Mr. Greg SukenikThe real estate investment trust (REIT) group has withstood several months of naysayers expecting stock prices in this sector to fall. However, they remain trading at record-high levels. We asked senior REIT analyst Greg Sukenik about some of the reasons behind this.
We've noticed a bit of consolidation in hotel REITs lately. Can you give a little background on how this has come about?
There has been a disconnect between public and private pricing in the hotel sector. That is, as hotel companies have been trading below net asset value in the public markets, private institutional buyers have been willing to pay a premium to net asset value, and many hotel executives have decided that selling is the best way to maximize shareholder value in light of depressed public valuations. As there is still abundant capital chasing real estate, many large buyers are looking at hotels to be one of the better-performing sectors in the next few years.
Lodging companies took at big hit after 9/11, and suffered a couple years of depressed results. Since 2004, however, hotel companies have posted impressive results, with solid quarterly RevPar (revenue per available room) growth. We expect this continue into 2006 as new supply coming on line is limited due to ever increasing construction costs and longer entitlement times. Finding suitable sites in large urban areas for new hotel construction is more difficult. Hotel owners will continue to benefit from the lack of new competition coming on line.
There has been notable M&A activity in two companies that you follow, Host Marriott and La Quinta. Would you care to comment on the recent developments?
Host Marriott (HMT) signed a definitive agreement to purchase 38 upper scale properties from Starwoods Hotels and Resorts (HOT) for approximately $4 billion. The hotels are mostly located in high-density urban areas. Although the purchase price was high, about $215,000 per room, this acquisition upgrades the quality of HMT’s portfolio and gives the company an entrance into Europe.
Long-term, we like this acquisition, as it gives HMT more scale and a more diverse portfolio in some very supply-constrained areas. In the short run, this deal should be mildly accretive to earnings, as we believe the company will be able to push room rates and we are projecting increased demand for luxury and conventional properties in 2006.
In January, La Quinta Inns (LQI) was purchased by the Blackstone Group for about $3.4 billion. The Blackstone group paid about a 40% premium to La Quinta’s pre-merger share price. The Blackstone Group also recently agreed to spend $2.6 billion on Meristar Hospitality Corp (MHX) for a 20% premium over the company’s share price. These are two examples of private pricing that is significantly higher than public valuations.
It is hard to fault management for taking advantage of premium pricing and what seems like unlimited capital chasing large real estate operating companies. For the Blackstone Group, these acquisitions make sense in that they acquired large operating companies with management and systems in place. It would take years or more to buy up these assets on a one by one basis.
Do you expect much further consolidation in the industry in 2006? If so, what names are being discussed?
We expect more M&A activity in 2006 as improving fundamentals in the industry has made lodging an asset class of choice for large money managers. Recent M&A activity has given a boost to the entire sector as investors are trying to guess who will be next. We have heard rumors that Felcor (FCH) and Inkeepers (KPA) could be the next acquisitions. Keep in mind, though, these are just rumors and we do not like to speculate on rumors. Our investment strategy is to invest is solid, well-run companies, and not try to speculate on buyouts. We view trading on rumors as more gambling than investing.
Considering what many investors may already know about REITs (or at least the real estate market) - that earnings kept growing higher and higher but may now have peaked - what advice would you give to those looking to make plays in this space?
For the past several years, REIT returns have beat the broader market, and now REITs are trading at all-time highs. While the current P/E ratio on the S&P is now about 15x forward earnings, the 50 or so REITs in the Zacks’ coverage universe are now valued at over 20x our forward AFFO (earnings after capital expenditures) estimates. We think real estate fundamentals will continue to improve in 2006, as real estate operating companies are starting see good earnings growth at the property level.
However, we think this improvement in operations is already priced into shares. We expect REIT returns in line with the general market in 2006. We are not looking for huge share appreciation this year; most of the return will be comprised of dividends. While many REITs do not have a large cushion in dividend coverage, we note that many companies can make up any shortfalls with asset sales. Commercial property has appreciated so much in the past couple years, and companies will have large gains as they sell assets.
Despite lofty valuations, we would continue to keep REITs in any portfolio, as REITs offer a great diversification to the broader markets. In the past, REITs returns have not correlated to the overall markets.
Two sectors that we like in 2006 are lodging and retail. Hotel companies continue to post improved results each quarter and we expect more of the same throughout 2006. Retail has been strong for the past several years, and all signs indicate that the consumer continues to spend and retailers are opening more and more stores to keep up with demand.
In particular, we like Host Marriott (HMT) as one of the best-positioned hotel operators, with an excellent asset base in top markets. On the retail side, I would recommend The Macerich Group (MAC), a regional mall owner that continues to post impressive earnings and rent growth at its regional malls. The company is a skilled developer and redeveloper and we expect good growth in 2006. We also like real estate service companies Jones Lang LaSalle (JLL) and Trammell Crow (TCC). Both of these companies continue to benefit from hot national and international real estate markets. Both of these companies have strong balance sheets with low debt and produce plenty of free cash flow.
Greg Sukenik is a senior analyst covering the real estate investment trust (REIT) market for Zacks Investment Research, Inc. His comments also appear regularly at www.zacks.com. To speak with Mr. Sukenik, please contact Terry Ruffolo, Media Relations Director at Zacks, at , ext. 213 or truffolo@zacks.com
