How hospitality REITs work
Hospitality REITs own hotels but, due to various laws, cannot directly receive rent from tenants. They typically hire an independent management team to run the hotel portion of the business.
So, before you even get to the pricing models or cyclic nature, you're dealing with a very different kind of owner and management structure than a typical office, industrial, or residential REIT, since those generally own the property and lease it to companies that want to occupy it.
With a hospitality REIT, you're also facing a very dynamic and changeable pricing environment. Since rooms are rented daily or weekly, in the case of some business hotels, pricing can change on a dime based on consumer demand. Not only are they constantly outlaying funds to find new tenants, but they're also having to spend money regularly to update and refresh the units to stay competitive.
Hotel REITs can be cyclical, moving in years-long cycles of growth, oversupply, underutilization, and recovery. Some performance metrics to watch include occupancy, average daily rate (ADR), and revenue per available room (RevPAR).
Advantages of investing in hospitality REITs
REITs in general tend to be fairly stable, solid long-term investments when managed properly, and hotel REITs aren't much different when times are good. There are some distinct advantages of this special kind of REIT, including:
- Improved returns: Hospitality REITs give investors a chance to buy a piece of the lucrative hospitality industry, which can result in higher returns and higher dividends than other types of investments.
- Truly passive income: Unlike real estate purchases, REIT investors have no active involvement in the property. They never have to evict anyone or clean up after a messy tenant; professional management teams behind the REITs do all the heavy lifting.
Risks of investing in hospitality REITs
Despite their significant rewards, hospitality REITs are not without risk. These risks cause many REIT investors, especially those who want a smoother and less heart-clutching ride, to choose other REIT classes.
Hospitality REITs come with four major risks, many of which can be avoided or minimized with good management. Risk factors include interest rates, oversupply, economics, and financing:
- Interest rates: REITs tend to move in the opposite direction of low-risk interest rates, such as the 10-year Treasury note. Investors who choose REITs are forgoing the opportunity to earn interest with absolute certainty. As those safe investment yields rise, investors expect their REIT yields to rise as well. However, higher REIT yields can translate to lower stock prices.
- Oversupply: If there are too many hotels in one place competing directly with a particular hotel REIT, vacancy rates can become so significant that room prices fall to stimulate demand. A thoroughly diversified hospitality REIT can be a better choice since a wide range of locations and property types will help to spread the risk.
- Economics: Because hotels are so often a discretionary expense, they don't do great when times are tough. However, hotel REITs also include properties that are popular with business travelers and luxury vacationers who travel regardless of the economy. Also, because hotels offer what are essentially daily leases, they can respond quickly to an upturn and increase rents without any hesitation when the tide turns back in their favor.
- Financing: As with all types of REITs, financing plays a crucial role in the expansion and upkeep of hotel REITs. Hospitality REITs may require lines of credit to get through tough economic times, acquire new real estate, or upgrade properties. Because of how quickly they can suffer in difficult times, it's important for hospitality REITs to maintain a low debt-to-capitalization ratio to avoid being dragged under if rents dry up.
What to consider before choosing hospitality REITs
When choosing hospitality REITs, you have to understand that these are not investments for the faint of heart. The daily operations are challenging, the environment ever-changing, and the cycles long and mentally exhausting. Here's a short list of things to consider before jumping in.
Hospitality REITs are long-term investments. There is no world in which a hospitality REIT is a functional short-term investment. Hotel industry cycles run too long and can take a lot of money to move a hotel from point A to point B. If you can't hold for the long run, don't buy these stocks.
Hotel economics are ever-changing. Hotels are in the business of renting rooms, but what it takes to get someone in the door one day may be very different from what it was a week ago. Today, you might need good prices and a pool; next week, it could be updated furniture in the official blue of the year and breakfast that's more than just passable. These expenses can't always be anticipated, so you'll have to trust the management of your hospitality REIT.
Hospitality REITs are constantly spending money. If you prefer investing in companies with a lot of assets and few expenses, this may not be the kind of investment you're after. Hotels and other hospitality REITs are part of the greater experience for travelers and, thus, require constant refreshing, renewing, and reimagining. That all costs money, but it can also create a dangerous spending cycle. Keep a close eye on financials with these kinds of investments.
Future outlook for hospitality REITs
With so much uncertainty in the macroeconomic environment, it's hard to say what the future holds for hospitality REITs, except that it may be a difficult business in the short term. With a decline in foreign visitors, uncertainty for middle-class vacationers, and ongoing labor issues, hospitality REITs could struggle -- but this can also spell opportunity to get good businesses at bargain prices.
In the longer term, there's a lot of potential for hospitality REITs to reposition themselves, including finding ways to package their rooms as parts of all-in-one experiences or developing more mixed-use properties on or near the same facilities, which can be attractive to guests.
An increased use of technology in hospitality and travel can help compensate for missing hotel workers and create efficiencies in the longer term. Vacations have been popular since the Roman Empire, so there's no reason to think the hospitality REIT as a concept is done and dusted.
