Summary
- Sunstone Hotel Investors offers a very attractive preferred dividend yield thanks to its low LTV ratio (less than 25%).
- The preferred dividends are exceptionally well-covered: Sunstone needs less than 10% of its pre-dividend AFFO to cover the preferred dividends.
- Both issues are yielding north of 7%. As there is no material difference, I just keep on buying the one that has the highest yield at that moment.
Introduction
I have been an avid fan of the preferred shares of Sunstone Hotel Investors ( SHO ). Although I'm not necessarily a big supporter of the hospitality REITs, I am really impressed with how Sunstone is running its conservative balance sheet. And although the share price of the common shares hasn't gone anywhere recently, the preferred shares still offer a very attractive risk/reward ratio and I have built up a substantial position. Now Sunstone has released its Q4 and FY 2022 results, I wanted to have a look at Sunstone's financial performance to make sure the preferred dividends are still fully covered.
2022 was a good year, and the guidance for 2023 is encouraging
For a better understanding of the REIT's assets and focus points I'd like to refer you to my older articles on Sunstone as this article will focus on the recent financial performance and what this means for the dividend and asset coverage levels of the preferred shares.
The most important metric for a REIT is the FFO and AFFO result. Forget about the net income as a reliable metric as there are plenty of elements that can have an impact on the net income with the depreciation of the assets as the most important factor.
Fortunately Sunstone does a good job providing plenty of details in an easily accessible format. The fourth quarter was pretty strong thanks to a very substantial increase in the RevPAR which increased by 34% from $144 to just over $193 per night per room in the final quarter of 2022. This was caused by a combination of a higher occupancy (67.6% versus 56.4%) and a 12% increase in the average daily rate.
As you can see in the image below, the total FFO came in at $46.1M. That's almost three times higher than the reported FFO in the final quarter of 2021 so that's an excellent result.
The AFFO came in even higher than the FFO as the REIT recorded about $3.5M in impairment charges while there were a few other non-cash elements as well. With an AFFO of $53.7M, the AFFO per share came in at $0.26 while the FFO per share was $0.22.
That's a good result and this also means the full-year AFFO was $0.87 per share. That obviously is a much stronger performance than in 2021 when the AFFO per share was barely positive at $0.09. Also keep in mind the full-year AFFO of in excess of $184M already includes the in excess of $14M in preferred dividend payments. This means the total AFFO before making those preferred dividend payments came in close to $200M and implies Sunstone needed less than 8% of its FY 2022 AFFO to cover the preferred dividends. That's a very low ratio and even if the AFFO would fall by 75%, the preferred dividends would still enjoy a coverage ratio of in excess of 300%.
Sunstone Hotel Investors also provided a Q1 guidance and the REIT is aiming to publish an AFFO of $0.16-0.18 per share. Considering there are currently just over 208M shares outstanding, the guidance implies a Q1 AFFO result of $33-37M. And considering this already includes the approximately $3.75M in normalized quarterly preferred dividend payments, the coverage ratio will continue to exceed 1,000% so the preferred dividends should be safe.
And considering Sunstone only pays a quarterly distribution of just $0.05 on its common shares , the vast majority of the AFFO is retained on the balance sheet. To put this into perspective: assuming a full-year AFFO of $0.90 for this year, the $0.70 that won't be paid out as a dividend will add almost $150M in cash to the balance sheet. This could be used to reduce the net debt and/or pursue additional acquisitions. The recent acquisition of the Confidante in Florida is an excellent example of an accretive way to deploy cash. Including a $60M renovation budget, the total investment in The Confidante will come in just below $300M while Sunstone is eyeing a stabilized NOI Yield of 8-9% for an EBITDA contribution of almost $30M.
The preferred shares offer an excellent risk/reward ratio
There are currently two series of preferred shares listed. The H-series are trading with ( SHO.PH ) as ticker symbol and offer a 6.125% preferred dividend for a total of $1.53125 per year while the I-Series are trading with ( SHO.PI ) as ticker symbol offering a 5.7% preferred dividend for a payment of $1.425 per year. Both issues are cumulative and can be called by Sunstone from May 2026 and July 2026 on.
On Friday, February 24th, the H-Series closed at $21.16 for a current yield of 7.24%. The I-Series closed at $20.18 for a yield of 7.06%. Based on these prices, buying the H-series clearly is the better option as the yield is about 18 basis points higher.
In the previous section of this article I already discussed the dividend safety. But I obviously also want to have a look at the capital structure.
We see the balance sheet contains almost $3.1B in assets. The real estate is valued at $2.84B which means the LTV ratio (including the impact of restricted cash) is just around 23% as the net debt is just $656M. The book value of the assets already includes in excess of $1.1B in accumulated depreciation .
That LTV ratio is low and this has positive implications for the preferred shares as well as they rank just junior to all debt, but senior to the common equity. There are currently 11.25M preferred shares outstanding (only the H and I series are listed) for a total value of $281.5M.
This means that of the $2.085B in equity, about $1.8B ranks junior to the preferred shares. So even if the value of the hotels would drop by 50% to $1.42B, the net asset value of approximately $750M would still handsomely cover the $281.5M in preferred equity. This makes Sunstone very appealing from both the dividend coverage and asset coverage perspective.
Investment thesis
The low debt level also means the REIT won't be hit as hard by increasing interest rates. The average effective interest rate in 2022 just exceeded 5% and I don't anticipate a substantial increase. But even if the average cost of debt would increase by 200 basis points, this would still add just $14-16M to the interest expenses which is less than 10% of the AFFO. And don't forget Sunstone retains the vast majority of the AFFO it generates so it could easily mitigate the impact of higher interest expenses by repaying debt. I'm not worried about the higher interest rates at all.
I have a long position in both issues of the preferred shares and I regularly add on dips and then I just buy the preferred issue with the highest yield at that specific moment. I think the 7%+ preferred dividend yield offers an excellent risk/reward ratio given the low leverage on its balance sheet.
For further details see:
Sunstone Hotel Investors: A 7.2% Preferred Dividend Yield And A Safe Balance Sheet