4 Top Hotel and Resort REITs to Consider Now

Real estate investment trusts, or REITs, typically specialize in a single type of real estate asset. One major REIT category is hotel and resort REITs, which own properties ranging from budget motels to ultra-luxurious travel destinations.

Hotel REITs come in a variety of sizes and sub-specializations, and have some unique business dynamics and risks that investors should know about. With that in mind, here's an introduction to REIT investing, what you need to know about hotel real estate investing, and four excellent hotel and resort REITs you might want to put on your radar.

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What is a REIT?

I've written a thorough primer on REIT investing, but here's a rundown of what you should know before buying your first REIT stock:

A real estate investment trust, or REIT (pronounced "reet") is a special type of investment vehicle that pools investors' money to purchase real estate assets. Whereas you and some friends may pool your resources to buy a home to use as a rental property, REITs essentially do the same thing on a much larger scale.

There are two broad categories of REITs -- equity REITs and mortgage REITs. When I use the term "REIT" from now on, I'll be referring to equity REITs, which own properties. Mortgage REITs, on the other hand, invest in mortgages and mortgage-backed securities, among other assets. In fact, mortgage REITs are such a different type of investment that they aren't even classified in the S&P Real Estate sector.

Equity REITs own a variety of commercial properties, and most specialize in one main property type. You can find REITs that invest in office buildings, shopping malls, healthcare facilities, warehouses, apartment buildings, and of course, hotels, just to name a few categories.

In order to be classified as a REIT, a company must invest at least 75% of its assets in real estate, be structured as a corporation, and pay out at least 90% of its taxable income to shareholders. There are also restrictions regarding how much of a REIT's stock can be owned by a single investor, or by a group of investors.

Benefits to REIT investing

There are good reasons you might want to add a REIT (or a few) to your portfolio. Here are some of the advantages of REIT investing:

• REITs allow everyday investors to put their money to work in types of real estate that would otherwise likely be unaffordable to them. For example, there are few people who could buy a high-rise apartment building in Manhattan on their own, but a REIT can allow you to invest in such a property.
• Because REITs are required to pay out 90% of their taxable income, they tend to have above-average dividend yields.
• Since REITs pay out most (if not all) of their taxable income to shareholders, they are not taxed at the corporate level. This makes REITs a particularly smart investment for retirement accounts like IRAs.
• REITs are great for diversification. Although they are technically stocks, real estate is generally considered a separate asset class.
• It's easier to own a REIT than to buy and operate an investment property.
• REITs have excellent long-term total return potential. High dividends combined with rising property values over time have allowed many well-known REITs to handily beat the S&P 500 over long periods of time.

A word about REITs and taxes

I already mentioned that REITs have a unique tax structure. This works both for and against investors, although the pros generally outweigh the cons.

First, since REITs are not taxed at the corporate level, there's no double taxation of REIT dividends. Even if you own a REIT in a taxable account, you'll only have to pay tax once. In contrast, when most publicly traded corporations earn a profit, they pay corporate tax on it. Then, when they pay dividends to shareholders, those same profits are taxed again.

On the other hand, because of this favorable tax structure, REIT dividends generally don't meet the IRS definition of a qualified dividend, which are taxed at favorable dividend tax rates. In other words, REIT dividends are typically treated as ordinary income.

The Tax Cuts and Jobs Act's pass-through income deduction applies to REIT income for qualified taxpayers, which should help alleviate this additional tax burden. Plus, if you own REITs in tax-advantaged accounts like traditional or Roth IRAs, you won't have to worry about the dividend tax implications at all.

The most important REIT metric you need to know

One of the most common mistakes new REIT investors make is looking at these companies' "earnings."

Traditional methods of calculating a company's earnings, or net income, don't really translate well to REITs. Specifically, real estate assets are allowed to be depreciated (written off) for tax purposes over a number of years, thereby reducing a REIT's net income. However, it's important to realize that this depreciation "expense" doesn't cost the REIT a dime -- in fact, the opposite is generally true, as real estate values tend to increase over time.

