Pebblebrook Preferred with 40% upside value of face value
At Portfolio Income Solutions, we constantly scour the REIT investment universe for valuation errors. Usually this means a stock that is mispriced relative to its peers, but sometimes there is a particularly intriguing situation where there is mispricing within a company’s capital stack. .
Pebblebrook Hotel Trust (NYSE: PEB) is a hotel REIT with approximately $7 billion worth of upscale hotels in coastal markets. For a hotel REIT this is quite significant and within this business runs the full game of a traditional capital stack
- ~$2.8 billion in debt
- Preferred shares of $740 million
- ~$3.5 billion in common stock at net asset value
I think a case could be made for investing in PEB, but the main point of interest for me is the favorite Series G which I think is clearly mispriced compared to the rest of the capital stack. With a current yield of 9.2% and a 44% discount to liquidation value, it offers unusually high return potential relative to its top position in the capital stack above $3.5 billion. dollars of common stock.
A successful investment in a preferred stock requires net asset value to protect liquidation value and cash flow to fund dividend payments. Let me start by digging into the fundamentals of the hotel in order to get an idea of the quality of coverage of the favorite.
The fundamentals of hospitality in a post-pandemic world
There is no denying that Covid has hit the hospitality industry. Revenues fell off a cliff, but operating expenses remained largely in place.
Poorly capitalized hotel REITs have had to endure highly dilutive emergency measures to stay alive and I doubt their earnings will return to 2019 levels per share for very long.
Pebblebrook, however, has always been among the best-capitalized hotel REITs, so its situation hasn’t gotten that bad. In fact, PEB is on track to almost fully recoup its FFO of $2.63 2019/share by 2024, according to the consensus estimates below.
As hotels reopened more fully in 2022, Pebblebrook saw a rapid recovery in key operating metrics such as ADR (average daily rate) occupancy and RevPAR (revenue per available room).
June’s ADR hit $323 per night with a very healthy 73% occupancy rate.
Since hotels are a very different type of industry, there are 2 pieces of information to keep in mind when digesting this data.
- Occupancy never really hits the 80s and 90s in a sustained fashion like in other sectors, as it consists of a mix of peak nights and off-peak nights. Peak nights are of course capped at 100%, so 73% occupancy is more or less full occupancy.
- Hotels are cyclical, with 2Q and 3Q being the best quarters. June is supposed to be a good month and I expect slightly lower numbers as we head into the 4the trimester.
At a broader level, the industry is recovering with nominal RevPAR already expected to exceed 2019 levels in 2022 and inflation-adjusted RevPAR expected to exceed 2019 levels in 2024.
PEB’s portfolio is almost exclusively a gateway city.
In recent quarters, its performance on the West Coast has lagged that of the East Coast, with Georgia standing out significantly on the upside.
Longer term, I think these markets are generally doing well. Larger markets tend to be more stable. Maybe not as explosive on the upside, but there are more consistent demand drivers.
Preferred Liquidation Preference Net Asset Value Hedge
Remember that due to the way the cascade works, the privileged will get their full liquidation preference before the common gets any. Thus, any asset value greater than debt counts as hedge for preferred stock.
PEB has approximately $7 billion in assets at cost.
Today, these assets are worth slightly more than PEB paid for them based on general real estate value trends and consensus estimates of net asset value.
PEB has a debt of approximately $2.8 billion.
That leaves over $4 billion in asset value to cover the $740 million in pari-passu preferred stock shown below.
This seems to me to be a sufficient level of asset coverage. At the height of the financial crisis, the price of commercial real estate was around 70% of the December 2006 level. 70% of the value of PEB assets would still cover debt and preference. So, I’m not particularly worried about that angle. It seems to be the cash flow side that tends to be more of a threat to hotels.
Preferred dividend cash flow hedge
Let me start with some background information on how FFO accounting works.
REIT FFOs are net of interest expense and preferred dividends. Thus, an FFO of $0 per share fully covers preferred dividends.
This would of course not be sufficient coverage, but it would technically be sufficient to pay preferred dividends.
With the exception of the pandemic, the PEB has always generated strongly positive FFOs.
Hotels are a cyclical industry, so even if the pandemic was a once-in-a-lifetime situation that probably won’t happen again, there will be recessions. The FFO/PEB share became negative in 2009 during the GFC.
Preferred dividends are cumulative, so briefly not hedging does not reduce the dividends to which shareholders are entitled.
I think PEB’s positive FFO in normal times far outweighs the brief periods of negative FFO during the 2 toughest challenges for the industry in modern history. I would feel less comfortable with the preferences of other hotel REIT issuers, but PEB is still one of the best and best capitalized operators. He also has a nice list of assets that I think will hold their value well.
As such, I view Pebblebrook preferred stock as a reliable source of dividend income.
Wrong pricing in preferred stack
Each of the PEB preferred shares is pari-passu with each other, meaning they are at the same level in the cascade and PEB cannot pay dividends on one without also paying dividends on the others.
As such, the level of risk is nearly identical except for different liquidity due to some issues being larger than others.
PEB-H is probably the most liquid with $250 million in circulation, but Series G is close at $230 million.
I don’t necessarily see the decline in liquidity as a negative. For a patient trader who buys and sells with limit orders, this can be a positive as one can get the better end of the bid/ask spread on both the entry and the exit.
There are 2 factors that make a preferred yield higher
- Au pair discount
- Bigger face coupon
Series G is the best of both worlds, trading at $17.25 against a face value of $25 and having a coupon of 6.38% which is on par with the highest with Series E. This makes PEB- G has a current yield of 9.24% while the other issues are in the 8s.
In addition, PEB-G has an increase of 44.9% in the event of a takeover or sale/liquidation of the company. Series H is almost as good due to the higher par discount, but since I view liquidation as an unlikely scenario, I would prefer to have the higher book yield.
The E and F series aren’t even that good. Either they’re overpriced or the G is underpriced, and I think it’s the latter.
Pebblebrook is a solid company that I have respected for a long time. Achieving a 9.24% yield on a preferred stock with significant capital appreciation potential on top sounds like a bargain from this issuer.
What about the common
The valuation of PEB is currently attractive. It generally traded as a high-end hotel REIT, but it now sits in the middle of the pack.
The 6.6X forward FFO is a pretty low multiple, but I think the hospitality sector should be trading at a significantly lower multiple than other REIT sectors.
PEB also looks pretty cheap on a NAV basis, with its 41% discount higher than hotel peers and REITs in general.
I think PEB common is a decent buy if you want exposure to the hotel REIT sector. That said, I’m still hesitant. Strategic positioning has not been fixed, with brands and online travel agencies still getting the better market share compared to hotel owners.
Additionally, it is unclear to what extent the huge recovery in RevPAR is simply the result of pent-up travel demand as opposed to sustained demand. Finally, Airbnb (ABNB) and its clones are a persistent threat to real hotels.
All in all, I consider the preferred G to be a reliable source of significant income and the common is more of a high-risk, high-reward sort of proposition.