Investors take a risk by buying an income-focused stock like a REIT instead of investing in Treasuries. They expect to be compensated for the additional risk in the form of a higher yield. As risk-free rates rise, investors expect risk premiums to stay roughly the same, so REIT yields rise. Since price and yield have an inverse relationship, higher REIT yields translate to lower stock prices.
During strong economies, there’s often a surge in new constructions. For example, if a city is doing well as a tourist destination, it’s reasonable to expect a surge in hotel construction.
Sometimes supply grows at a faster rate than demand, which creates oversupply problems. If there are 5,000 hotel rooms available for 5,000 tourists, everything will be full. If another 2,000 hotel rooms are added to the inventory, the average property will only have 71% occupancy.
Vacancy rates will rise and hotels will likely lower their prices to be more competitive.
Hotels tend to perform worse than most other types of commercial real estate during tough times. We’ll get into that more in the next section.
Here’s the basic idea: A hotel stay is often a discretionary expense. So it’s easy for people to cut back on hotel spending in tough times.
Like other types of REITs, hotel REITs generally rely on borrowed money. It’s especially important for hotel REITs to maintain a conservative balance sheet because of their economic sensitivity. That way, if the economy takes a downward turn and profits fall, the company will still be able to meet its obligations.
Although this isn’t a set-in-stone rule, I generally look for hotel REITs to have a debt-to-capitalization ratio of 40% or less.
How do hotel REITs hold up during recessions and tough economies?
Not all forms of commercial real estate are in the same boat when it comes to business characteristics. Perhaps the best way to get a basic understanding of the business dynamics of any REIT is to consider two main factors: The cyclicality of the property type and its typical lease structure.
Not surprisingly, hotels are one of the most cyclical, or economically sensitive, of all commercial property types. When the economy takes a turn for the worse, discretionary expenses like vacations are among the first to go.
There are varying degrees of economic sensitivity. For example, luxury resorts that cater to vacationers suffer more during recessions than hotels that accommodate business travelers. However, as a whole, hotels are a cyclical form of real estate. It’s common for hotel REITs to be among the sector’s worst performers during tough economies.
The lease structure of hotel properties doesn’t help. While other types of commercial properties lease out space on an annual or multi-year basis, hotels lease their space to “tenants” on a daily basis.
This makes it extremely easy for vacancies to spike during tough times. It also means that hotels have the ability to adjust their rent on a daily basis, which is a great characteristic to have during booming economies. But it’s not so good during recessions.
Three of the largest hotel REITs