2023-08-08 15:43:39 ET
Summary
- Sunstone Hotel Investors' Q2 results show over $1.8B in common equity, providing a safety net for preferred shares yielding in the mid-7% range.
- Q2 FFO increased by over 15% compared to last year, with AFFO per share in the first semester almost 50% higher than H1 2022.
- Q3 AFFO is expected to be lower, but the payout ratio remains below 9%, and preferred dividends appear to be safe.
Introduction
I o wn the preferred shares of Sunstone Hotel Investors ( SHO ). Although I'm not necessarily a big supporter of the hotel REITs, I'm really impressed with how Sunstone is running its balance sheet . The Q2 results have now been published, and it looks like the balance sheet contains in excess of $1.8B in common equity which ranks junior to the preferred equity, providing a nice safety net for the preferred shares which are now yielding in the mid-7 range.
I was looking forward to the Q2 results
As discussed in a previous article, Sunstone started 2023 well with an AFFO of $0.21 per share, which was substantially higher than the $0.08 it generated in AFFO/share in 2022 as the hotel REIT gradually recovers from the COVID crisis.
The summer quarters are traditionally much better than the winter quarters, and it probably doesn't come as a surprise when I say I really was looking forward to seeing Sunstone's performance in the second quarter of this year.
And Sunstone didn't disappoint. The FFO came in at $71.55M, which is an increase in excess of 15% compared to the second quarter of last year. And despite having to record a few more adjustments to calculate the AFFO this year, the total adjusted FFO increased by just over $4M to $67.4M. That works out to about $0.33 per share and brings the H1 AFFO to $0.54 per share . That's almost 50% higher than in the first half of last year.
Looking at the H1 results, the AFFO of $111.2M is pretty strong, especially considering the $7.5M in preferred dividends already are included in this result. This means the AFFO before making the preferred dividends was almost $119M, and the REIT needed just over 6% to cover the preferred dividends. And that obviously is much better than the 8.6% payout ratio in the first half of 2022 (which also wasn't too bad at all).
Looking at the Q3 results, the REIT now expects to generate a total AFFO of $0.18-0.21 per share. Substantially lower than in the second quarter, that's for sure, but even at this lower rate the payout ratio of the AFFO before taking the preferred dividends into consideration will remain below 9%, even if the REIT only reaches the lower end of its guidance range. I'm looking forward to seeing the details of the Q3 AFFO considering the REIT generated $51M in AFFO in the third quarter of last year and that's quite a bit higher than the $38-44M projected for Q3. But then again the Q4 AFFO in 2022 was much higher as well , so perhaps we will see encouraging signs throughout the third quarter (not in the least because Sunstone's Q2 AFFO/share came in at $0.33, beating its $0.29-0.32 guidance). For 2024, I'm hopeful the new Marriott in Washington, D.C ., will provide a positive contribution.
So from a dividend coverage perspective, the preferred dividends appear to be very safe. The 9M 2023 AFFO per share will come in at $0.72, including the impact of in excess of $11M in preferred dividend payments, while Sunstone should be able to beat last year's $0.87 per share in AFFO.
As Sunstone only pays a quarterly dividend of just 7 cents per share, the vast majority of the AFFO is retained on the balance sheet. As you can see below, the REIT has $163M in cash and restricted cash on the balance sheet while its total debt is just $815M for a net debt level of just over $650M.
And looking at the balance sheet, the total equity portion on the liabilities side is $2.1B of which just over $280M is preferred equity. This means there's in excess of $18B in common equity ranked junior to the preferred shares. Even in the event of a liquidation scenario whereby the hotel properties are sold at 50% of the book value, there would be enough cash on the table to repay the preferred shareholders in full (the $2.83B book value of the hotel properties already includes in excess of $1.2B in accumulated depreciation). And thanks to the low amount of debt on the balance sheet, the increasing interest rates will be manageable. A 200 bp increase in the average cost of debt would reduce the annual AFFO per share by just $0.08-0.09.
I will try to add to my position in the preferred shares
As explained in my previous article , there are currently two series of preferred shares listed. The H-series are trading with ( SHO.PH ) as the 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 the 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 ( SHO.PH ) and July 2026 ( SHO.PI ) on.
As both preferred shares rank equal, it all comes down to buying the one that has the highest yield (as I think the risk for the preferreds to be called is negligible). That's also why looking at the current yield makes more sense than the yield to call as I think a call is pretty unlikely. At the closing bell on Monday, the H-shares closed at $20.53 while the I-shares closed at $19.40 for a yield of respectively 7.46% and 7.35%. This indicates that, at the current share prices, it makes more sense to buy the H-shares. And the higher likelihood of those H-shares getting called (Sunstone would obviously want to call the higher-yielding securities over the lower-yielding preferred shares) is just a bonus at this point.
Investment thesis
I'm not very interested in the common shares of Sunstone Hotel Investors at this point. Not because they are expensive (I expect the P/AFFO multiple to be around just 10) but because I feel more comfortable pursuing an income strategy with the preferred shares that have been issued by Sunstone. The common shares are interesting at the current multiple and considering the current book value of $8.78 per share (including the accumulated depreciation expenses), but I'm more interested in the additional layer of safety offered by the preferred shares.
While I'm giving up potential capital gains (other than the gains that could be generated in case the interest rates on the financial markets go down, which would boost the share price of the preferred shares), the yield of almost 7.5% is still appealing. I own both series of the preferred shares, and I plan to add to the position that gives me the highest yield.
For further details see:
Sunstone Hotel Investors: I'm Still A Buyer Of The 7.5% Yielding Preferred Shares