Room service: exploring investment opportunities in the hotel sector

Stuart Cartledge

The Cromwell Phoenix Global Opportunities Fund assesses potential investments in a bottom-up manner, selecting the best opportunities, rather than following broad thematics.

Despite this, investment opportunities may have similar drivers – or operate in similar industries – from time-to-time. This is currently the case for the Fund’s exposure to hotel properties – these opportunities all exist for different reasons and have unique risk/reward propositions; however, the true value of each is predominantly derived from the ownership of hotels.

Before examining specific examples, it is worth touching on how to think of the value of a hotel.

Like other types of property, one way to think about valuing hotels is to apply a capitalisation rate to the earnings the asset generates. Unlike some types of property (but much more similar than some realise), hotels need to be refurbished frequently to stay up-to-date and attract customers. Any income should be adjusted lower for a normalised capital expenditure amount.

Those who buy and sell hotels also often think of valuing hotels on a “per key” basis – this describes the hotel’s value relative to the number of rooms available. A well-located, extremely high-end hotel may trade for well above $1 million per key, while a motel in the middle of nowhere would likely trade for less than $100,000 per key.

The per key valuation of a hotel can be used to compare hotel valuations to replacement cost, which is the amount required to replace the hotel from the ground up (inclusive of land). This is important because, if hotels are trading for below replacement cost, it is less likely that new hotels will be supplied in that market. Hotels are extremely sensitive to demand and supply, as anyone who has travelled in peak periods can attest to. As an example, a high-end hotel on the Las Vegas Strip is commonly available for AUD$200 per night. Booking even a basic room in that same hotel during the Las Vegas Formula One event would set you back more than AUD$3,500.

Recognition of the value of hotel properties by listed markets is held back by two components. Firstly, financial results have been negatively impacted by COVID restrictions, meaning that those looking solely at the recent income generated by many properties are underestimating the true earning power. Applying a capitalisation rate to this smaller income number is understating the property’s true value. Secondly, unlike some other forms of property, hotels are held on a company’s balance sheet at the lesser of its depreciated cost or net realisable value. If a hotel was built long ago, this may significantly understate its true value and make it difficult to identify for investors screening for discounts to book value.

With this background detail out of the way, let’s look at some examples in which the Fund invests.

Park Hotels & Resorts Inc. (NYSE:PK)

Historically, the world’s leading hotel operators used to own hotel properties and manage their operations. In more recent times, these companies realised they could split the businesses, with one company managing the hotels – requiring very little capital (and, therefore, generating high returns on equity) – and one owning the more capital-intensive properties. Recognising this, Hilton Hotels spun-out its physical real estate in 2016, creating Park Hotels. At the time of the spin, Park comprised Hilton assets from all over the world. Today it is an entirely US-based portfolio of predominantly Hilton-run hotels.

A well-located, extremely highend hotel may trade for well above $1 million per key

Park owns some of the world’s most iconic hotels, including the 1,921-room Hilton San Francisco Union Square and the 1,878-room New York Hilton Midtown, which both dominate prime blocks in their respective cities. Perhaps more importantly, it owns two exceptional hotels in Hawaii – the Hilton Hawaiian Village Waikiki Beach Resort and the Hilton Waikoloa Village. We previously discussed the importance of replacement cost; however, these two sites are genuinely irreplaceable.

Despite the challenge in assessing the replacement cost of these hotels, a reasonable estimate for Park’s hotels is USD$735,000 per key. At the current share price, Park is trading for less than USD$250,000 per key. Using capitalisation rates from comparable property transactions ascribes a net asset value of $28.50 per share, compared with Park’s period end closing share price of $12.36. With a solid management team in place and a world class array of assets, Park Hotels appears very attractively priced.

Sotherly Hotels Inc. (NASDAQ-CM:SOHO)

While Sotherly Hotels is another US-based hotel owner, it is in a very different situation to Park. As its name suggests, the organisation’s hotels are based in the South of the US, predominantly in states like Florida, Georgia, and North Carolina. These hotels are smaller and more downmarket than Park’s hotels, with many branded as Doubletree by Hilton, the company’s lower upscale brand.

