Hotels aren't the most defensive type of real estate, but they do have the potential to produce fantastic profits in strong economies. So, if you believe that the U.S. economy will continue to strengthen for several more years, a real estate investment trust, or REIT, that specializes in hotel properties could be a smart choice for your portfolio. With that in mind, here are three hotel REITs that look attractive and also do a nice job of mitigating risk.
Risks and rewards of investing in hotel real estate
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To be clear, hotel real estate is not a defensive type of asset. In fact, among all of the different types of commercial properties REITs invest in -- apartments, offices, healthcare, self-storage facilities, malls, and so on -- hotels are arguably the most susceptible to recessions and other types of market weakness.
The reason? Hotels essentially lease their real estate on a daily basis. In contrast, if you rent an apartment, you're generally locked in for at least a year. If you sign a lease on a retail space, your lease could run for a decade or more. With a hotel, you can rent a hotel room today and leave tomorrow. Therefore, during tough times, it's easy for demand for hotel rooms to fall, and rental rates to plummet.
To be fair, the other side of this equation is that hotels are generally great businesses during good economic times. They're the only type of commercial real estate where rent can be readjusted on a daily basis. If the market rate on hotel rooms jumps 20% in a year, hotels are well positioned to take full advantage.
The upside of the additional risk is that hotel REITs often pay some of the highest dividends in the real estate sector, as you'll see later.
Things to look for in a hotel REIT
Having discussed the risks, let's examine some things investors should look for to help you choose a hotel REIT that can capitalize on the good times, without getting crushed too badly during the bad times. These include, but are not necessarily limited to:
- Geographic diversification: If a REIT's properties are spread out, it isn't too vulnerable to weakness in any one particular market.
- Mid-level hotel properties: I tend to avoid REITs that only focus on super-luxury resorts, as these often see the biggest losses during recessions as value-conscious consumers cut back. In contrast, mid-range hotels do lose some of their regular business during tough times but gain some business from customers who normally stay in luxury hotels but are looking to save money.
- A reasonable debt load: The more debt a company has, the less likely it will be able to continue to pay its interest obligations when times get tough.
- Some clear competitive advantage(s): This can mean a number of things and basically refers to how a hotel REIT maintains a leg up on its competition. For example, Apple Hospitality REIT (NYSE: APLE) is one of the hotel REITs I'm about to discuss, and the company's properties are newer than the competition.
3 Top hotel REITs to consider now
1. Apple Hospitality REIT
Apple Hospitality REIT invests in "select service" hotels, which is a middle-market classification of hotels that offer more amenities than bargain-oriented hotels, such as continental breakfast, fitness centers, and pools. However, they don't offer the level of services of luxury hotels and resorts. Homewood Suites by Hilton and Courtyard by Marriott are good examples of select-service hotels.
All of Apple Hospitality REIT's properties are operated under Hilton and Marriott brand names, such as the two I just mentioned, and the company owns a total of 238 properties with more than 30,000 guestrooms.
While hotels aren't a defensive asset, Apple Hospitality REIT is one of the more risk-averse hotel REITs. For starters, select-service hotels tend to do better than discount or luxury hotels during downturns, as I discussed earlier. Not only do select-service hotels tend to hold up better during recessions, but they also tend to have lower operating expenses than luxury-oriented properties.
In addition, the company's properties are, on average, newer and more desirable than those from the competition, and Apple Hospitality REIT continuously reinvests in its properties to maintain this advantage.
Furthermore, the combination of strong brand names and newer properties allows the company to operate at one of the highest profit margins in the industry, giving more room to absorb a revenue drop when times get tough.
2. Host Hotels and Resorts
To be clear, Host Hotels and Resorts (NYSE: HST) is not a midrange hotel operator, in contrast with what I've discussed so far in terms of what to look for. In fact, the company focuses on luxury and upscale hotels -- the Ritz-Carlton Naples and Hyatt Regency Maui Resort and Spa are among the company's properties.
However, Host Hotels and Resorts has a few key advantages which make it worth a look. For starters, it has the advantage of scale, as the company is the largest hotel REIT in the market by a considerable margin, with 60,931 rooms. This not only gives the company efficiency advantages, but it also gives it more financial flexibility to pursue large deals that may be out of reach for smaller competitors.
Over the years, Host Hotels and Resorts has done an excellent job of actively investing -- not only acquiring properties, but also strategically selling significant amounts of hotels to take advantage of price appreciation. Since 2010, the company has acquired $4.4 billion worth of hotels and has sold $3.1 billion. This has maximized returns and has allowed the company to increase its dividend consistently and buy back nearly $900 million worth of its shares at a discount to net asset value.
Finally, Host Hotels and Resorts maintains one of the most attractive balance sheets in the hotel REIT industry, with approximately half of the leverage of its peer group average, which helps offset the risk that comes with owning more recession-sensitive hotel properties.
3. Hospitality Properties Trust
Hospitality Properties Trust (NASDAQ: HPT) is a unique investment in that it isn't just a hotel REIT. In addition to its portfolio of 323 hotels, the company also owns approximately 200 travel centers adjacent to interstate highways, operated under the TravelCenters of America and Petro brands.
The company owns a variety of hotel property types -- full-service, select-service, and extended-stay hotels -- with most of the portfolio concentrated in midrange hotels. To give you an idea of what hotels make up the portfolio, Courtyard by Marriott, Candlewood Suites, Residence Inn by Marriott, and Hyatt Place are among the largest property brands.
The travel centers add a nice element of diversification to the portfolio and helps to further mitigate the risk that comes with hotel properties. Specifically, while customers rent hotel properties on a day-to-day basis, travel centers can be counted on for more consistent income since they sell non-discretionary goods such as fuel and food.
As a final thought, Hospitality Properties Trust's 7% dividend yield may seem a bit on the high end, but it represents just 48.6% of the company's funds from operations for the most recent quarter. In other words, there is plenty of cushion where earnings could drop and the dividend could be sustained.
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