A Peak Inside Of My Durable Income Portfolio
Just over a year ago I decided to add Pebblebrook Hotel Trust (PEB) to my Durable Income Portfolio (results will be published in the Forbes Real Estate Investor newsletter on Friday). I summed up the BUY recommendation as follows,
“There is a good reason that shares in all Lodging REITs are getting hammered. The market has already priced in a recession and we believe that we are a few years away from the actual event. Brexit certainly signals unstable economic conditions in Europe, but we don't believe that muted rate increases in the U.S. warrant such a discount in shares of PEB.”
My bet was that U.S real estate in gateway markets would perform well and that PEB was best-positioned to benefit due to its high-quality portfolio of trophy hotels. I summed it all up as follows,
“…it's much harder to predict earnings and dividend growth in the lodging sector due to the higher degree of economic uncertainty. I wish I had a better crystal ball for you – my forecast for PEB is 27.8% annualized returns.”
This is just a glimpse inside of my Durable Income Portfolio, and while I don’t profess to be the “Wizard of Oz” when it comes to REITs, I do have a secret weapon for picking the best REITs and it’s not ruby slippers…
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Let me be the first to explain that I am not a market timer. I typically invest in REITs that I plan to own at least one or two years, and I generally look for companies that I can own for much longer.
Some investors were fearful of investing in the Lodging sector (much like Outlet Centers today), but I knew that I could generate favorable results by “going against the herd” and focusing on the highest-quality REITs within the sectors that could out-perform.
The reason that Dorothy in the Wizard of Oz was able to find her way to Emerald City was because she was not scared of the witch. She knew that she could find her way back to Kansas by simply trusting herself and listening to the wise and powerful Wizard of Oz.
In the investing world, I consider Benjamin Graham one of the most astute wizards of all time and his words provide timeless relevance as it relates to the REITs inside of my Durable Income Portfolio,
“You are neither right nor wrong because the crowd disagrees with you. You are right because the data and reasoning are right.”
Pebblebrook Is Like Ruby Slippers
Most hotel landlords were hit hard during the Great Recession; however, PEB dodged the disaster, as the Maryland-based hotel REIT launched its IPO at the end of 2009.
The timing could not have been better (for PEB), as the Great Recession had a major impact on the performance of hotels, with the average hotel's cash flow declining by 50% between 2008 and early 2010.
But PEB took advantage of the financial collapse by raising $400 million in an IPO that was the genesis of a premier Lodging REIT that now owns 28 high-quality hotels with 6,970 guestrooms.
It's important to recognize that PEB has "no legacy assets," and the company was able to acquire hotels operating significantly below comparable operating margins. This presents substantial margin expansion opportunities.
The company's hotels are located in major U.S. gateway cities like San Francisco, West Los Angeles, Seattle, Portland, Boston, Washington, D.C., and Miami. Currently, it has properties in 13 major urban markets, with 13 different operators. Around 66% of 2017F Hotel EBITDA came from West Coast Properties.
Here's a snapshot (below) that illustrates PEB's geographic diversification. As you can see, San Francisco (24%), Los Angeles (16%) and Portland (13%) are the top markets:
PEB focuses on acquiring assets that are broken, either operationally or physically, and then utilizing its expertise, in collaboration with the expertise of the operators, to fix the problems and significantly improve the performance of the hotel, thus creating significant value for shareholders.
As you can see below, around 58% of its operators are independent, and 42% represent major brands (like Kimpton, Viceroy, etc...) Here's a snapshot of the company's operators:
PEB was able to exit the NYC market (6-hotel collection) before the weakness in that trade area. The company exchanged an interest in a 49% JV with the Denihan Hospitality Group and it was a strategic decision (by PEB) to exit the Manhattan market with continued increases in new hotel supply and declining operating performance.
This pivot demonstrates management's willingness to recognize mistakes, take losses and reallocate capital in a timely manner.
On arecent earnings call, PEB's CEO, Jon Bortz, explained:
"The New York market continues to be under stressed from too much supply growth and relentless labor and real estate tax increases and we’ll look for a better opportunity to invest again in New York City whenever the new cycle begins."
Since its IPO, PEB has acquired 37 properties and sold, or has contracted to sell, 4 properties in addition to other investment sales. Here's a timeline of the evolution of PEB:
As you can see, the REIT is selling (in late June) the Dumont Hotel in Manhattan in 2017. PEB had acquired the hotel in 2011, and it was able to sell the property for $118 million, representing an exceptionally low cap rate of 3.5%.
Assuming the Dumont sale is completed, PEB will have sold a total of $581.8 million of property at an average trailing 12-month NOI cap rate of 4.1% and an average trailing 12-month EBITDA multiple of 19.7x. In other words, this proves that the company is not only good at buying, but also selling, at the right time. Here's a list of dispositions:
Defining Pebblebrook's Experiential Redevelopment Process
PEB's experiential redevelopments are often extensive, evolutionary and have historically driven outsized growth and returns. Assuming a 14x EBITDA multiple, total invested capital in experiential redevelopments of $194.0 million is forecasted to create $27.0 million of incremental Hotel EBITDA and $184.0 million of incremental value above the investment amount.
Major redevelopments and operating efficiency implementation through year-end 2017 have and are projected to assist in producing $64.3 million of incremental Hotel EBITDA at a 24% implied yield.
Here is the impact of value creation opportunities on PEB's valuation. As you can see, the stabilized EBITDA multiple is materially below the long-term average premium to the peers:
There is significant upside opportunity from prior RevPAR underperformance due to capital deprivation, foreclosure, receivership and lack of asset management or poor positioning by prior ownership.
