was king, and the industry players best positioned for all-cash investments were the real estate investment trusts, or REITs, which had gone into the downturn with lower leverage ratios and higher cash balances than their non-REIT peers. In 2010 and 2011, REITs accounted for 51 percent and 38 percent of major hotel acquisitions, respectively, with an even greater share of full-service, gateway city hotel trades.
Many non-REIT market participants were forced into the sidelines or secondary or tertiary markets as they couldn’t compete due to a higher cost of capital and lack of available debt financing. Although the debt market has come back to life, REITs continue to be active participants in the acquisition market, accounting for 32 percent of major hotel transactions year-to-date through August 2012.
Created in the 1960s to allow small investors to participate in commercial real estate investment opportunities, REITs generally have a lower cost of capital than private equity firms. A lodging REIT underwrites to a 10-11 percent unleveraged return, whereas a private equity fund requires a 12-14 percent unleveraged return, an obvious advantage for REITs in a debt-constrained market.
The average dividend yield for publicly traded hotel REITs is 3 to 4 percent, attractive in the current low-interest-rate environment. Overall, stock market returns for publicly traded REITs have outperformed the S&P 500 over time, although share prices can be volatile over the short term, as witnessed last summer during the U.S. debt crisis, when REIT shares declined by as much as 40 percent.
It is important to note that REITs primarily invest in just the top 15 U.S. markets, allowing private equity to invest in all other markets with minimal competition from the REITs. By expanding outside the top 15 markets, REITs could increase their overall share of the ownership universe. There is clearly room for these companies to grow.
In addition to the relatively small size of the industry, there are several other factors that may favor the continued growth of the lodging REIT model over the intermediate- to long-term, including investor need for yield, liquidity, diversification and inflation protection. Perhaps the greatest impact will be from the aging and retirement strategy of the Baby Boom generation.
After the dotcom disaster in the early 2000s and the real estate crash in more recent years, investors are re-evaluating their risk tolerance and strategy. Baby Boomers entering retirement are seeking safety and yield in a global investment environment that offers historically low interest rates, with money market rates of practically zero and 10-year Treasuries hitting a low of 1.50 percent for the first time in summer 2012.
Concerned that bonds could be the next crash due to record low yields and the threat of inflation in future years, these investors are increasingly turning to REITs to satisfy their desire for yield, growth potential and diversification. The relatively low leverage of lodging REITs provides investors comfort that their investment won’t be wiped out by another credit crisis.
Furthermore, hotels have proven to be an excellent inflation hedge due to the fact that their “leases” roll nightly (a hotel can increase its rates daily depending upon demand for rooms). Average daily rate (ADR) is highly correlated with inflation, particularly in periods of above normal inflation, and ADR growth has outpaced the increase in CPI over the last 40 years. With 10,000 Baby Boomers entering retirement every day, their investment decisions will have a significant impact on the competitive positioning of market players, which we believe will favor low leverage lodging REITs.
With the overall lodging industry experiencing strong growth trends (revenue per available room, or “RevPAR”, increased 7.3 percent year-to-date through July 2012) and a constrained supply environment likely for several more years, the fundamentals of the hotel business are highly favorable, benefiting all investor types in the sector. Private equity and institutional capital will have opportunities to take advantage of these market conditions as well, but the low cost of capital advantage currently held by the REITs has more room to run.