Hotel REITs can be excellent income-generating investments, and they can have a lot of upside potential as the values of their properties increase over time. Apple Hospitality REIT (NYSE:APLE) is one of the largest hotel REITs out there, and it invests in what's known as the "select service" hotel market. Not only does the company pay a dividend yield of over 6% based on its recent trading price, but it also does an excellent job of mitigating the risk factors that naturally affect hotel properties.

I recently had a chance to speak with Apple Hospitality REIT CEO Justin Knight and other members of the company's management team at the REIT Week 2017 conference in New York, so here's an overview of the current state of the company, the risks involved, and why Apple Hospitality REIT should be less prone to risk than many of its peers.

SpringHill Suites in Burbank, California.

Image source: Apple Hospitality REIT.

What is a select service hotel?

Simply put, select service hotels are a hybrid segment of the hotel market. They don't provide the extensive amenities and services offered by resorts and luxury hotels, but they also offer much more than no-frills bargain hotels. Generally, these hotels have relatively few rooms (200 or less) and generally don't have restaurant facilities. Select service has been the fastest-growing segment of the hotel industry over the past few decades, and continues to grow rapidly.

Many select service hotels offer features such as continental breakfast, fitness centers, a business center, and an indoor or outdoor pool. Brands such as Homewood Suites, Courtyard by Marriott, and Hampton Inn are good examples of select service hotels.

Homewood Suites in Cape Canaveral, Florida.

Image source: Apple Hospitality REIT.

Apple Hospitality REIT's portfolio and strategy

Apple Hospitality REIT owns 235 hotels with a total of 29,979 guestrooms, located in 33 U.S. states. Virtually all of the properties (98%) are select service or extended stay hotels, fitting the description listed in the previous sector, and all are operated under various Hilton or Marriott brand names. The company is one of the largest hotel REITs, and is the largest focused on upscale select service hotel properties.

Major hotel brands in Apple Hospitality REIT's portfolio include Hilton Garden Inn, Homewood Suites, Hampton Inn, Courtyard by Marriott, and Residence Inn, just to name a few.

The company's strategy is rather simple. Offer select service hotels that are newer and more desirable than the competition, partner with the best brands, and hire the best operators to run the properties. Then, regularly reinvest in the properties to maintain their competitive advantages. In fact, Apple Hospitality REIT (including its predecessor companies) has invested more than $450 million in its own properties, and the average property has an effective age (time since built or last renovation) of just four years.

APLE reinvestment statistics.

Image source: Apple Hospitality REIT investor presentation.

All of Apple Hospitality REIT's properties are managed by third-party companies, whose management fees are tied to the performance of the properties. In other words, the managers have a strong incentive to generate value for shareholders.

The company's management team has extensive experience, and although the company looks rather young at first glance (listing on the NYSE in 2015), the Apple REIT Companies have been around for much longer. In fact, the company's management team has established and operated eight public hospitality REITs, and has purchased a total of more than 400 hotel properties.

Hotel risk factors and how Apple Hospitality REIT mitigates them

In a 2016 conversation with Knight, he pointed out that one of the unique features of hotel real estate is that these properties can adjust rental rates on a daily basis -- as opposed to other property types where tenants are on annual (or longer) leases.

This is certainly a benefit in strong economies. For example, if a particular hotel is charging $200 per night for a room, and next month determines its rooms can now fill up at a rate of $250, it is free to make that increase. Retail and office real estate operators have no such luck.

On the other hand, this can be a serious disadvantage in recessions, a fact that Knight and his team openly acknowledge. However, the company has taken prudent steps to mitigate any risk to shareholders. "We focus on smaller hotels, with fewer rooms to sell, and with less reliance on group business -- one of the first parts of the business to suffer in tough times," said Knight.

In addition, the portfolio is broadly geographically diverse, and its portfolio of high-quality brand-name properties allow the company to operate at higher margins than most competitors, which gives it more cushion to absorb a revenue hit during a recession.

Comparison of hotel REIT profit margins.

Image source: Apple Hospitality REIT investor presentation.

Apple Hospitality also has a strong balance sheet, with a debt to capitalization of just 25%, remarkably low for the REIT sector.

Finally, Knight points out that Apple Hospitality's properties are in the middle of the market, which is a segment that has broad appeal in any economy. "In past recessions, consumers who generally stay at higher-end properties become more value-conscious, which benefits us." In other words, while Apple Hospitality's properties may lose some of its usual clientele during tough times, people who typically stay at, say, Westin or Hilton hotels might stay at some of Apple Hospitality REIT's core brands, such as Homewood Suites, in order to cut back on expenses.

To be perfectly clear, I'm not saying that any of this eliminates the risk. In fact, if another 2008-like recession were to hit, you can be almost certain that Apple Hospitality's revenue would drop significantly. The point is that the company should be less affected by recessions than most of its peers.

The bottom line

Without getting too deep into an economics discussion, the basic point of investing is to generate the best risk-adjusted return potential possible. In other words, you want to achieve the best possible long-term return potential for a given level of risk you're willing to accept.

Apple Hospitality REIT isn't exactly a low-volatility investment, but I wouldn't call it an overly risky one, either. The company has done a great job of setting itself up for strong return potential without taking on excessive leverage, relying too much on any single brand or geographic areas and by investing in hotels that can function well in any economic climate.

The bottom line is that while Apple Hospitality REIT will almost certainly have its ups and downs over the years, its dividend is secure and those with a long time horizon could be handsomely rewarded.