Rationalizing the irrational
Like many other hotel industry investors and investment advisors, I have been observing with some measure of incredulity the high price that REITs are paying for lodging assets. Since it is unlikely that this entire class of investors is smarter that every other class of investors — or that they would, as a class, have a view of the lodging market that is uniformly brighter than every other class of investor — it is difficult to attribute their actions to anything other than the fact that their cost of capital is substantially less than that of other types of investors.
If a public REIT is trading at 15 times Funds From Operation (FFO), their cost of equity is roughly 6.6%. If they can buy an asset and achieve even a 10% return on net investment in three to four years, they have achieved a 350-basis point positive arbitrage. Another way to look at this is that if a REIT’s FFO grows 10% per year in each of the next five years, the multiple on their stock in 2015 would only need to be 9.3 to yield the same market cap as a 15 multiple today. Is it possible to realize a 10% compound annual growth rate in the EBITDA of acquired assets over the next five years? Maybe, given the low base that will prevail in 2010 and 2011.
Private REITs have a similar advantage in that their high-commission broker-dealer networks are able to generate seemingly unlimited low-cost capital from small investors willing to accept modest current returns. Their biggest challenge is paying dividends before the money is spent and earning current yields. (Perversely, this accentuates the need to pressure-buy — in other words, overpay for — assets.
Contrast the REIT situation with that of most private equity investors (especially funds). Total yields on hotel investments for private equity groups needs to start with a two — that is, 20% plus — with a reasonable possibility of additional upside. So unless the delta between acquisition price and terminal value is greater than what most buyers could rationalize in their underwriting, you simply can’t get there by matching what the REITs are prepared to accept: 10% unlevered cash on cash returns that take three years or more to achieve. This is especially true with the conservative leverage in today’s marketplace.
This massive disparity between the cost/expectations of public and private equity (especially opportunity funds) is proof positive that beauty is, indeed, in the eye of the beholder.
Clearly, there have been periods in the past where differences in the cost of capital between various types of investors created temporary pricing advantages/disadvantages. But I’m wondering if this is more than a temporary condition. That is, are the twenty-something expected returns of private equity too high considering capital market conditions that exist today and are likely to exist in the foreseeable future — namely, bountiful low-cost capital from the public markets and conservative leverage? And will private equity have to accept lower returns to compete for investments in the lodging sector (or other real estate sectors, for that matter)?
Fundamentally, the answer comes down to this: how much of this low-yield capital will be available to both public and private REITs, and for how long? Here are some of the factors that will determine the answers:
- Alternative investment returns, both in equities and other safer classes of real estate
- Hotel industry performance (Will the REITs achieve their minimum level of returns on the assets they are buying at these seemingly inflated prices?)
- Whether the values of the assets being acquired are accretive to the net asset value (NAV) of the REITs
- Inflation (absent material supply/demand imbalances, hotels perform well in an inflationary environment because of their ability to constantly adjust pricing)
For now, at least, private equity seems to have one of four options:
- Pursue notes instead of hard assets.
- Pursue more complex and riskier transactions (which would logically drive yield requirements even higher).
- Lower yield requirements.
- Take a long vacation.
NOTE 1: I acknowledge that the investment horizon may also be a factor influencing REIT acquisition behavior. Both public and private REITs can hold assets for long periods and enjoy growing FFO without the concern of having to return principal and close out a fund. This is also true for high-net worth individuals, both foreign and domestic. Although longer hold periods will likely erode IRRs, these buyers are often driven by different metrics.
NOTE 2: To be fair (and accurate) there are groups other than REITs that have paid hefty prices for assets – especially prime assets in gateway markets with high barriers to entry. Generally, these are foreign and domestic high-net worth individuals mentioned in NOTE 1 along with buyers who have an overriding strategic objective.