Recent market trends indicate a compelling shift in investment appeal within the hotel real estate investment trust (REIT) sector. While common shares of prominent hotel REITs, such as Pebblebrook (PEB) and Chatham (CLDT), have experienced substantial gains driven by a recovery in tourism and anticipated demand from major events like the World Cup, their preferred counterparts now present a more judicious allocation for investors seeking both income and capital appreciation. This dynamic arises from the robust, yet inherently constrained, operational environment of the hotel industry, where long-term margin expansion faces headwinds despite cyclical demand surges.
The hotel sector has demonstrated a remarkable comeback, with tourism revenues largely returning to pre-pandemic levels. The U.S. Travel Association projects continued growth in travel spending, further bolstered by events such as the World Cup, which is expected to significantly impact international inbound travel. This optimistic outlook has fueled strong RevPAR (revenue per available room) growth, leading to a surge in hotel REIT common stock valuations. However, this recovery primarily stems from operational leverage rather than sustainable, repeatable growth. Hotels typically operate with high revenues and high expenses, meaning that even modest revenue increases can lead to disproportionately large gains in EBITDA. While impressive in the short term, maintaining such a pace requires continuous margin expansion, which is increasingly challenging due to aggressive supply growth.
The supply side presents a persistent challenge for the hotel industry. While new hotel construction is moderate, a significant "shadow supply" comes from short-term rental platforms like Airbnb (ABNB). The projected increase of 750,000 short-term rental units between 2021 and 2027 represents a substantial 13% addition to the existing hotel room inventory in the U.S. This form of competition operates under different economic viability, leveraging tax deferral benefits that allow owners to charge lower rates, thus impacting the profitability of traditional hotels. Given these ongoing supply pressures, it's improbable that hotel margins will continue their recent upward trajectory. Consequently, while the market has enthusiastically priced hotel REIT common shares based on improved AFFO (Adjusted Funds From Operations) per share growth, this valuation may be considered full or even slightly excessive when accounting for the sector's long-term competitive landscape and capital expenditure requirements.
In light of these considerations, the preferred shares of Chatham (CLDT.PR.A) and Pebblebrook (PEB.PR.H) emerge as particularly opportune investments. These preferred stocks offer attractive current yields, with Chatham's preferred A yielding 8.3% and Pebblebrook's preferred H yielding just under 8%. Crucially, they also present substantial upside potential to their par value, with CLDT.PR.A having 25% upside and PEB.PR.H boasting 38% upside. This significant disparity in response compared to common shares is notable. The improved underlying fundamentals of the hotel sector, combined with the substantial equity cushion now supporting these preferreds due to the common stock's appreciation, significantly enhance their safety profile. Previously trading at a discount due to market apprehension about hotel fundamentals, the current environment renders this discount unwarranted. As a result, these preferred shares are expected to gravitate closer to their par value, offering a dual benefit of considerable dividends and potential capital gains. For instance, a fair value for PEB-H would imply a 7% current yield, and for CLDT.PR.A, a 7.1% current yield, translating to market prices of $20.35 and $23.32, respectively. These thinly traded issues often go unnoticed by the broader market, suggesting that their price adjustment may still be pending, allowing astute investors to capitalize on this current imbalance.
The present market environment favors a strategic rotation from potentially overvalued hotel REIT common shares into their preferred equivalents. The preferred shares of companies like Pebblebrook and Chatham offer an appealing combination of high, stable income and significant potential for capital appreciation as the market eventually reprices them to reflect the improved financial health and reduced risk profile of their issuers. Investors can collect attractive dividends while awaiting the realization of these capital gains.