To make a long story short, the "earnings" metric REIT investors should pay attention to is known as funds from operations, or FFO. In a nutshell, it adds the depreciation expense back into the calculation and makes a few other smaller adjustments to better reflect how much money a REIT is actually making.

So, instead of using net income when computing a REIT's price-to-earnings multiple or any other earnings-based valuation metric, be sure to use FFO.

Reasons to invest in hotel and resort REITs

The most unique aspect of investing in hotels, as opposed to other types of commercial real estate, is the extremely short-term nature of their "lease" structure.

Unlike other types of commercial properties, hotels have the ability to adjust their rental rates on a daily basis. If you lease a restaurant property, for example, you know exactly how much rent your tenant will be paying, no matter what the business climate is throughout the term of the lease. On the other hand, hotels can adapt on a day-to-day basis. If a particular destination has an uptick in demand next summer, the operator can choose to increase room rates on short notice in order to take full advantage.

Risks of investing in hotel and resort REITs

Like any stock investment, hotel REITs have several risks that investors should be aware of. The other side of the daily rental structure discussed above is that it makes hotels far more vulnerable to recessions than other types of commercial properties. For example, if you sign a one-year lease on an apartment, you have to pay the monthly rent for the next year no matter how the economy fares. On the other hand, in tough times, consumers can simply decide to stop going to their favorite hotels. So if the economy falters, it's reasonable to expect your hotel REITs to take a relatively large hit.

Additionally, interest rate fluctuations are a major risk factor for all REIT investors. In a nutshell, REIT stocks tend to fall when bond yields rise (the 10-year Treasury is a good REIT indicator). In addition to putting downward pressure on stock prices, rising rates also make it more expensive for REITs to borrow money, which can cause profits to fall.

4 top hotel and resort REITs to consider

Now that we've gone through a primer on hotel REITs and REITs in general, let's take a look at some of the top hotel and resort REITs. In no particular order, here are four well-run hotel REITs you may want to take a look at, followed by some information about each one.

Data source: CNBC. Figures are current as of Dec. 26, 2018.

The biggest hotel REIT in the market

Host Hotels & Resorts is the largest hotel REIT, and by a considerable margin. In fact, the company is more than 2.5 times the size of the next largest peer.

Not only is it the largest in overall size, but most of its properties are large, upscale luxury hotels and resorts. Per the most recent data, Host Hotels owns 94 properties with an average of 578 rooms each. Examples of the most well-known properties in the portfolio include the Hyatt Regency Maui Resort & Spa, The W Hollywood, and the New York Marriott Marquis, just to name a few.

Size is one of Host Hotels & Resorts' biggest advantages. It gives the company efficiency advantages over smaller peers, and also allows for more flexibility to pursue investment opportunities as they arise. And, as the largest owner of Marriott-branded hotels in the U.S., the company has the additional advantage of benefiting from the Marriott-Starwood merger's efficiency improvements.

Another big strength is that Host Hotels and Resorts does an excellent job of capital recycling, the practice of selling properties at favorable valuations to reinvest the proceeds in ways that will maximize shareholder value. To illustrate, the company recently disposed of $1 billion worth of properties at a capitalization rate (a property's net income as a percentage of its market value) of 5.1%, while buying $1.4 billion worth of properties at a better cap rate of 5.8%. In simpler terms, the company sold properties that were producing lower yields compared to their value and bought higher-yielding properties with the proceeds.

Finally, Host Hotels has a strong balance sheet with low leverage and lots of financial flexibility. For example, Host Hotels has an interest coverage multiple of 9.2 -- its earnings are over nine times the cost of its interest expense. In comparison, the typical REIT has interest coverage closer to five or six times.

In fact, Host is the only hotel REIT with investment-grade credit ratings, meaning that creditors consider its debt low-risk. To sum it up, although the properties owned by Host Hotels may be a bit more vulnerable to economic downturns than some of the others on the list, this is somewhat offset by the company's scale advantages and rock-solid financial condition, which should allow it to fare better in tough times better than its peers would.

Mid-market hotels are more recession-resistant than other types

Apple Hospitality REIT could be a smart choice for investors who want to buy a hotel REIT but are worried about the risks during a recession.

