In January, Daniel Donlan, managing director of equity research at Ladenburg Thalmann, cut his rating on the hotel REIT sector in an industry report to investors. Six months later, Donlan, who tracks 16 hotel REITs at the Wall Street investment banking firm, stands resolute in his bearish outlook for the sector.
Although, despite hotel fundamentals regressing, he believes there are various technical factors have been supporting the stocks in recent months, which could continue into the Fall of this year. He tells Hotel Management why he downgraded the rating and where he sees the sector headed.
HM: What prompted the “sell” rating?
Donlan: We are negative on hotel REITs and have been for a while as we downgraded several urban focused hotel REITs to "neutral" after the ALIS conference in January 2015. There are three reasons:
#1: Supply growth, particularly for hotels in urban locations within the top 20 markets. Supply growth for urban hotels is up nearly 3 percent this year, and it is forecasted to stay around this level well into 2018. In the past few years, supply growth has been below 2 percent, and for many years, it was less than 1 percent. So, it is hard for us to see how demand growth can outstrip supply growth when the U.S. economy is growing in the low 1 percent range.
#2: Occupancy levels compared with prior cycles, again more so for urban hotels. If you look at urban occupancy, its roughly 500 basis points higher on a trailing 12-month basis than where it was at this stage of the recovery in prior two cycles. So, future RevPAR must come solely from rate, which should prove tough as U.S. hotel occupancy has been falling consistently for several months now.
#3: Price transparency offered by the online travel agencies (OTAs) and the last minute booking nature of many consumers, which makes it hard for revenue managers to fill up in advance without dropping their rate. Lastly, despite our view that hotel REIT earnings have peaked, many analyst are still forecasting EBITDA growth for hotel REITs in 2017, which is making valuations look more compelling than they really are.
HM: Why have hotel REITs done well recently despite lowering their full-year outlooks for RevPAR growth?
Donlan: While every hotel brand and hotel REIT that reported earnings in July downwardly revised their outlooks for 2016 RevPAR growth thanks to weakness they see coming in the second half of 2016, the news may have largely been anticipated by Wall Street. In addition, the downward revisions to EBITDA guidance have not been as bad as many investors may have feared too. More importantly though has been the flood of investor capital into the equity REIT space. With equity REITs getting their own Global Industry Classification Standards (GICS) code this September, and the Brexit vote largely being viewed as a positive for U.S. commercial real estate, we believe generalist investors have started to allocate more capital towards equity REITs and by extension, hotel REITs. In addition, with interest rates continuing to drop, and the economy still muddling along, we suspect income investors are more interested in hotel REITs today given their yields are nearly 200bps higher than the average equity REIT.
HM: How has the continuous contraction in RevPAR growth impacted your view of the sector?
Donlan: As far as RevPAR growth is concerned, we’ve seen it decelerate for five consecutive quarters until the second quarter of 2016, but we believe it would have declined again in the second quarter of 2016 if there wasn’t the benefit from the Easter and July 4th holiday shift. How long can RevPAR growth stay in the low single digits before it turns negative? Just looking at how the numbers have trended historically, RevPAR growth does not stay below 3 percent for several consecutive months and then not turn negative; the exception being the months that follow a recession end. My guess would be that by August or September, urban RevPAR growth will turn negative with the overall U.S. taking a few months longer. A classic sign of a lodging recovery ending is when occupancy growth consistently turns negative and the secondary cities outperform the primary locations and markets in terms of RevPAR growth, which is happening across the U.S. With that in mind, we see hotel REITs falling out of favor with generalist investors as there are better companies to own that don’t suffer from negative cyclical trends. We also see REIT-dedicated investors losing interest in the names as there are other REIT sectors that have much better prospects for earnings growth.
HM: When will the sector begin realizing reasonable returns again?
Donlan: The share prices of hotel REITs should recover well ahead of trough earnings just like the sector fell well ahead of peak earnings. For instance, in 2009, hotel REITs recovered several quarters before RevPAR and EBITDA growth stopped declining on a year over year basis. So, with that in mind, we see share prices for hotel REITs bottoming out sometime in the back half of 2017, maybe early 2018. As far as how far hotel REITs may fall from current levels? We see 35 percent to 50 percent downside from here for the names that we cover, and that is based on corporate EBITDAs declining around 15 percent to 20 percent peak to trough and EV/EBITDA multiples dropping to 10x to 12x. While EBITDA multiples dropped to 7.0x to 8.0x in the prior downturn, we do not believe those valuation levels should be seen this cycle as 1) we do not see RevPAR declining in the mid to high double digit range again and 2) hotel REIT balance sheets are much less levered this cycle versus last and their debt maturity schedules are much more staggered today within very little maturities scheduled to occur until 2019, in many cases.
Daniel Donlan covers the equity REIT sector. Prior to joining Ladenburg Thalmann, he was a VP at Janney Capital Markets, where he covered over 25 stocks within the apartment, hotel, industrial, office, net lease, and student housing REIT sectors. He was previously a REIT associate analyst at BB&T Capital Markets and a sales/leasing associate focusing on office and industrial properties at Thalhimer Cushman & Wakefield. Donlan holds a degree in finance from the University of Notre Dame.