The Dash – For – Trash

The stock market had a big rally in January as (once again) the idea of peak inflation grabbed investors. Whenever this happens, there is what I call a Dash-For-Trash in interest-rate-sensitive stocks.

As interest rates go down, these stocks go up–and depending on how big their debt load is, they can go up A LOT.

So, the most beat-up, highly levered stocks (read: huge debt) get the biggest run-ups, the highest alpha—as investors gamble that rates will fall. For any high-debt business, less interest rate payments means more principal payments, and that means the equity value of the stock rises.

Think of interest rates as just another commodity, as this happens in commodity stocks all the time. As these cyclical plays go in and out of vogue, depending where we are in the business cycle, the riskiest companies with the worst balance sheets and cash flows—do the best (for a short time).

That’s what happened in January to REITs—Real Estate Investment Trusts. And the poster child here is Ashford Hospitality AHT-NYSE. This company has US$3.8 billion in debt and a market cap of only $230 million.

Every percent lower interest rates means revenue can go to debt paydown, not debt servicing—great news for equity! But it’s also vice versa—and last Friday changed the game.

Last Friday, The United States jobs report came out and shocked everyone—517,000 net new jobs!

What’s more, if you dug into the numbers, they weren’t just smoke and mirrors. It was good old-fashioned strength.

All of a sudden, The Street is (once again) now saying rates will stay higher for longer. Rates may not go a lot higher, but they could stay high a lot longer – and this is bound to cause a pause on plays levered to low-rate expectations.

Stocks that are interest rate sensitive (ie Ashford) – especially stocks with a lot of floating rate debt (ie. Ashford), had a lot of room to run up when interest rates could only go down.

But now? Mr. Market is not so sure.

Of course, it is not all bad news for REITs.  The jobs report is a good thing for economic growth. That is a good thing for the hotel business—high occupancy!

And the hotel business is booming.  There is no evident of slowing here.

Just last week Morgan Stanley hosted Costar’s STR, a leading source of hotel data and analysis.

What did they say? No slowdown in demand. A strong leisure hotel market. An especially strong luxury hotel market.

That plays right into Ashford’s hand.

But is it enough to offset higher-for-longer rates?

That is the million-dollar question. The one that made me second guess my purchase of the stock.

AHT IS THE HIGHEST LEVERED PLAY ON TRAVEL

Here is the short story on Ashford.

Ashford operates hotels and if the hotels fill up with guests, Ashford makes money.

Ashford has 99 hotel properties across the United States.

These are all branded hotels: Hilton, Hyatt, Marriott and Intercontinental Hotel Group brands.  Higher end. Ashford describes their niche as “upscale and upper-upscale” full-service hotels.

Source: Ashford Hospitality Investor Presentation

Ashford is in the hotel business.  But that is not really the story here. Instead, the story is about debt. A lot of it.

Ashford has $3.8 billion of debt. Another $163 million of preferred shares. Against that, Ashford has about $225 million of common equity. That is a huge debt to equity ratio, by any measure.

What’s more, Ashford’s debt is highly exposed to changes in interest rates.  Ashford ranks top-of-the-list in terms of their exposure to floating rate debt.

Source: Morgan Stanley Research

If you wanted more to worry about, almost all Ashford’s debt is maturing in the next 3 years.

Source: Ashford Hospitality Investor Presentation

Those 3 attributes: a lot of debt, floating rates, and near-term maturity, make Ashford one giant bet on interest rates, more than a bet on the hotel business itself. If rates actually go back to 2%, then this stock could be a massive winner (disclosure: no position here, long or short)

DEBT CUTS BOTH WAYS

The upshot of all this? Ashford carries with it a lot of risk.

The question is – is that risk worth the reward?

One way to look at Ashford’s valuation is to compare it before COVID versus today.  A quick snapshot then and now:

Source: Ashford Hospitality Filings

Today, Ashford has a lower enterprise value than it did in 2019. It has less debt, fewer shares outstanding and more cash.

But wait, how is that possible? How could Ashford manage through the pandemic while reducing debt and share count?

It’s a mirage. Ashford did a 1:10 share consolidation in 2021 (the equivalent number of shares in 2019 terms would be 344,980,000).

