Chlorophyll Inc

Snippets from the book "DIY Guide to Winning with REITs" 

Four Seasons, JW Marriott and Westin hotels and resorts: all these names are synonymous with one of my favorite words. A holiday!

But for Hospitality reit unit-holders, investing in hotels may not be all that enjoyable for the following reasons:

Capital expenditure may not be for growth

REIT unit-holders usually expect higher returns (higher DPUs) after their reit spends money on renewing their buildings (recall the concept of organic growth-asset enhancement initiatives). But for Hospitality reits, they must enhance their properties regardless of whether it leads to higher DPU. This is to stay competitive amidst newer rivals.

Vulnerable to many uncontrollable factors

Unlike Healthcare reits with their long lease agreements that help ensure distribution stability, the hospitality industry can have its fortune changed overnight based on conditions which are totally outside of anyone’s control, such as the weather pattern which disrupts tourism, terror attacks and more. This can be a real headache for someone who has a huge proportion of their portfolio allocated to such reits.

In light of this, some Hospitality reits do negotiate a master lease agreement with a hotel operator which provides for a minimum fixed revenue amount. This is one matrix to look out for when investing in such reits.

An example of a worthy hospitality-industry reit is OUE Hospitality Trust (SGX: SK7). This reit pledges a minimum yield of 4.5% simply due to the master lease agreement they contracted with their hotels. If their hotels have great daily occupancy rates for the year, that’s just gravy on top of an already healthy rate of return.

A new threat

Booking.com and Hotel.com are some of the latest social media initiatives that help boost the occupancy for hotels. However, there is a new threat to the industry, which is this social website called Airbnb. Airbnb is an online platform for people to list their own homes and apartments to travelers.

A study conducted by HVS (Hospitality Valuation Services, a consulting firm that provides market studies and educational information relating to the hospitality industry) from 2014 to 2015 shows that hotels lost more than $400 million in direct revenues per year to Airbnb. The popularity of Airbnb is bad news to REITs that hold hotels catering to the low and middle class clientele.

So, based on the considerations above, here are some factors to note for Hotel REIT unit-holders.

Focus on quality

When looking at Hospitality REITs, pay attention to the overall feel and look of the underlying properties. Unlike some other REITs such as Industrial reits where the appearance of the property may not matter much, Hospitality REITs need their hotels and service apartments to keep up with appearances and standards. Moreover, with the threat of Airbnb, you want your Hospitality REIT to hold higher quality hotels whose service standard and experience cannot be so easily replicated by homeowners.

While some of these hotel properties can be evaluated by personally going down to the hotel, the quantitative method of determining the earnings potential of a hotel is to calculate the revenue per available room or “RevPAR”.

RevPAR: Average Daily Rate (ADR) * Average Occupancy Rate (AOR)

Although the higher the RevPAR, the better, there is a common misconception that high RevPAR is only achieved from operating five-star hotels due to the higher pricing.

This is not true, as star rating achievements do not necessarily mean better investment results.

Modify your investment strategy via lease structures

As mentioned earlier, the relatively unique lease structure of hotels is a big advantage of owning a Hospitality reit over the other types of property. Understanding the lease structure plays an important role in your portfolio objective.

An investor looking to take advantage of an upcoming tourism boom in a country, for example, should go for Hospitality reits that have negotiated a larger proportion of their lease structure on the variable side. Vice versa, an investor looking for more stability in the sector should go for Hospitality reits with a higher fixed portion in their lease structure.

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Industrial assets are properties such as business parks, flatted factories, show houses, and warehouses. While these kinds of reits may offer higher yields relative to other reits, they do come with risks. Below are a few areas of which unit-holders need to be aware when investing in industrial reits.

So common

Which is cheaper and easier to build – a hotel or a warehouse? The answer is, of course, the warehouse.

Building a simple warehouse requires relatively little capital upfront, and it can be constructed fairly quickly and easily as compared to a hotel, hospital or office building. Thus, the barrier to entry is low, and this can lead to situations of market oversupply and volatile rental rates.

The occupancy of industrial space in America during the weak economic environment in 2009-2012 was in the low 60% range, unlike the average occupancy rate of Retail reits, which was above 75%. This goes to show that Industrial reits are much more sensitive to the economy as compared to Retail reits. So, if you’re interested in investing in Industrial reits, the first thing is to understand the domestic demand and supply dynamics in the area/city/country in which the Industrial reit’s assets reside. Ideally, you want to invest in Industrial reits when the demand for goods is healthy, and the supply of new warehouses and storage buildings are lacking.

Quality concerns

Besides the macro factors, let’s focus on the Industrial assets themselves. Smart investors tend to pick industrial properties that are adaptive and well-equipped to serve big-business clients. Easy access to wide roads or highways (for logistic purposes), built-in high floor-loading capabilities, high ceiling heights and wide column spans are some examples of highly desired industrial assets for big companies.

“Logistics continue to play an increasingly pivotal role for companies to gain market share and deliver higher levels of customer satisfaction. With the industry evolving, basic warehousing and delivery are just not enough. Therefore, look out for Industrial assets that are equipped with sensory technology that can monitor people and equipment (heighten safety levels), as well as assets that are equipped with systems that can drive inventory efficiency for their clients.”

I tend to avoid Industrial reits that own small warehouses for the purpose of renting out to small fleeting enterprises. The reason is because the typical industrial tenants are usually non-investment grade; as such, their ability to honor rent payments during difficult times can be quite worrisome for me. As such I tend to focus more on the quality of the Industrial REIT’s leases – who they are leasing out to. Although in reality, it is difficult to find Industrial reits that lease 100% of their properties to reputable MNCs, a 60% or more exposure to the latter will be deemed as a considerably “safer” Industrial REIT investment.

The point is that if the tenants do not have the cash flow to pay, no matter how long the contracted lease term is, it is of no value to the unitholder.

“There is still value in investing in Industrial reits that serve small companies. However, they must have plans to diversify their tenant base; for example, plans to have their logistic centres convert from a master lease basis to multi-tenancy and a management that is active in negotiating higher levels of security deposits from these tenants.”

My theory: Higher yields – perhaps there is a reason

Industrial reits enjoy low property upkeep and repair expense, while still generating relatively higher yields than other reits.

But note that there is a reason for these high yields; my assumption is that capital gains (from these industrial properties) have already been priced into the yield. If you take a step back and compare an office building to a warehouse in New York, which do you think will appreciate in value more during euphoric times? More industrial reit land lease tenures are much lower as compared to the other reits. Meaning to say, the land in which the industrial buildings are built on, have lesser years left, in which the government can take it back once the tenures are up.

Perhaps it’s the way the industrial buildings look, or the difficulty in raising rent even through property enhancement initiative; or it may just be due to perception. Industrial reits give higher yields because their unit price hardly moves upwards.

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