Just look at PEB's EBITDA margin (below). As you can see, the company has made relentless improvements to operating efficiencies. The Same-Property EBITDA margin differential between PEB and LaSalle Hotel Properties (NYSE:LHO) reduced by 145 bps in 2011, 150 bps in 2012, 69 bps in 2013, 161 bps in 2014, 30 bps in 2015 and 19 bps in 2016 - for a total of 574 bps.
Significant improvement in Hotel EBITDA margin growth is expected to continue during the next several years as asset management initiatives are implemented.
PEB Has already identified Hotel EBITDA opportunities of $19.2 million that will drive Stabilized Operating Hotel EBITDA to $275 million in 2017.
Balance Sheet Initiatives Are Working
PEB has used disposition proceeds to reduce its outstanding debt, strengthening the balance sheet and repurchasing shares it continues to be undervalued. The company updated its NAV following these sales and its stock repurchases and now estimates its NAV as $36.50 to $41 per share, up $0.50 at the bottom end of the prior range and up $1 at the upper end.
Year-to-date PEB bought 3.2 million shares for a total of $93.3 million at an average share price of $20.77 (that includes 1.1 million shares repurchased during Q2-17 at an average price of $29.80). PEB’s Board authorized a $100 million increase to the share repurchase program.
As of Q2-17 PEB had $43 million outstanding on its $450 million unsecured credit facility. The company’s fixed charge ratio was 3.5x, the debt to EBITDA ratio was 3.6x, and there are no debt maturities till 2020.
PEB’s current outstanding debt is 87% fixed rate and the remaining is 13% floating-rate. The company is currently focused on capital reinvestment projects, the company invested $25.5 million across the portfolio is Q2-17. Year-to-date PEB Has invested $47.4 million into hotels as part of capital reinvestment programs.
PEB continues to pursue other potential dispositions in an effort to take advantage of the very large differential between private market values for its properties and the much lower public market value for the combined portfolio and company.
The Latest Results
PEB’s Q2-17 financial performance exceeded the upper end of its guidance outlook range. Adjusted EBITDA was $67.2 million which was $2.3 million above the upper end of the Q2 outlook.
PEB’s Adjusted FFO was $52.1 million, or $0.75 per share, which exceeded the upper end of the outlook by $0.05 per share. This resulted from the hotel EBITDA and adjusted EBITDA beats, interest expense savings, a lower TRS tax expense, and a lower share count due to the shares repurchased during the quarter.
On the hotel operating side, same property RevPAR declined 2.4% which is in the middle of PEB’s outlook of -1.5% to 3.5%. PEB’s RevPAR decline was driven by 1.7% decrease in ADR and a 0.8% decline in occupancy. Excluding the San Francisco same property RevPAR for the rest of the portfolio increased 2%.
PEB’s Q2-17 hotel operating results were significantly impacted by renovations at Hotel Zoe San Francisco which is more disrupted than the original forecast due to the extended delays getting the rooms completed and back in service.
Fortunately the redevelopment and transformation of Hotel Zoe is now complete and PEB is “really excited with how the renovation turned out and the very favorable reviews we've been receiving from both guests and the media”.
On the recent earnings call, John Bortz, PEB’s CEO, added,
“with the completion of the transformation of Hotel Zoe, Hotel Revere Boston Common and Hotel Palomar Beverly Hills and the coming completion of the renovation of the Golf Tower at LaPlaya in Naples this summer, we will have completed all of the major transformations and renovations that we planned when we acquired the hotels in our portfolio.”
He added,
“We should see significant upside from these renovations over the next few years, as well as continuing ramp up from the completion of similar renovations and transformations and Hotel Zephyr Fisherman's Wharf, WLA West Beverly Hills, Vintage Portland, Union Station Nashville, Hotel Monica DC, Hotel Colonnade Coral Gables, and Hotel Zeppelin San Francisco.”
Follow the Yellow Brick Road
As I said, I’m not the “Wizard of Oz” but I do believe that PEB has been a gem of a REIT (referring to Emerald City). By ignoring the “overblown fears” in the Lodging REIT sector I was able to capitalize on a position in PEB that has resulted in out-performance within my Durable Income Portfolio.
Let’s compare PEB’s dividend yield today with the peer group:
Of course, I would not expect to see a trophy hotel landlord trading at the same price as a limited service hotel REIT. I consider the dividend safe, and a better metric for valuation is illustrated below:
Although PEB shares have increased substantially (around 30%) since my BUY recommendation (June 2016) I am maintaining (a BUY). I expect to see out-performance in 2017-2018 as recently completed renovations payoff. On the latest earnings call PEB’s CEO remarks,
“Most economic statistics have been improving since last fall such as employment growth, corporate profits, and consumer confidence. But other ones that also correlate with the travel industry such as business investment and airline employments have yet to substantially improve…
We're also raising our outlook range for adjusted EBITDA for the year by $5.3 million at the bottom of the range and $2.3 million at the high-end of the range. This takes into account our second quarter beat which also applies to our FFO per share outlook revisions. We're increasing FFO per share by $0.10 per share at the bottom end of our range, and $0.05 per share at the top of the range.”
My Conclusion: While I am maintaining a BUY on PEB, I have also decided to trim shares in the Durable Income Portfolio. This does not reflect a panic to SELL shares, as I am essentially re-balancing the portfolio in an effort to increase my stake in a Lodging REIT that has a better growth profile. PEB should continue to out-perform, but I am not anticipating the same ~30% growth enjoyed by PEB (over the last year or so).