by: Tam Ging Wien
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The unprecedented worldwide COVID-19 pandemic had delt a heavy blow to the U.S. hospitality sector. Stringent lockdowns, movement controls restrictions, and boarder closures all led to rapid deterioration of the business environment and the worse hospitality sector downturn in history.
ARA US Hospitality Trust (“ARA H-Trust”) released its full year FY2020 results last week, it was clear that the trust had not been spared from the pandemic. The trust had only managed to achieve a 41.0% occupancy rate through FY2020 while its initial asset portfolio value had declined by 13.5%. As a result, its gearing ratio had jumped to 48.2%. Due to high fixed cost related predominantly to real estate taxes the trust had recorded a net property loss of US$5.0 million.
Due to the adverse situation, the trust did not declare any distributable income for FY2020.
What does all these mean for shareholders? Could the situation ease in FY2021 and lift their fortunes? Or does the trust need to execute an equity fund raising to stay afloat? We examine some of these possibilities here in this article.
For a better understanding of the business model and the Hyatt Place and Hyatt House brands, do reference our previous coverage of ARA US Hospitality Trust during the IPO period and the history of the initial asset portfolio.
The key to understanding why ARA H-Trust was severely impacted is to understand their business model and how the entity is structured. ARA H-Trust is a staple security consisting of a REIT, namely, ARA H-REIT and a Business Trust, namely, ARA H-BT. As both the REIT and Business Trust is stapled together, each time we trade a stapled security unit in ARA H-Trust, we are actually trading one unit in the REIT and one unit in the 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 can 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.
However, this is not the case for ARA H-Trust. The Business Trust component is wholly active and in charge of managing all 41 assets. Operationally, this means that ARAHT is not a passive investment vehicle, but instead draws income from the active hospitality business management.
I quote directly from ARA H-Trust’s IPO prospectus the purpose of both the REIT and Business Trust entities:
As a result, the Business Trust side clocks a sizable amount of revenue and profit for ARA H-Trust. However, the rental revenue recognised by the REIT side is rental expense incurred by Business Trust. In other words, an investor cannot view ARA H-Trust as a passive investment vehicle as the fixed rental earned by the REIT is effectively an expense at the Business Trust level. Instead, investors need view the entire entity as owning and operating the hotels an earning revenue from the hotel operations.
This creates an interesting situation where an investor investing in the stapled securities of ARA H-Trust effectively own units in both the landlord and the tenant since ARA H-BT is the sole tenant to ARA H-REIT.
Further from the diagram, you can see that ARA H-BT is a franchisee of the Hyatt and Marriot brands. This franchisee operational model will mean that the ownership of the brand belongs to the franchisor – this this case Hyatt and Marriot. Hyatt and Marriot being the franchisor will receive a franchise fee which is pegged to a percentage of the hotel revenue. Quoting directly from ARA H-Trust’s IPO prospectus, the operating company shall pay on a monthly basis:
Instead, it is the operating company, or in this case ARA H-BT and indirectly unitholders ARA H-Trust that bears all costs and risks of operating the hotels. For unitholders of ARA H-Trust, dividends can only be based on the profitability of the entity as a whole after deducting the expenses of hotel operations and franchise fee.
Other hospitality trust such as Far East Hospitality Trust and Frasers Hospitality Trust do not fully operate the hotels but instead signs a large portion of its assets using master leased with its sponsor and/or 3rd parties to operate the hotels and receiving a fixed plus variable rental for the master leases. In this model therefore, the sponsor and/or 3rd parties instead bears the operational cost and risk of the hotel business while the REIT continues to receive passive income, albeit lower due to loss of the variable component should the hospitality business underperform.
Having understood the structure, model and impact it has on the business, it is clear that investors would naturally be exposed to an actively managed Business Trust and would take a hit should the business trust component performs poorly. The franchisor on the other hand does not bear any cost for the operations of ARA H-Trust but will take a cut of the revenue regardless of the business environment.
Investing through ARA H-Trust means direct exposure to the business landscape of the U.S. hospitality sector.
The U.S. hospitality sector clocked its worse performance on record due directly to the COVID-19 pandemic. Stringent lockdowns, movement controls restrictions, and boarder closures all led to rapid deterioration of the business environment. To add fuel to fire, the U.S. suffered several large-scale civil unrest, political turmoil and natural disasters throughout 2020 leading to the worse U.S. hospitality sector downturn in history.
Source: ARA US Hospitality Trust
Looking forward info FY2021 and beyond, we think that the worse is likely over and the U.S. hospitality industry and this could only improve from here. Two main factor fuelling the recovery of the hospitality sector is the mass vaccine distribution and vaccination drives around the U.S. as well as President Biden’s attempt to push through a $1.9 trillion stimulus packages.
