Investing in Hotel REITs
How Real Estate Investment Trusts Work for Hotels
Imagine you want to own a collection of hotels. (Maybe you played a lot of Monopoly as a kid and relish the idea of receiving a stream of cash from someone checking into one of your rooms for the night.) If you are wealthy, you can franchise a hotel concept directly from one of the major hospitality companies.
Unfortunately, many business-class hotels cost somewhere between $2 and $15 million. Luxury and upscale hotels can easily require $30 to $60 million or more. Although most of this is traditionally financed with debt, the required equity down payment is still far beyond the realm of possibility for practically all investors.
The good news? These days, there is another way to invest in hotels. You can purchase hotel REITs in your brokerage account the same way you buy stocks, bonds, or mutual funds. First, though, let's back up and talk about REITs for a moment. In case you've forgotten or have never studied them, a real estate investment trust, or REIT is a special type of corporation focused on acquiring and managing real estate and real estate related assets.
One of the things that differentiate REITs from ordinary corporations is that Congress made them exempt from corporate taxes provided several strict conditions are met, the most relevant of which is the distribution of at least 90% of all of the profits in the form of cash dividends to stockholders. This makes REITs highly sensitive to interest rate movements but also means they tend to offer much fatter dividend yields than their blue-chip stock counterparts.
The downside? REIT distributions are not "qualified dividends" under the tax code, meaning you'll be taxed as if they were ordinary income, not at the lower, more attractive dividend tax rates. Once you start building a significant portfolio, this can sometimes get you in trouble if you buy too many through a Roth IRA, SEP-IRA, 401(k), or another tax shelter, as you might trigger the Unrelated Business Income Tax or UBIT. That is a different discussion for a different day.
How Hotel REITs Differ From Other REITS
Just as stocks in different industries and sectors have different risk characteristics, REITs vary significantly depending on the type of real estate project in which they specialize.
This isn't news to real estate investors who are accustomed to acquiring property outright. As they know from first-hand experience, an apartment building behaves very differently from an office building or storage units based on the underlying economics, traditions, practices, laws, and forces at work. But, it sometimes comes as a surprise to new investors acquiring real estate through publicly traded securities.
They don't understand that your commercial office REIT might experience cyclical lease rates as it follows boom and bust cycles, whereas your industrial warehouse REIT might be far more steady, as overcapacity can be shut down with minimal maintenance costs much more quickly than is possible with something like an apartment building. It's the nature of the asset class.
One interesting sub-specialty in the real estate investment industry is the hotel REIT. As you can probably surmise from the name, hotel REITs focus on developing, managing, acquiring, or financing hotels and hospitality-related properties.
These can range from budget inns located on the side of forgotten highways and state roads to five-diamond prestige resorts in some of the entertainment, gambling, and population capitals of the world. They can involve developing and owning the property, paying a third-party management team to handle the actual running of the hotel in exchange for a share of the revenue.
They can focus mostly on managing other people's hotel properties for a cut of revenue. They can involve financing hotel projects, acting more like quasi-fixed income investments. You absolutely must understand what it is you own or you're risking your hard-earned savings.
Hotel REITs are notoriously volatile because hotel occupancy correlates with general economic conditions, making them highly sensitive to expansion and contraction. When a recession hits, businesses slash travel budgets, opting for video conferencing or telephone calls instead. Families and organizations postpone vacations, staying closer to home.
For a hotel REIT, this frequently means cash flows dry up at the same time yields are rising, so you get dramatic declines in the value of the units or shares. Conversely, when things turnaround, cash flow sometimes explodes through the roof, so you get these skyrocketing payouts and market values.
They are very different from the stalwarts of the world that pump out money like clockwork, generation after generation -- businesses like Colgate-Palmolive or Nestle. Let's look at a real-world illustration to demonstrate how an actual hotel REIT works.
Hotel REIT Example From 2008-2009 Economic Collapse
Hospitality Properties Trust is a hotel REIT that owns 291 hotels, encompassing 43,976 rooms or suites, as well as 185 owned or leased travel centers. According to the SEC filings, these properties are located in 44 states in the United States, Canada, and Puerto Rico.