Specifically, Apple Hospitality REIT invests in the middle of the market, with properties known as "select-service" hotels. Courtyard by Marriott and Homewood Suites are good examples of this category: These hotels offer much more than bargain hotel brands, but don't have the amenities and services offered by high-end hotels and resorts.

Here's why select-service hotels are more recession-resistant than high-end resorts. In bad economic times, people who would generally stay at luxurious hotels will downgrade to select-service hotels. Plus, these properties cater to business travelers and have relatively few rooms to fill, which helps to keep occupancy up even when times get tough.

At the end of the second quarter of 2018, Apple Hospitality REIT owned 241 hotels located in 34 states, virtually all of which are in the select-service category. About half are operated under Hilton brand names, and the other half are Marriott brands.

There are additional aspects of Apple Hospitality REIT's business model that suggest the company is managed conservatively. For one thing, its debt represents just 25% of its total capitalization -- an extremely low leverage ratio for a REIT. Additionally, Apple Hospitality does a great job of incentivizing its operators to perform well: All of its properties are run by third-party management companies, and most of these companies receive variable management fees that depend on how well each property performs.

Upscale hotels in strong markets

Xenia Hotels & Resorts is an upscale hotel REIT with a focus similar to that of Host Hotels & Resorts, but operates on a significantly smaller scale. The company owns 39 hotels, with about three-fourths of the properties operated under Marriott or Hyatt brand names.

My primary reason for including Xenia is the company's excellent track record of achieving peer-beating returns. In fact, since its 2014 listing as an independent REIT, Xenia's total return has been the best among 10 REITs in its peer group (including Host Hotels and a number of other upscale-focused hotel REITs).

To be fair, Xenia' balance sheet is slightly more leveraged than Host's, so it's not exactly an apples-to-apples comparison. I wouldn't call Xenia's debt excessive by any means, but its capital structure certainly isn't as conservative as Host Hotels'. For example, Xenia's net debt-to-EBITDA ratio is 3.6, while Host Hotels' is just 2.4. To sum up the difference, both Xenia and Host invest in similar properties, but Xenia uses significantly higher leverage. So during good times, Xenia's returns are likely to be better, which is a major reason it's outperformed in recent years.

Finally, despite its excellent track record of returns, Xenia trades at a rock-bottom valuation of just 10 times its expected 2018 FFO.

To be clear, I'd consider Xenia to be the most vulnerable of the four hotel REITs listed here in terms of how they'd fare in a recession or other adverse economic conditions. However, if you believe that the good times will continue for several more years, it's hard to make the case against Xenia.

A hotel REIT with an extra element of diversification

Hospitality Properties Trust isn't just a hotel REIT. While it does own an extensive collection of 325 hotels -- mostly extended-stay and mid-market properties under brand names such as Residence Inn by Marriott, Candlewood Suites, and Hyatt Place -- the REIT also owns about 200 travel centers that are adjacent to interstate highways.

So not only does Hospitality Properties Trust benefit from the market dynamics I discussed with Apple Hospitality REIT, but it also gets additional diversification because its travel centers are somewhat less cyclical. In other words, travelers still need to buy gas and food during recessions.

On the hotel side of the business, one major distinction between Hospitality Properties Trust and fellow select-service hotel REIT Apple Hospitality is the management structure. While Apple Hospitality's properties are run by third-party managers, all of HPT's hotels are operated by the brands' owners. For example, the company's Residence Inn by Marriott properties are actually operated by Marriott International.

The travel centers are operated under TravelCenters of America brand names (TA and Petro) and are all located near exits along major interstate highways. Each site consists of over 20 acres of valuable land, and travel centers are well-positioned to take advantage of demographic trends over the coming years. For example, the trucking industry is expected to grow by about 34% over the next 10 years, according to a study by trade group American Trucking Associations, so this should lead to a steady uptick in demand for conveniently located travel centers.

Which should you buy?

These are four of the top hotel REITs in the industry. All four have certain characteristics that make them unique, but they also face different levels of risk when it comes to recessions and other economic weakness. So be sure to weigh the pros and cons of each when deciding which one is the best fit for your own risk tolerance and investment goals.