Source: ARA US Hospitality Trust
Travel restrictions and fears that weighted on the hospitality sector should ease over the coming quarters as the vaccine rollout becomes widespread. This should lift confidence in both leisure and business travel segments.
The management of ARA H-Trust has shared in their presentation slides the phased strategy approach to be adopted for the mass vaccination of the U.S. population.
In our view, the essential workers who are vaccinated in Phase 1 and the vulnerable in Phase 2 are unlikely to make a significant difference in the travel sector. Its only after economically active population of young adults and industrial workers who receive their vaccination in Phase 3 and Phase 4, will this travel sector really being its road to recovery.
While we lack the data to produce a high-quality numerical analysis of the recovery, on a qualitative front, we think its possible that 1H-FY2021 could see a return of essential travel which would improve the business landscape compared to 2H-FY2020. As the U.S. enters the summer months of June, July and August 2021, its likely that the pent-up demand for leisure travel will accelerate the demand for hotels leading to a faster pace of recovery in 2H-FY2021 onwards.
While the recovery in the business travel sector underway, we expect that due to the rapid digitalisation of businesses, we are unlikely to see the same travel patterns and demand pre-COVID. Over the course of the last one year, many businesses have been forced to adopt or accelerate their digital strategies which would permanently reduce business travel. We are likely to see more businesses being conducted online, more conferences conducted digitally, more meetings and deal making conducted over the internet. Businesses have also learned that technology adoption can help to cut business cost while still maintaining business efficiency. It is highly likely that many businesses are going to be more selective on approval of business travel budgets and defining what is essential business travel and what is not in order to manage and control cost.
With business travel patterns permanently changed due to accelerated technology adoption and cost control being a central focus of businesses, we think that it will be several years before we see same glory days of 2019 in the hospitality sector.
Source: ARA US Hospitality Trust
On the bright side, for ARA H-Trust who has a predominantly select service hotel portfolio, they could potentially experience a recovery sooner due to their lighter expenses and simpler operational format compared to full service hotels.
Based on the latest valuation report, the initial portfolio of assets had declined in value by about 13.5%. The total portfolio value had only declined 2.5% as much for the decline was offset by the acquisition of Marriott portfolio consisting of 3 hotels in Jan-2020. As a result, the NAV per Stapled Security had declined -17.3% from US$0.75 down to US$0.62.
The combination of declining asset values and increased debt from the most recent load resulted in the gearing jumping from 43.0% to 48.2%, just 1.8% shy of the 50% regulatory gearing limit in Singapore.
Given this tight ceiling, the trust would now have a debt headroom of just US$24.4mil before hitting the 50% regulatory limit.
Source: ARA US Hospitality Trust
Source: ARA US Hospitality Trust
Interestingly that while the asset valuations are temporarily depressed, the valuers had provided an “prospective” valuation in consideration that once the economic conditions stabalises, the portfolio could potentially recover 26.1% to US$888.4mil. The assumptions timeline for stabilisation is anticipated around 2024. Based on today’s valuation, that would mean a US$820.9mil portfolio asset valuation which could imply that the gearing eases back to an estimated 38.1% or a debt headroom of approximately US$165,892.
In view of the unexpected situation, ARA H-Trust was granted a waiver on financial covenant from all three (3) of its Singapore-based lender banks for a limited period up till Mar-2021 which was further extended to Jun-2021. We contacted ARA H-Trust with regards to the nature of these financial covenant understand that these include the standard requirement to meet a minimum gearing ratio and interest cover.
The management has clarified that had the waivers not be granted, the trust would currently be in breach of the financial covenant requiring a minimum interest cover to be met. This is due to them clocking a net property loss of US$5.0mil. The exact figures of the minimum financial ratios had not been disclosed by the management as they are not public information.
Under the new waiver, the next testing period will be based on 3Q 2021 (Sept 2021) results and to be performed by Nov 2021. The end date of these waivers coincides with the U.S. government’s plan to have enough vaccinations for all US residents by the summer, thus the resumption of more leisure and corporate travels within the U.S.
ARA H-Trust has also clarified that these financial covenant waivers do not come attached with any conditions. This is an indicative signal to investors that ARA H-Trust has a strong trust and financial backing from their lenders to support the trust through this trying time.
Due to the adverse economic situation recently, the trust had on 18-Dec-2020 secured with its lenders an additional US$10mil unsecured loan to help the trust partially finance the operating expense of the trust in order to tide through this difficult time.
Assuming that the lender’s financial covenant waivers are aligned with the upcoming MAS amendments to the Requirements for REITs 2020 (which will require REITs to maintain an Interest Coverage Ratio (ICR) threshold of 2.5 times from 01-Jan-2022), we could estimate the annual interest expenses and extrapolate that to the required minimum EBITDA.
