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
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.
|Host Hotels & Resorts||19.7|
Ashford Hospitality Trust
Innsuites Hospitality Trust
|FelCor Lodging Trust||16.6|
|Sunstone Hotel Investors||22.1|
Hospitality Properties Trust
Strategic Hotels & Resorts
|LaSalle Hotel Properties||16.0|
Hersha Hospitality Trust
|Chesapeake Lodging Trust||40.4|
|Chatham Lodging Trust||15.0|
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.