The investment opportunity for Sotherly Hotels is largely tied into its capital structure. Most recently, Sotherly took on too much debt and preferred equity instruments to grow assets. This proved to be ill-advised when COVID hit, and their business was effectively shut down. They stopped paying dividends on their preferred equity, which began to accrue, and the company took on emergency debt.

As things began to improve, they have been able to repay their most costly debt that was taken on in their darkest days. They have also been able to retire some of their preferred equity and have resumed paying dividends on these instruments, reducing arrears. Dividends to regular shareholders can be paid again once the arrears are repaid. At a market capitalisation of just US$37 million, the implied value per key is approximately USD$175,000. This is a long way below replacement cost. As some property investors like to say, you couldn’t build those hotels out of playdough for that price!

Sotherley’s high debt load is a risk, however, which could be destructive should the macroeconomic environment turn more negative as a meaningful reduction in cash flow could make the interest burden extremely difficult. The Fund’s position sizing of approximately 2% of assets acknowledges this risk.

sagon-hotel

Stamford Land Corporation (SGX:H07)

Stamford Land is a Singaporean-based owner of the Stamford hotel portfolio in Australia, and it is run by eccentric Chairman CK Ow. In 2021, Mr. Ow put the entire portfolio on the market for sale. The portfolio attracted bids at multiples of the share price, but the offers did not hit Mr Ow’s target, so he u-turned and decided to raise capital at a massive discount.

Stamford has perpetually traded at a discount to the value of its properties, in part due to governance concerns, but also due to the aforementioned accounting treatment of hotels. Some of these hotels were purchased in the 1990’s and therefore their book value significantly understates their true value. Despite initially raising capital and saying he was no longer selling the hotels, Mr Ow has begun selling some assets. This includes the Stamford Circular Quay, sold as a development site, at a price of more than $2 million per key and the Stamford Plaza Auckland, sold at a price of more than $550,000 per key. Stamford has not yet reported its financial accounts since these transactions closed. When it does, the book value will reflect the sale prices of these properties highlighting some of the company’s latent value.

What the Ow family will choose to do with the money received from these sales, or whether they will sell more properties in the future remains a mystery. However, trading at a big discount to the value of the properties, with a near term revelation of value, we maintain a holding in the company.

Keck Seng Investments Limited (SEHK:184)

Keck Seng is controlled by Ho Kian Guan, one of Singapore’s 50 richest people. Keck Seng predominantly owns upscale hotels across North America and Asia – its major assets include the W Hotel San Francisco, the Sofitel New York, and the Sheraton Saigon Hotel. It also owns residential property in Macau. It has approximately zero net debt, with almost all gross debt held in the form of non-recourse mortgages tied to the US hotels.

Current earnings for these properties understate their true value due to the impact of COVID restrictions. The Sofitel New York was closed for most of 2021 and occupancy through 2022 was meaningfully below current levels. Restrictions in Macau and Vietnam have only recently been lifted and travel is still recovering to pre-covid levels. Keck Seng’s hotels are held on the balance sheet at depreciated cost. These hotels were purchased more recently than those owned by Stamford; however, book value still almost certainly understated their true value. At book value, the hotels are held at less than $175,000 a key, despite being predominantly 5-star properties. Even before considering how much this undervalues the property, Keck Seng’s book value is HKD$8.63 per share. This compares to a share price at period end of HKD$2.85.
Keck Seng’s governance is reasonable, with dividends regularly paid to shareholders and the share count remaining stable over time. Related parties are paid fair salaries and transactions seem sensible. Despite this, there is no reason why this discount is likely to close in the near term.

The stock is illiquid and, while it trades at one of the largest discounts in its history, it has always traded at somewhat of a discount to its fair value. Given the size of the discount and the quality of the underlying properties, Keck Seng appears to be a very attractive investment idea.

Checking Out

Hopefully, the above provides examples of the different ways the Fund is investing in hotel properties. Despite the similarities in the underlying assets held by each, they are all somewhat unique from an investment perspective. Collectively at quarter end, these four investments constituted approximately 10% of fund assets.

For the period, they added a small amount of value relative to global indices, however as described above, they still appear to be attractive investment propositions.

Cromwell Phoenix Global Opportunities Fund

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