Blessed by the Potato

An investment idea a bit off the beaten track to discuss today: American Hotel REIT. This is a new REIT, still flush with cash from its IPO. They identified the small, economy hotel market as one that’s fragmented and where they could make a number of accretive acquisitions. It has purchased a set of low-end hotels from a private chain in the US. The neat thing about these hotels is that they are focused on serving railroad workers: Union Pacific pre-pays for the majority (74%) of the rooms so that their unionized employees can take their required rest periods, with some room-nights also booked by other railways.

I found it interesting that one of the words used to advertise their rooms was “dark” – not something you hear all the time to describe hotels, yet precisely what I want in a room where all I want to do is sleep and get back on the road.

In terms of cash flow, it’s a little difficult to say for sure because the REIT has only been operating the hotels for a few months, and only part of the cash raised in the IPO has been put to use. They are vastly overpaying because of that last factor, but I think we can assume they will build or buy more hotels, so we can estimate the payout for the long-term.

Looking at the statements from the hotels under the private label (available on SEDAR), it looks like if they can invest the remaining $26M they’ll have no problem covering the distribution with the raw cash flow. However, depreciation and amortization can’t be completely ignored – some maintenance capex will need to be put into keep these stick construction hotels up-to-date, especially since about 30% of the balance sheet is “equipment” with projected lifetimes of 5-15 years rather than real estate. Making some rough estimates as to what to reserve – the engineering report from the purchase identified ~$1M/year in projects – I figure that this portfolio is generating about $0.50-$0.70/unit in distributable cash. Assuming that the rest of the cash buys similar properties, that works out to about $0.80/unit – a bit under the announced payout of $0.90/unit.

Now, this is a recent IPO, and it’s nearly a sure bet that there will be more secondary offerings to come, so they may have purposefully set the distribution a bit high to attract investors. Personally, I’d prefer they set it too low and then adjust higher once the properties prove themselves, but that strategy doesn’t move shares on the TSX. Because of the virtual guarantee of future secondary offerings, the price isn’t likely to shoot through the roof. The newness and small size also means that it is not widely followed, possibly making for opportunity.

But if even being fairly conservative I figure they can support a 7% payout, with the only substantial risk being re-contracting with Union Pacific, then I’m pretty happy. Plus there’s a good chance that growth, synergies, and inflation can help them meet that $0.90 payout in short order – at least before deferring maintenance capex catches up to them. In this environment, an 8% yield with a bit of risk is a decent deal.

One area of conservatism is the loan on the properties: the private company holding the hotels before the purchase was borrowing at 3.5% with floating-rate mortgages, but HOT.UN’s new financing is 5-year fixed at 4.85%, which is nearly ten cents per unit of cashflow right there. Lowering their borrowing costs (e.g., by growing larger and becoming more credit-worthy) could help make the distribution safer.

Disclosure: currently long HOT.UN. Note that this is a new, small, illiquid REIT with many risk factors (e.g., actually putting the cash to productive use; subsequent/dilutive offerings).