Canada is fortunate to be home to two high-quality global lodging companies — Four Seasons Hotels and Resorts as well as Fairmont Hotels & Resorts. Unfortunately for public investors over the past number of years, the listed lodging sector in Canada has meaningfully decreased in size through multiple take-private transactions (Four Seasons, Fairmont, Legacy REIT and CHIP REIT). Today, there are still a number of publicly listed lodging entities including InnVest REIT, Lakeview REIT, Holloway Lodging REIT, Royal Host and Temple REIT. However, in contrast to the commercial property REIT/ REOCs which are enjoying tremendous growth, the publicly listed lodging sector has seen its growth all but stall.
Still, we think there is a place for the listed lodging sector in Canada, likely through a corporate structure and featuring low leverage and dividend payout ratios. Indeed, in the mid-term we think it is possible that some of the hotel portfolios that were taken private could find their way back into the public markets through new IPOs. This is something we think investors would welcome.
We recently published our “10 Timeless REIT Rules” which explains key concepts for investing in the listed real estate sector. These investment principles apply to the lodging sector although there are some notable differences. For instance, lodging stocks would likely be a positive exception to rules #1 & 2 as lodging stocks would offer more immediate upside to an expanding economy (which the most likely reason why interest rates would increase). This would cause a positive flow of funds to the lodging sector as many investors would be looking for cyclical plays.
10 Timeless REIT Rules (in summary)
1. No one will be spared in a rising interest rate environment.
2. When the flow of funds is negative, fundamentals become secondary.
- In an expanding economy with rising interest rates, we believe investors will allocate more capital to better positioned cyclical stocks;
- Though real estate assets should keep pace over the long-run, the consequence of being a lagging sector in a favourable economic environment is that other sectors may well be more attractive–at least in the near term. This would likely cause a fund flows out of REITs and put downward pressure on REIT trading prices;
- Despite negative fund flows, we believe NAV (Net Asset Value) provides a visible price floor and yield will support trading prices.
3. Lowest cost of capital wins.
- REITs with a low cost of capital are better positioned to acquire higher quality properties with greater total returns and less volatility;
- Needless to say, higher total returns at the property level leads to greater long-term unitholder wealth creation;
- The best REITs use their cost of capital advantage to make better investments —acquisitions, developments, redevelopments — and generally outperform over the long-run.
4. All else equal, franchise value & alignment drive long-term outperformance.
- Franchise value is the ability to maximize unitholder value by driving above-average NOI and NAV growth on a favourable risk adjusted basis;
- Typical characteristics of franchise value include: 1) a difficult to duplicate skill set; 2) the ability to manage finances and allocate capital; 3) dominance/expertise in a specialized niche, sector or geographic area; 4) Employee talent and corporate culture;
- When management is aligned, it naturally acts in the best interest of unitholders on a long-term basis rather than what could be accretive in the short-term.
5. When decisions are influenced by personal conflicts, unitholders suffer.
- Conflicted REITs frequently make short-term decisions that often produce low quality or unsustainable income or expose unitholders to senseless risk;
- When management is aligned, decisions are grounded on what maximizes unitholder value on a long-term basis rather than what could be accretive in the short-term;
- When there are major personal conflicts, not only are unitholder returns siphoned off, but important decisions can be influenced inappropriately. This leads to negative franchise value and an intrinsic value at a discount to NAV.
6. A good REIT trading below NAV is usually a good bet.
- NAV is an excellent indication of intrinsic value as it illustrates the market value of a REIT based on what its assets would be worth in the private real estate market;
- Past evidence suggests that if negative market sentiment drives REIT trading prices below NAV and there is sufficient liquidity, the much larger private market will step in (pension funds and others);
- Importantly, NAV is an asset-only metric that aggregates the value of each individual asset owned by the REIT. NAV does not capture 1) a portfolio premium; 2) the value of a platform/competitive position; or 3) any unique skill set that management may possess. For high-quality REITs, this can represent significant additional value.
7. In the long-run, financial engineering, like steroids, hurts more than it helps.
- Steroids can temporarily enhance an athlete’s performance and provide a visible advantage. But we all know it’s not a risk free proposition and “enhanced performance” is not sustainable;
- While similar to steroids, financial engineering is different in that it only provides the appearance of enhanced (financial) performance;
- What you get in the short run you give up in the long run, and usually you give up more than you get;
- A structured transaction typically gives the appearance of accretive growth, a higher NAV and a lower FFO (Funds From Operations) multiple but in truth, its dilutive to both NOI and NAV growth.
8. AFFO multiples are often misleading.
- The two main factors that distort AFFO (Adjusted Funds From Operations) multiples are: 1) Asset quality: a low-cap-rate property will produce a higher AFFO multiple; 2) Leverage: in higher leverage translates into a lower AFFO multiple. In addition, since there are no reporting standards for AFFO, multiples can be further distorted by different reporting and accounting choices;
- Unless comparing REITs of similar quality and leverage, an AFFO valuation approach can be misleading. We assert that Price-to-NAV ratio is better valuation tool.
9. For most, frequent trading adds only marginal value.
- The REIT sector’s small float in combination with numerous long-term individual investors meaningfully reduces trading volumes and liquidity;
- REITs are highly correlated in the short term and it’s hard to see the value-add of paying up for a block and selling at a discount with a frequent trading strategy;
- Execution costs associated with frequent trading (timing, market impact, commissions) diminishes the intended outcome and creates only marginal benefits at best.
10. Platforms are worth a lot of money.
- A platform encompasses a cohesive portfolio of assets, people, relationships, a national/regional presence, systems and development know-how;
- In our view, a sizable well-functioning platform enables a real estate organization to drive above-average returns (e.g., income/NAV growth);
- Based on historical M&A transactions, a well-functioning platform is worth roughly 10-15 per cent of gross assets.