Real estate can be an excellent long-term investment. That's evident in the data as real estate investment trusts (REITs) have outperformed stocks over the years.
Unfortunately, not all REITs have what it takes to generate market-beating returns. Because of that, investors should consider selling those that aren't likely to create wealth. Three candidates where that seems to be the case are hospitality REITs Hersha Hospitality Trust (NYSE: HT), Chatham Lodging Trust (NYSE: CLDT), and Park Hotels & Resorts (NYSE: PK).
Going from bad to worse almost overnight
COVID-19 has devastated the hotel industry. Many REITs had to temporarily close hotels because that was cheaper than having them operate at ultra-low occupancy levels. Even with those closures, REITs were burning through cash, causing them to pile on more debt.
While some hotel REITs had lots of financial cushion to weather this storm, others entered this turbulent period with weaker finances. For example, Hersha Hospitality Trust ended the first quarter with a leverage ratio of 8.5 times its debt-to-EBITDA, nearly double the sector average of 4.7 times. Chatham Lodging Trust and Park Hotels & Resorts also entered the turbulent period with above-average leverage of 6.4 times and 5.0 times, respectively.
Unfortunately, those already high numbers have gotten worse in the months since because those REITs burned through their cash positions and started tapping their credit facilities to fund the gap. Hersha burned through $33.6 million of cash from April through July, which tacked more debt onto its balance sheet. Meanwhile, its earnings crashed through the floor, sending its leverage ratio soaring even higher. That rapidly deteriorating financial position will make it hard for the company to refinance debt, which is a concern since it has $216.5 million coming due next year.
Meanwhile, Chatham and Park are experiencing similar deteriorations in their already below-average balance sheets. While both have enough liquidity -- cash and available borrowing capacity -- to quench their cash burn rates for several more quarters, they're digging themselves deeper and deeper into debt.
A big hole to dig out of
Hotel REITs will eventually need to get back to making money. On a positive note, they've seen a nice rebound from leisure travelers as more people are driving to vacation destinations to get a break from it all. However, the biggest revenue generators for most hotels are the group and business transient markets. For example, Park Hotels & Resorts got 31% of its revenue from groups and 29% from the business transient segment last year.
Unfortunately, neither are likely to bounce back until after there's a widely available vaccine to combat COVID-19, which most experts don't expect until the first half of next year. Because of that, it will be a while before hotel REITs start making money again and generating free cash flow.
Meanwhile, once they start making money, they'll likely earmark it initially toward paying off the debt they piled on during the downturn. Most will probably aim to have even stronger balance sheets on the other side of this downturn, suggesting that they will likely focus on shoring up their finances for quite some time. Because of that, many might not bring back their dividends for a while, and if they do, they'll only pay out the minimum to maintain their REIT status. Further, financially weaker hotel REITs like Chatham, Park, and Hersha will be more likely to sell hotels than buy them in the future, which will impact their ability to grow.
It's hard to see the bright side here
Conditions in the hotel industry are brutal these days and don't seem like they'll improve too much over the next several months. Meanwhile, even when conditions get better, the first thing most hotel REITs will do is work on repairing their balance sheets. Because of that, dividends and growth will likely be on the back burner for quite some time, especially for financially weaker REITs like Hersha, Chatham, and Park. That will probably keep the weight on their stock prices, which are all down more than 50% this year. Given that bleak outlook, investors who own these beleaguered REITs might want to consider selling since they face a long road to recovery.