The hotel REIT operates its hotel portfolio under a diversified collection of franchise agreements, including Courtyard by Marriott, Candlewood Suites, Residence Inn by Marriott, Royal Sonesta, Sonesta, Staybridge Suites, Hyatt Place, Crowne Plaza Hotels & Resorts, Wyndham Grand, Wyndham Hotels & Resorts, Sonesta ES Suites, InterContinental Hotels & Resorts, Marriott Hotels and Resorts, the Clift Hotel, Radisson Hotels & Resorts, TownePlace Suites by Marriott, Hawthorn Suites, Country Inns & Suites by Carlson, Holiday Inn Hotels & Resorts, SpringHill Suites by Marriott, and Park Plaza Hotels & Resorts.
In the boom years before the real estate collapse tanked the economy in the worst recession since the Great Depression, this hotel REIT generated fat distributions for owners. In 2004, they received $2.88 cash per share; in 2005, $2.89 cash per share; in 2006, $2.94 cash per share; in 2007, $3.03 cash per share; in 2008, $3.08 cash per share.
When the financial world fell apart, though, hotel bookings fell off a cliff. Business conferences were canceled and cash distributions were decimated, dropping to $0.77 per share, a staggering decline of 75%. If you were relying on that money to pay your bills, you suddenly found it had evaporated at the very moment you needed it most.
Foolishly selling their stakes (again, if you own a hotel REIT you should know this is part and parcel of the ownership experience), the shares collapsed from a high of $51.50 in 2006 to a mere $6.90 in 2009. This 86.6% drop in the stock price was added insult to the injury of the severe cut in your passive income.
What happened to sophisticated investors who understood the nature of hotel REIT ownership? They sat on their proverbial behinds, watching the cash distributions climb to $1.96 per share with a stock price of $32.46. Sure, it's nowhere near the good years, but for a fairly horrific measurement period, you slightly beat inflation after taxes, retaining your purchasing power.
You bought the real estate security 10 years ago, paying between $26.50 and $42.40 per share. Over that time, you collected $24.83 or so in cash distributions. If you were smart and reinvested those dividends during the crisis, they became what one financial academic has referred to as a "return accelerator," making several hundred percentage points of profit on each check or deposit plowed back into buying additional shares due to the partial recovery in market value.
Contrast that hotel REIT with something like an industrial REIT. Even with the world falling apart, businesses don't want to vacate their warehouses, shipping facilities, and factories. Also, they are often (not always) able to pay the lease contracts they legally owe even if the firm itself ultimately goes bankrupt. During the same meltdown, an industrial REIT like EastGroup Properties didn't cut the dividend.
The stock fell from $48.54 to $24.58, a decline of only 49.36%, which wasn't much different than the stock market indices, such as the Dow Jones Industrial Average and the S&P 500! Given the flow-through nature of the securities, and how that influences market value, it's incredibly impressive. Even more impressive? The shares are actually at $59.32 right now, so you have a $10.78 unrealized capital gain, or 22%+ on the stock itself on top of all of those dividends you've enjoyed.
The Implications for Hotel REIT Investors Are Clear
There are four major ways you can strategically approach acquiring hotel REITs if you want to own them:
- Only buying blocks of hotel REITs during stock market crashes, treating it very differently from your index funds or other holdings that you then plan on holding forever. The lower your cost basis, the faster you can extract your purchase price back out in cash dividends if you plan on investing that money somewhere else.
- Regularly dollar cost average into hotel REITs, knowing that sometimes, you're going to be buying at the worst possible moment but trusting the highs and lows, combined with reinvested dividends, will average everything out for you for a satisfactory total return. For most people, this is probably the better approach as dollar cost averaging drastically reduces stock market risk, especially when combined with diversification.
- Speculate. When the hotel industry is in collapse, buy hotel REITs until the boom years return, then dump them even if they end up going a lot higher. The odds of long-term success here are not great unless you can understand the hotel industry implicitly and treat the REIT acquisition the same way you would if you were spending millions of dollars to buy a property outright. But, there are a minority of financially sophisticated people out there with the capability of doing it on a valuation-driven basis, provided they can live with buying too soon or selling too early, which is bound to happen given investors, as a whole, have a habit of getting too optimistic or pessimistic from time to time.
- Throw in the towel and buy something like the Vanguard REIT Index Fund, which mixes lots of different REITs, including hotel REITs, as part of a diversified portfolio. It has a much lower dividend yield, but if you think the reduced risk is worth that trade-off, it might be your wisest course of action.
In any event, hotel REITs are not the faint of heart. If you don't know what you are doing, tread lightly.