by: Tam Ging Wien
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ARA Group intends to spin off its US$719.5mil US hotels assets under the Hyatt brand into a stapled security for listing on the Singapore Exchange (SGX). The proposed ARA US Hospitality Trust (ARAHT) aims to focus on US based income-producing hospitality real estate.
ARAHT had lodged its preliminary prospectus on Tuesday (23-Apr) last week and it’s final prospectus on Thursday (02-May) with the Monetary Authority of Singapore (MAS).
It priced its IPO at US$0.88 per Stapled Security with an initial yield of 8.0% for the forecast period 2019 and growing to 8.2% yield in projection year 2020. Valued at a Net Asset Value per Staple Security of US$0.86, at the offer price, ARAHT will is priced at a P/B Ratio of 1.023x.
As at the Listing Date, ARAHT is expected to have gross borrowings of US$251.8 million, with gearing of 35.9%.
The IPO opens to the public for subscription on 02-May and closes on 07-May. The units will trade on a ready basis on SGX on 09-May.
Here in this article, we take a look at the offer of this new trust.
Besides what we have to share about ARAHT, we also recommend that you look at additional analysis beyond the scope of this article covered by our friends at Financial Horse.
The initial portfolio comprises 38 hotels with a total of 4,950 hotel rooms.
The assets are franchised under the brand name Hyatt Place and Hyatt House, which operate in the select-service space and extended-stay space respectively. 27 out of the 38 Hotels are Hyatt Place hotels and the remaining 11 Hotels are Hyatt House hotels.
Not to be confused with the 5-star luxury Hyatt and Grand Hyatt hotels, Hyatt Place and Hyatt House brands are closer to the mid-size hotels and service apartment concepts respectively with chic and modern feel.
The way to think about a Hyatt Place hotel is in between a Holiday Inn and a Hilton. Definitely more classy than a Holiday Inn, but don’t expect the elegance of a 5-star Hilton.
Hyatt House on the other hand being focused on extended-stay customers is closer to a Somerset Residence where the size of the rooms are more spacious with separate bedrooms, kitchenettes and living rooms.
We will let Hyatt.com do the rest of the talking below about these 2 brands:
The portfolio is distributed across 21 states with the bulk of the portfolio being in the South and Northeast regions. All the properties are freehold except the following two:
These 38 assets were first acquired by ARA Group back in December 2018 from Lone Star, a Dallas-based private equity group for US$700.0mil. Given that the proposed IPO currently values the assets at US$719.5mil, ARA Group would have clocked a gain made a 2.8% gain in 5 months or 6.7% on an annualised basis.
Lone Star in turn had purchased these assets directly from Hyatt Hotels Corp. back in November 2014 for US$590.0mil. As part of the deal, Hyatt will enter into franchise agreements with Lone Star, with all hotels maintaining their existing Hyatt Place and Hyatt House branding.
Lone Star together with Aimbridge Hospitality, a large US-based independent hotel management company, had spend a total of US$55mil over the next 2 years to renovate and refurbish all the 38 assets. These refurbishments where completed in May 2017.
Aimbridge Hospitality is also the appointed hotel manager of these 38 assets.
Including the refurbishment cost, Lone Star would have netted a profit if US$55.0mil or 8.5% by flipping these assets to ARA since obtaining them from Hyatt in 2014. Over the last 4 years, this would average 2.1% gains per year.
ARAHT has earmarked US$14.7mil worth of property improvement plan (PIP) renovations which is expected to be carried out through 2019. With these plans in place, the expectation is that the asset value will be boosted.
Looking at the rate of return of both Lone Star and ARA, its clear that ARA certainly had a higher rate of return by spinning off a new REIT. The average rate of returns shown by Lone Star’s low rate of return of 2.1% per year shows that the assets are likely matured and therefore experiencing fairly slow rate of growth. In addition, this growth comes with a boost from the renovations and refurbishments completed in 2017.
Going forward, we think that the US$14.7mil PIP renovations will only marginally improve the asset value and returns of these 38 assets.
Considering the timing of ARA’s purchase of the assets from Lone Star and the timing of IPO, it is clear that ARA had purchased the assets with the key objective of spinning off a REIT.