Given that the Interest Payable to Banks for FY2020 is US$11.25mil, we could conclude that ARA H-Trust would need to show that they are able to generate an annual EBITDA or at least US$28.12mil.
The Trust has clocked a total revenue of US$78.161mil in FY2020.
Using their existing expenses as found in their Statement of Comprehensive Income for FY2020, we estimate that ARA H-Trust would need to generate total revenues of approximately US$100.0mil to US$105.0mil in order to just meet the required EBITDA. To match up to the 2.5x ICR ratio based on EBITDA, revenues would need to grow by another 27.9% to 34.3%. This also assumes that there is no significant cost increase.
For the above recovery scenario, both the occupancy rate and the revenue per available room (RevPar) would need to be boosted. Portfolio occupancy rate was 77% in FY2019 compared to 41% in FY2020 while RevPar was US$94 in FY2019 compared to US$42 in FY2020.
Assuming that 1H-FY2021, the occupancy rate and RevPar recovers to the mid-point of 59% and US$68, given that the portfolio has a total of 5,340 rooms with an average of each room able to generate 180 room nights per half year, 1H-FY2021 revenue could come in at approximately $65.3mil. Assuming interest rates remain low and no significant increase in the operating expenses, ARA H-Trust would likely be able to fulfil its ICR ratio of 2.5x, but with rather thin margin of error. Would ARA H-Trust want to take the chance given the uncertain landscape?
Looking at things from another angle, with the using the stabalised valuation of US$888.4mil in today’s terms over the next 4 years, we could average the asset value growth to be approximately US$50.0mil per year. At the current portfolio valuation of US$686.9mil, a US$50.0mil portfolio valuation growth to US$736.9mil and outstanding debt of US$354.7mil would reduce the gearing to 44.9%. That’s’s still a tad too high and difficult to manoeuvre especially when making an acquisition.
Therefore, looking at potentially then margin of error in fulfilling the 2.5 ICR and an elevated gearing, we think that there is a high possibility that ARA H-Trust would raised funds via an equity fundraising, perhaps together with its next acquisition, but before the expiry of it financial covenants waivers in Jun-2021.
The COVID-19 pandemic delt a severe blow to the hospitality sector around the world in 2020. However, going forward, we expect that the mass vaccinations and the massive government stimulus measures will gradually lead to a recovery of the sector in FY2021 onwards. Despite the evidence of recovery, we do not expect the travel and hospitality sector to rebound back to the travel patterns of 2019.
ARA H-Trust was similarly affected as its structure and model exposes unitholders directly to the business environment and operational risk. Unlike other domestically listed hospitality trust which relies more heavily on the fixed plus variable fee rental structure without taking on the risk of the business and operations compared to the franchise modal.
Examining its recovery in revenue and potential near-term growth in its portfolio asset valuation, we think that ARA H-Trust’s debt and profitability figures lean towards the elevated side leading to difficulties in acquisitions and risk in meeting the lender’s financial covenants. Therefore, to ease the pressure on its debt and profitability metrics, it is very likely to rise an equity fund raising to shore up its capital, bring down its debt and do so via an acquisition.
There could a possibility however its fortunes reverse in 2021 and beyond and the hospitality industry lead by select service hotels outperforms the broader U.S. hospitality market and ARA H-Trust could see a recovery its business and head towards its IPO prices, but we think that likely to be a lower probability bet.
The COVID-19 crisis has brought about an unprecedented economic shock to many sectors, and yet it has also generated opportunities in others.
The tech sector has been a major beneficiary and along with that, S-REITs exposed to the Data Centre sector such as Keppel DC REIT and Mapletree Industrial Trust gained phenomenally.
But are the investment opportunities in REITs now gone? Personally, we do not think so. There are still many REITs below their pre-COVID-19 levels poise to recover strongly in the coming quarters – and now it is the best time to prepare to capture the post-COVID recovery.
Join us as we discuss the opportunities and risk in the S-REIT space sector-by-sector as we try to uncover recovery opportunities for FY2021 and beyond. Real estate sectors that we will be covering include the Retail, Hospitality, Offices, Healthcare, Industrial and Data Centres.
Our speaker Tam Ging Wien will be sharing his knowledge and experience including:
Some key highlights that will be covered includes:
During the sharing session, various Singapore-listed REIT examples will be used.
There will also be a Q&A so that members of the investing community may engage in open dialog and discussions in order to deepen their understanding of REITs. Do prepare your writing materials for note taking.
Please note that the duration of the on-site seminar is 7pm to 9:45pm Singapore Time (GMT +8).
The details of the event are as follows:
To learn more about REITs, we recommend the article: What are REITs?
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