2023-05-06 08:55:54 ET
Summary
- Occupancy rates have stubbornly stayed around 90% of 2019 levels but room rates are still increasing thanks to inflation and remodeling.
- Leisure travel has moved beyond 2019 levels. Business travel seems to be a drag.
- The REIT has been favoring share buybacks for capital return, leaving dividends far below 2019 levels.
- The non-callable "busted convertible" preferred is well-covered and could get some support from open market buybacks.
Hard To Get Past 90% Of 2019 Occupancy
When I last covered RLJ Lodging Trust (RLJ) in December 2022, I mentioned that occupancy levels had been running at around 90% of 2019 levels during the last 3 quarters of the year. Since then occupancy appears stuck at that level. After a full year at this level, I am ready to concede that this is the new normal. While leisure travel has improved well beyond 2019 levels, business travel does not look like it will catch up. (The uptick in the second half of April is likely due to easy comps since Easter occurred on 4/21/2019.)
Much of the focus on the earnings call was about RevPAR starting to exceed 2019 levels in many markets, but this was bound to happen at some point as room rates went up due to inflation.
Indeed, many leisure markets in Florida as well as urban "weekend getaway" markets like Washington, DC, and Chicago have exceeded 2019 occupancy levels, and RevPAR is far better. This is a big contrast with business travel-driven areas, especially with tech-oriented businesses most likely to meet remotely. If we look at Northern California, which comprises 1/8 of RLJ's hotels, we still see huge underperformance compared to 2019.
Author Spreadsheet (Data Source: RLJ Q1 2023 Earnings Supplemental)
Management was optimistic about this region on the call, with companies like Tesla ( TSLA ) doing more business there, but there is still a long way to go.
Looking forward, I expect 90% of 2019 occupancy to be the ceiling for the foreseeable future unless some hotels leave the business. While consumers still have disposable income and haven't stopped taking vacations, a recession would be a downside risk that takes occupancy back below 90% of 2019.
Room rates in the overall economy are up 7.3% in the past year based on the latest CPI release. (See "Lodging away from home".) As I have mentioned in previous articles, RLJ regularly completed brand conversions, remodeling, conversions of common space to guest rooms, and other projects to enhance revenue. As these projects pay off, RLJ can grow room rates ahead of inflation, and I am assuming 8.5% growth for the rest of 2023.
RLJ, like all hotel operators, had to cut costs during the pandemic. They have been successful at retaining some of these cuts, but inflation is inevitable. The net result I expect is that they can generate adjusted funds from operations (AFFO) at 76% of 2019 levels ($350 million) this year and 80% of 2019 levels in 2024. I will show this calculation in the earnings model below. With this reduced earnings power, the REIT would already have a hard time getting back to pre-pandemic dividend payments of $0.33 quarterly, but they also have decided to prioritize share buybacks, further limiting dividend growth.
Financial Model
As discussed above, I am forecasting 8.5% growth in average daily rate in 2023 followed by 4.5% in 2024 as inflation slows. Occupancy remains at 90% of 2019, which could be optimistic if a recession occurs. Food and beverage sales have improved, and I am now assuming F&B revenue at 12% of room revenue, up from 11.5% in my last article. Other revenue is 7.5% of room revenue.
Room expense costs have improved, and I am now assuming they are 25.3% of room revenue, down from 26% in my last article. Food and beverage expenses are still 78% of F&B revenue. I am showing other expenses at 41% of room revenue. Other costs stay flat with 1Q 2023, however tax, insurance, general, and administrative costs go up 4% in 2024. Interest expense increases in 2024 as some debt is refinanced, which I will go into further below. The REIT has approved a 1-year, $250 million share buyback plan, but the pace of buybacks through April suggests they will not execute that fast. I am showing $40 million per quarter, in line with Q1 actuals.
The resulting AFFO estimates are $1.73 per share in 2023 and $2.09 in 2024. That values the REIT at 6.1 times this year's AFFO and 5.1 times next year's.
Capital Management
RLJ has managed its balance sheet conservatively, and I would not expect them to return capital (buybacks + dividends) in excess of AFFO. For 2023, expected AFFO is $266 million, and they are on pace for $160 million of buybacks. That leaves a maximum of $106 million available for the dividend, or $0.69/share. Having already paid $0.08 in 1Q, they could increase the dividend to about $0.20 quarterly for the rest of the year. By similar math, we can calculate a dividend of about $0.225 quarterly in 2024. The yield would be 6.4% for 2023 and 8.5% in 2024 at these payouts.
On the low end, REITS have to pay out at least 90% of their net income as dividends. On that basis, they would continue to pay $0.08 quarterly in 2023 and increase to $0.09-$0.10 quarterly in 2024. The yield would be 3% in 2023 and 3.6% in 2024 at these payouts.
This is a wide range, but the probability of the dividend being at the high end is low. The REIT will want to maintain some flexibility to do acquisitions, increase buybacks, or contribute toward debt repayment. In any case, the dividend will be lower than the pre-2020 level of $0.33/share.
RLJ has no debt due this year but has considerable amounts due each year from 2024 to 2026. These amounts are in excess of AFFO each year. The REIT has $474 million of cash on hand and an undrawn revolver of $600 million. These two sources combined could pay off the debt due in any given year, but I expect the REIT to maintain financial flexibility by refinancing the debt when due.
Given the higher rates now present in the market, I expect interest expense to increase in 2025 as shown below. I am assuming RLJ can get a secured mortgage loan for 6.75% and unsecured term loans for 7.5%.
The growing interest expense will be another hurdle to common dividends getting back to pre-2020 levels. The preferred shares are still the best choice for income investors.
An Update On the Preferred Shares
RLJ has only one series of preferred shares ( RLJ.PA ) which were inherited from FelCor in 2017 at the time of the merger. The shares are convertible but far out of the money and are not callable. The quarterly dividend is $0.4875 and RLJ has paid it every quarter including during the pandemic. The yield is now 8.2%. This payout is covered by net income and is only 9% of forecasted 2023 FFO. Compared to competing hotel REIT preferreds, RLJ.PA has the highest yield even though the payout is second lowest as a percentage of FFO.
Author Spreadsheet
The latest buyback authorization allows the company to buy back preferred shares on the open market, though they do not appear to have done so yet. Buybacks would provide a floor of support for the share price while allowing the REIT to pare down one of their highest costs of capital.
Share Repurchases Year-to-date through May 4, 2023, the Company has repurchased approximately 3.9 million common shares for approximately $40 million, at an average price per share of $10.22, including 1.2 million shares repurchased so far during the second quarter for $12.5 million at an average price per share of $10.21. The Company's Board of Trustees recently approved a new one-year share repurchase program to acquire up to an aggregate $250.0 million of common and preferred shares under the same terms as the expiring program.
Source: RLJ Lodging Trust 1Q 2023 Earnings Release
Conclusion
The business travel recovery has stalled out over the past year, leaving occupancy rates at 90% of 2019 levels. This could be an optimistic estimate if a recession occurs. Higher room rates are helping RevPAR to grow slowly. While costs as a percentage of revenues have improved in many cases since before the pandemic, they are still going up on an absolute basis.
Management appears to favor buybacks over dividends to return capital. Therefore, I do not expect dividends to get close to the pre-2020 level of $0.33 quarterly. The most I can see them paying is $0.20 quarterly for the rest of 2023, but it could be as low as the $0.08 they paid this quarter.
The preferred shares remain the best choice for income investors as they are well-covered and not callable but could be supported by voluntary buybacks.
For further details see:
RLJ Lodging Trust: Business Travel Might Be As Good As It Gets