Further, given that all the 38 assets have been handed down from one party to another as a collective portfolio these assets are highly interrelated given them great synergies. However, as ARA decided to inject all 38 assets into this REIT, there is no clear acquisition pipeline in the future for inorganic growth for this portfolio.
In ARAHT’s IPO proposal, the entity is structured as a staple security consisting of a REIT and a Business Trust.
A typical REIT cannot take on business operations, instead it needs to generate revenue through its passive real estate investments. A Business Trust on the other hand can take on business operations.
By stapling both a REIT and a Business Trust together, the entire entity is able to both hold real estate assets passively for income yet operate the hospitality business simultaneously. Usually for listed hospitality trust in Singapore, the Business Trust component is dormant and is structured in purely for the purposes of risk management. This is the case for OUE Hospitality Trust, Far East Hospitality Trust and the upcoming Eagle Hospitality Trust as well.
Interestingly for ARAHT’s IPO proposal, this is not the case. The Business Trust component is wholly active and in charge of managing all 38 assets. Operationally, this means that ARAHT is not a fully passive investment vehicle, but instead draws income from both passive rental from the assets as well as active hospitality business management.
I quote directly from the prospectus the purpose of both the REIT and Business Trust entities:
Aimbridge Hospitality is the appointed hotel manager for the 38 assets through ARA Hotel Manager.
As a result, ARA H-BT clocks a sizable amount of revenue and profit for ARAHT. Rental revenue recognised by ARA H-REIT is rental expense incurred by ARA H-BT.
This creates an interesting situation where an investor investing in the stapled securities of ARAHT effectively own units in both the landlord and the tenant since ARA H-BT is the sole tenant to ARA H-REIT at IPO!
The advantage of this structure is that investors has full transparency of the counter-party and will be able to observe side-by-side the performance of the tenant and its ability to service its rental obligations to the landlord. Investors would also have exposure to the gains and growth of the US hospitality sector through the ARA H-BT.
On the other hand, having exposure to an actively managed ARA H-BT means that investors also take a hit should ARA H-BT business perform poorly.
Therefore, investors in ARAHT should be aware that they are not simply just taking on the passive investment risk of the hospitality portfolio, but are also taking on the active business and operational risk of running the hotels. This exposes them directly to the business landscape of the US hospitality sector.
Another aspect that investors need to be aware of is that regulations surrounding REITs are different from those around the Business Trust. One key aspect is the tax transparency requirement for REITs to pay 90% of their income, a rule that a Business Trust need not follow. Therefore, with an active Business Trust component, ARA H-BT is free to adjust its distribution policy annually. The advantage of this is it allows the ARAHT to smoothen out the DPS as it can dynamically adjust the pay-outs flexibly between years. But the flip size is this control is dependent on the management’s decision and it could be decided both for or against investors.
The management fees of both the REIT Manager and Business Trust Trustee-Manager is 10.0% per annum of the total Distribution Income of ARAHT. This means that the larger then total distribution income, the more fees the respective managers receive. From an investor’s perspective, it is not the size of the distribution income that matters, but rather the distribution per stapled security.
Hence, the base management fee isn’t fully aligned with shareholder’s interest.
However, the performance fee is based on 25.0% of the increase in the distribution per stapled security (DPS) in a financial year over the DPS in the preceding financial year. This on the other hand aligns both shareholders and manager’s interest as the manager is incentivised to grow the DPS year on year.
For Forecast Period 2019 and Projection Year 2020 each, both the Managers have elected to receive 50.0% of the Total Management Fee in the form of Stapled Securities. The remaining 50.0% shall be paid in the form of cash.
REITs and Business Trust in general grow using a combination of organic and in-organic growth strategies.
Organic growth involved growing revenue while reducing expenses. Examples of organic grow are step-up rental agreements, performing AEIs to enhance the asset value and rental income, profit sharing agreements with the tenants, maximize lettable floor spaces…etc.
Inorganic growth involves making DPS accretive acquisitions that will growth the distributable income.
The fact that Lone Star had already spend US$55mil on the AEIs which was completely fairly recently in 2017, it doesn’t leave much room for organic growth through AEIs. It also doesn’t make sense for the REIT to step-up rentals since the business trust income would then fall netting out any effects. Similarly profit sharing agreements is not possible since it also nets out the effect between the REIT and Business Trust components.
