Lodging real estate investment trusts (REITs) have been on a tear, generating total returns, including dividends, of about 25% so far this year. But the group's high-speed run may soon hit a road bump or even a blowout as money managers increasingly believe the rally is premature and that a significant rebound in the hotel business is still more than a year away.
"I think people are trading on not only what the sector is going to do this year and next but what it's going to do over the next four or five years," says John Arabia, a managing director at Green Street Advisors in Newport Beach, Calif. Valuations appear to be "at the high end of a fair range," he says. David Loeb, a senior analyst at Robert W. Baird & Co., expects little earnings growth until 2012 and believes the wait will "test the patience" of investors who have already bid up the shares. "I do think [the rally] is largely ahead of itself," he says.
Lodging REITs generated total returns of 67.2% in 2009 and have gained an additional 25.5% so far in 2010 (as of market close Friday, April 16), outpacing the S&P 500 index, which rose 26.5% in 2009 and has advanced only 7.5% so far this year. They also outperformed equity REITs in general, which rose 28% in 2009 and are up another 11.2% in 2010.
Many investors jumped into lodging REITs, hoping to cash in on stocks that stand to see the biggest and earliest gains from an economic recovery. Since hotels change their rates nightly, they can respond quickly to changes in the economy and have historically rebounded faster. "Investors want to buy low and get in early," says Bjorn Hanson, a professor of hospitality and tourism management at New York University.
But Loeb believes the rally may be premature at best and overdone at worst. "I just think there could easily be a sell-off of 10% to 15%, or more than that" before the sector rebounds, says Loeb. Those who do buy now, he says, ought to be prepared to hang on to the stocks for at least three years. "They look really expensive to me," says Loeb. "Investors will just have to wait for several years before those multiples make sense."
The lodging sector has taken a beating in the recession, with revenue per available room, or revpar, having fallen year over year for 19 consecutive quarters. (Revpar is a key industry metric used to measure room rates and occupancy growth.) Investors, though, started moving into the sector when they noticed that year-over-year declines had steadily gotten smaller each month since August; revpar fell 19.1% in August, but the declines decreased each month and finally turned slightly positive in March, according to Smith Travel Research. That change prompted investors to become more optimistic that the sector's fortunes had turned. "We certainly think it has stabilized," says Brad Garner, a vice president at Smith Travel Research.
However, all of the gains came from occupancy improvement, not room-rate increases. Hotels rely on healthy room-rate increases to drive earnings, and significant rate hikes likely won't happen before the second half of 2012 at the earliest, analysts say. "When you put more bodies in hotels and are charging them less, costs are going to be rising, not falling," says Loeb. "So the profit trough may still be close to a year away."
Garner is predicting that revpar, which declined 17% over 2009, will be down only 0.5% in 2010 and will rise 5.4% in 2011. But Garner cautions the sector still faces considerable problems in high unemployment, weak consumer confidence, credit issues and other factors. "There is a lot of pessimism around the consumer in general," says Garner. "There's a lot more headwinds this time around that there has been in prior [downturns]."
Arabia is more bullish, calling for 2% revpar growth in 2010, 5% in 2011 and 9% in 2012. However, he believes it will be at least 2013 before revpar returns to its peak 2007-08 levels.
After all, it has a long fall to climb back from. Revpar at U.S. hotels plunged a whopping 44% from its peak of $73.72 in July 2008 to its trough of $41.26 in December 2009, according to Smith Travel Research. Occupancy fell to 43.9% in December from its 68.9% peak in July 2008, while average daily room rates slipped to $93.81 in November from their peak of $108.72 in April 2008.
Lodging companies that focus on luxury were hit the hardest, with rates falling 20% to 25% on average, according to Smith Travel Research. "No CEO wanted to be seen going into New York City and staying at a luxury hotel, so they suffered," says Garner. But the segment that was pummeled the hardest also offers the biggest potential windfall as the economy rebounds. "If you fall less, you have less to recover, but if you fall hard, you have more to recover," he says.
Of course, that assumes that travelers step up to full-priced luxury lodgings, and that may be a ways off.