Rising Star Buy: Pebblebrook Hotel Trust

This article is part of our Rising Star Portfolios series.

If you like ugly, you're going to love my pick today.

There are plenty of suffering industries out there, but few more hideous than hotels. However, aesthetically beautiful, economically ugly hotels are Pebblebrook Hotel Trust's (NYSE: PEB  ) bread and butter.

You can check out anytime you like, but you can never leave...
As the real estate bubble took hold few years ago, hotels went along for the ride. Hotel deals totaling $4.5 billion were signed in 2002; by 2007, that number had spiked tenfold to $45 billion. Then, the crash: In 2009, a scant $2.0 billion in hotels changed hands.

Just as homeowners took on imprudently large loans, hoping their houses would rise in value before they had to pay them back, hotel buyers fueled their hotel purchases with excessive debt. When the economy cratered in the aftermath of the crash, hotels rode it all the way down. Occupancy rates sank well below historic averages, and hotels have been forced to slash room rates. The recipe of excessive debt -- and thus, high interest payments -- and deteriorating business has left many hotel owners overcooked.

And just when they thought it couldn't get any worse -- guess what? It's time to pay back their loans.

But many hotel owners don't have the money to pay back their loans. Banks won't lend to them or let them refinance. And the market for commercial mortgage-backed securities, a traditional hotel financing source, is all but nonexistent. Hotel owners are increasingly left with only one option to avoid foreclosure: Sell their hotels -- cheaply.

Call the bellhop -- this hotel is on fire(sale)!
That's where Pebblebrook comes in, as I also explained here. The brainchild of industry veteran Jon Bortz, Pebblebrook has a simple strategy: Buy urban, upscale hotels in major coastal U.S. cities as cheaply as possible. This subset of the market consistently outperforms hotel industry averages.

Since launching Pebblebrook in December 2009, Bortz has raised about $700 million, and he hasn't hesitated to put that cash to work. Pebblebrook has bought six hotels since starting to buy in June, with two more purchases being finalized. As a rare cash buyer in a debt-flooded market, Bortz has his pick of the litter.

There are four ways Pebblebrook can create value for shareholders. First, when Pebblebrook buys a hotel, it buys the hotel without its previous debt. For some hotels, that's all it takes. The first hotel Bortz bought, for example, paid out a whopping 450% of its operating income in interest payments. The day Pebblebrook took over, that expense was wiped away, and the hotel was instantly profitable.

Second, we profit from Bortz's ability to buy hotels for less than they're worth. The bigger the discount he can swing on his purchases, the better for us. Third, hotel industry performance is closely tied to economic growth, so any economic improvements mean increased hotel profitability. Finally, Bortz claims he can improve the operation of some of his hotels. I'll believe it when I see it, but any profitable improvements are gravy to us.

Valuation: Stay two nights, get one free
By my calculation, Pebblebrook has $18.50 a share in tangible book value -- and that number assumes Bortz buys without any discount to intrinsic value. That seems like a conservative floor for my valuation.

There are a number of ways to think about valuing Pebblebrook's potential. We have enough data on his first three hotels to discount their cash flows and estimate how that will translate to his other purchases. My handiwork shows that Bortz's hotels should have free cash flow yields of 6.5% to 8%, implying a share price in the $27 range.

Alternatively, we can model hotel-level EBITDA. Once Pebblebrook is fully invested, I think it should be able generate $40 million to $70 million in EBITDA. Applying that number to the industry average EV/EBITDA of 19.9 implies a share price of $23 to $30.

Company Name

EV/EBITDA

Host Hotels & Resorts 19.7
Ashford Hospitality Trust (NYSE: AHT  ) 14.8
Innsuites Hospitality Trust (NYSE: HST  ) 32.5
FelCor Lodging Trust 16.6
Supertel Hospitality (Nasdaq: SPPR  ) 10.9
Sunstone Hotel Investors 22.1
Hospitality Properties Trust (NYSE: HPT  ) 8.8
Strategic Hotels & Resorts (NYSE: BEE  ) 19.8
LaSalle Hotel Properties 16.0
Hersha Hospitality Trust (NYSE: HT  ) 21.7
Diamondrock Hospitality 20.3
Chesapeake Lodging Trust 40.4
Chatham Lodging Trust 15.0
Average 19.9

At today's $18.50 price tag, we're essentially getting Pebblebrook's hotels at cost -- and that cost is likely lowballing their actual value. With limited downside, and the potential for as much as a 60% upside to $30, I'm more than willing to check in and stay a while. So I'm buying a 3% position in the company, or $510.

Foolish bottom line
It's no fun being a debt-laden hotel owner these days, but it's a blast being a cash-rich hotel buyer. And there may be no better value shopper than hotel pro Jon Bortz, who's running around the country scoring mouthwatering deals for his shareholders. The market, however, is running scared at the mere mention of the word "hotel." Today, we have the opportunity to jump on the Pebblebrook deal train for a dirt cheap price.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Alex Pape does not own shares in any company mentioned here. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (32)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 18, 2010, at 5:01 PM, XMFPapester wrote:

    Chime in with your thoughts on my discussion boards!

    http://boards.fool.com/rs-alex-pape-119865.aspx?source=irnsi...

  • Report this Comment On November 18, 2010, at 11:14 PM, goalie37 wrote:

    The stock is selling for basically cash + purchase prices of hotels already bought. This means that all future cash flows and any appreciation in land (from what are surely generational lows in price) can be bought for free.

  • Report this Comment On November 21, 2010, at 4:00 PM, XMFPapester wrote:

    Spot on, goalie37. That's what I meant when I said tangible book value is $18.50 - that's really just the cash and the hotels. We get any appreciation for free, but even more exciting (to me, anyway) is that, by my model, the hotels are being purchased for less than their true value. We don't even need appreciation - just the stock to gradually reflect the intrinsic value of the hotels.

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