With only US$14.7mil PIP renovations earmarked for 2019, its clear that there is limited opportunities to enhance these assets.
This leaves investors heavily on ARA H-BT to grow its top line revenue and manage its expenses to increase bottom line income rather than on ARA H-REIT. Therefore, the macro-economic factors affecting the US hospitality industry play a big part in the performance of this trust.
The REIT also does not have a clear acquisition pipeline of assets to fuel its organic growth. With an understanding of the history and full injection of these 38 assets into the portfolio, it does not leave any assets in the pipeline for future acquisitions.
Is that perhaps why ARAHT decided to list at a fairly high gearing of 35.9% as it does not expect to make acquisitions in the near future?
From the above, we have established that macro-economic factors affecting the US hospitality industry play a big part in the performance of this trust as it impacts its organic growth.
Observing the historical revenue and profit trends for ARA H-Trust and plotting them together with the annualised Forecast Period 2019 and Projection Year 2020, we observe a very flattish performance. Growth in the total distributable income clocked in at a compounded rate of 2.1% which supports the hypothesis above that the assets are likely already matured with limited organic growth.
Observing the macro-economic indicators for the South ad Northeast Regions which constitute approximately 76% of the trust’s total appraised value, we can see that the South Region is showing slowing growth while Northeast region growth spiked in 2018 in terms of RevPAR (short for Revenue per Available Room) and ADR (short for Average Daily Room Rates).
Occupancy rates between both regions are fairly similar with slight increases year-on-year.
The above observations are supported by the demand vs supply growth. The South region is showing fairly balanced demand vs supply while the Northeast region is showing that demand is outstripting supply in 2018.
Another observation that one can make from these demand charts is that the hospitality sector is very cyclic and lumpy. This is a risk that investors need to observe.
There is also new supply coming on-stream and it would be worth watching to see how these additional supply affect the demand.
In summary, we don’t observe high growth in the macro-economics of the US hospitality sector in the South and Northeaster regions where ARAHT have a high exposure to. This further strengthens our hypothesis that the assets listed are fairly mature and are likely to show slow growth and limited upside.
This explains why Lone Star was only able to squeeze a 2.1% gain a year from this portfolio despite having spend US$55mil on AEIs.
It priced its IPO at US$0.88 per Stapled Security and forecasting a payout of 7.0c and 7.2c per Stapled Security on an annualised basis for forecast period 2019 and projection year 2020 respectively. This equates to an initial yield of 8.0% in 2019 and growing to 8.2% in 2020 on an annualised basis.
Valued at a Net Asset Value per Staple Security of US$0.86, at the offer price, ARAHT will is priced at a P/B Ratio of 1.023x.
Given that the growth is estimated to be approximately 2.1% and using a discount rate of 4% and 5% over 15 years with no terminal value, we estimate that the fair value of ARAHT is between the ranges of 86c to 92c.
Therefore, pricing ARAHT at 88c places it squarely within our fair value range.
Investors should be well aware that ARAHT has a unique structure were both REITs and Business Trust components are simultaneously active. The BT component is also the tenant to the REIT component creating a situation where trading of a stapled security effectively trades both the landlord and the tenant simultaneously. This limits the REITs ability to grow through the usual organic strategies. Therefore, investors are reliant on the BT component to grow its revenue and income.
This exposure to the BT component in effect means that investors are directly exposed to the US hospitality macro-economic factors in the South and Northeast regions. Therefore having a view of these macro-economic factors are important considerations when investing in ARAHT.
We do like that the management performance fee is tied to DPS increase which is aligned with shareholder's interest. It would have been better if the base fee was also tied to DPS performance.
Based on our valuation estimations, we think that ARAHT is fairly priced and the yield of 8.0% and 8.2% respectively is decent.
Investors should not expect much growth going forward due as these are already matured assets. There is also no clear acquisition pipeline to fuel its inorganic growth.
ARAHT is a pure mature asset dividend play with direct exposure to US hospitality macro-economic factors in the South and Northeast regions that may be beyond the control of the management.
ProButterfly for one will give this IPO a miss.
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