In fact, Ashford made it through the pandemic by issuing a lot of shares. They exchanged preferred shares for common shares and also issued common share into the market.

They also sold properties. The number of rooms Ashford owns today is about 2,800 less than it was then.

All these changes make apples-to-apples difficult. To make a fair comparison you want to look at the enterprise value per hotel room. As it turns out, on that metric Ashford is worth a bit less:

Source: Ashford Hospitality Filings

Why is Ashford worth less per room now versus in 2019? It doesn’t appear to be the current state of the business.

Operating metrics seem relatively similar. ADR – which means Average Daily Rate – is slightly higher. RevPAR – revenue Per Available Room – is a tad lower. And occupancy is lower by 5%.

Source: Ashford Hospitality Filings

How about profitability?  I compared Q3 2019 to Q3 2022 below:

Source: Ashford SEC Filings

The operating performance in both periods is quite similar. Most important, the Adjusted Funds Flow per share (AFFO/share) is better in 2022 than in 2019.

AFFO is the most common measure of performance for a REIT. It gives us a picture of how much cash and equivalents the REIT is generating that could be used to pay a dividend. Ashford generates more AFFO/share now than then.

Yet you can pay about $19,000 per room less to buy Ashford today than you would have paid in the third quarter of 2019.

INTEREST RATES TELL THE STORY

If Ashford’s hotel business appears to be as good or better on a per share basis compared to 2019, then why isn’t the stock higher?

In my opinion, it all comes back to rates. The Big Worry is about:

1. how long they stay this high.
2. how much higher they might go.

Rates create THREE headwinds that work against Ashford.

First, cap rates. Hotels are valued on cap rates, which are defined as the operating income of a property divided by its selling price. Higher cap rates mean a lower selling price.

Today cap rate are higher than they were in 2019.

In Morgan Stanley’s December lodging report titled “As Secular & Cyclical Collide, Prefer C-Corps” they estimated that the cap rate on the full-service hotel market was 8.1% in Q3 2022, up 52 basis-points year over year.

According to CBRE the cap rate for full-service hotels was 7.75% in the second half of 2019.

While that may not seem that different, remember how levered Ashford is. Any difference in cap rate goes straight to that tiny equity value. A small change can have a BIG impact to a levered play like Ashford.

Second, while cap rates have moved up, they have not moved up as much as the Fed funds rate. Cap rates may have further to go.

This was another point noted by Morgan Stanley. They said (my emphasis) “current lending rates could still point to downside, in our view, given fed funds have moved more than cap rates.”

Given Ashford’s leverage, investors may rightly be asking for a cushion to equity if they worry that rates could head higher.

Third, Ashford’s interest costs will rise if rates just stay at current levels for a long enough time. This will eat into Ashford’s AFFO and could even put the whole business at risk.

Ashford has interest rate caps in place that limit their exposure to 4% max until 2024, but after that…

If interest rates remain high, Ashford will face higher borrowing costs.  If we are looking at the same level of rates in 2025, Ashford could be left with a double-whammy: refinancing their debt and paying higher rates to do it.

WHAT SHOULD INVESTORS DO HERE???

What is Ashford worth? Well, that depends on the glasses you are wearing.

If you put on rose colored glasses, you could focus on the stock trading at a steep discount to where it was in 2019.

You could also point to inflation coming down and the 10-year Treasury peaking.  You could argue that we are going back to a world of much lower rates in short order.

And if you were really bullish, you could point to the resilience of the economy, which would bode well for Ashford’s hotel occupancy.

With rose-colored glasses, you could imagine a MUCH higher share price for Ashford.  A triple is not out of the question.

BUT! If you put on glasses with a darker tint, you may see things quite differently.

You might see sticky inflation. You may note that if inflation doesn’t return to pre-COVID levels, where do rates need to be (or go!)?

If Ashford did have to refinance its very large debt load at even higher rates, you might wonder how much cash flow would be left?

And worst of all, if the economy succumbed to higher rates, what if Ashford was hit from all sides, with falling occupancy even as its borrowing costs went up?

In that case, a lower share price would be in the cards. Maybe even a much lower one.

Two extreme views. Lots of leverage—big moves can happen in this stock. I just don’t know if they will be up or down.