One thing to keep in mind when buying real estate as a long-term investment is that this is not traditional value investing. Most of my moves in real estate are much closer to distressed investing than classic deep-value investing. Many of these companies, especially real estate investment trusts, have far more debt on the books than I am usually willing to consider. Whatever margin of safety exists is a result of the probability of an eventual recovery in the commercial real estate market and management's ability to manage the debt load. This is especially true when buying the equity of preferred stocks issued by REITs. (Investing in debt in distressed, asset-rich companies is a subject for another day.)
One of the more distressed groups in the real estate space is hotel REITs. The higher-end properties in markets such as New York and Washington D.C. have held up during the long real estate recession, but properties out of the glamor zone have not fared as well. Occupancy rates have been down and room rates have fallen for several years. Room rates have been edging higher this year as the economy slowly recovers, but they are still well below the peak levels of early 2007.
I started tiptoeing into the hotel space in early 2009 when I read that both Sam Zell and Wilbur Ross were suggesting that most hotels were priced very cheaply and offered an opportunity for investors willing to stomach the risk of the highly distressed sector. I started buying a few issues in the space and it has indeed been a wild ride so far. We are just starting to see the sector show signs of an improvement, and transactions are still sluggish. As the economy improves, we should start to see some more deals and firmer pricing in the space. The wild card in the space could be the U.S. dollar. If it falls against its major trading partners, you could see a lot foreign money move into the space, as has historically happened. I am not counting on that, but it would be a bonus if it occurred over the next several years.
One of the first hotel REITs I purchased was Sunstone Hotel Investors (SHO). Sunstone owns 32 hotels with more than 13,000 rooms. Most of their hotels are in the upper tier brands like Marriott and Hilton nameplates. Their recent operating results show signs of improvement in the sector. Margins and room rates are rising, and earnings before interest, taxes, depreciation, and amortization is increasing as well. Management is actively managing the balance sheet, has refinanced several mortgage loans, and is conserving cash balances. The company currently has $150 million of unrestricted cash. This exceeds the $95 million of debt that matures between now and the end of 2015, so the company should be able to navigate the next three years without severe financial difficulties. The stock is still a buy trading at just 70% of tangible book, but I would look to buy on days the market is off sharply to improve my eventual return from the shares. The company is current on its preferred dividends but has not reinstated a payout on the common shares yet.
FelCor Lodging Trust (FCH) is not as financially sound as Sunstone but the upside here is substantial over the next few years. The firm owns interests in 77 hotels with more than 22,000 rooms in 30 different markets. FelCor has been selling off hotels it considers non-core assets and repositioning the balance sheet to increase the odds of long term survival. They are selling their suburban and airport hotel portfolio to concentrate on more premium and resort locations, using the proceeds to pay down debt. The shares are very cheap at just 50% of tangible book value. If FelCor merely survives, the shares are worth more than twice the current price. If management successfully executes a turnaround, pays off the arrearage on the preferred stock, and reduces debt levels, the return on this stock could be worth far more than that. It is a somewhat speculative bet but FelCor's management has been in the business a long time and I think it is a decent speculation on a distressed asset.
For investors willing to assume some risk investing in hotel REITs at current distressed levels, it's worth the time to do some homework on this sector.