I am recommending a long in Sotherly Hotels (NASDAQ: SOHO), an underfollowed lodging REIT trading at a meaningful discount to fair value.
Sotherly Hotels is a lodging REIT formed in 2004 that owns 10 hotels in major cities along the Mid-Atlantic and Southern United States. These hotels operate under well-known upscale franchised brands such as Hilton, Crowne Plaza, Sheraton and Holiday Inn. It also owns a 25% minority interest in Crown Plaza Hollywood with the Carlyle Group.
SOHO has been in recovery mode since 2009. Occupancy has grown from 60.4% in FY09 to 69.5%, RevPAR from $64.74 to $82.68, and Hotel EBITDA $14.7mm to $24mm+. Management sees additional runway for growth and intends to continue raising its dividend. Lodging industry fundamentals appear healthy as well, with ADRs and occupancy rates at historical averages.
Management has opportunistically restructured its balance sheet in the current low-rate environment, replacing its line of credit, refinancing all of its individual hotel assets at low rates, extending maturities, redeeming 12% preferred stock issued during the recession with a 5.6% fixed mortgage rate, and redeeming dilutive warrants.
In November 2013, the Company made its first acquisition since 2008 by acquiring Crowne Plaza Houston Downtown, an attractive asset located in the heart of the Houston business district and adjacent to a 50-story Chevron office development that is scheduled for completion in 4Q16. SOHO paid $30.65mm in cash and 32,929 units of LP interests, plus some working capital adjustments (all-in cost likely ~$31mm). The acquisition was financed with a $21.5mm mortgage at a 4.5% interest rate and the property will generate $3.2mm of EBITDA and $2.7mm of NOI in 2013. I estimate that the acquisition will be ~$0.10 accretive to AFFO per share (12% accretive), which is a further tailwind to earnings.
Notwithstanding its 240% two-year price appreciation, SOHO is still undervalued. Based on my estimates, the company currently trades at:
~6x ‘13E P/AFFO (2013 AFFO per share guidance of $0.87 adjusted for warrant dilution + estimated $0.10 for Crowne Plaza Houston)
~10.7x ‘13E EV/Adj. EBITDA ($21mm of 2013 Adj. EBITDA guidance + PF run-rate EBITDA of $3.2mm for Houston)
$106 Price Per Key (EV / pro-rata number of rooms owned)
Lodging REIT peers trade at an average ~14x P/AFFO, ~16x EV/EBITDA multiple and ~$280 price per key. RLJ, the next cheapest peer on a multiples basis, trades at ~8x P/AFFO, ~13x EBITDA and $179 price per key.
Several factors drive the valuation gap.
The underlying assets are generally lower quality, with occupancy rates and RevPar lower than lodging REIT peers (for example, occupancy rates stand at ~70% vs. ~75%+ for peers)
Hotel operations are externally managed by an entity controlled by the CEO and current / former members of the board, so there are meaningful conflicts of interest
The Company is a tiny, relatively un-diversified REIT and has a more conservative dividend payout ratio than peers
The Company has undergone several transactions in the past two years (multiple refinancings, Houston acquisition), creating some transactional confusion
Underwent a name-change in 2013 and has effectively no research coverage. The stock stumbled with the rest of the lodging REIT universe during the recession, but there was no research coverage to drive a re-rating in the subsequent recovery
If we apply a significant discount to the lodging REIT average given some legitimate differences, at a conservative 9.0x P/AFFO, SOHO is worth $8.7 per share, a 55%+ premium to the current share price. Putting this in historical perspective, SOHO was worth $9.61 per share in 2005, on AFFO per share of $0.76. Today, the stock trades 40% lower, on AFFO per share that is 30% higher and will likely continue to grow.
Nearly all SOHO properties are managed by MHI Hotel Services, which is majority owned by the Sims family (Andrew Sims is the Chairman and CEO of SOHO and Kim Sims serves on the Board). MHI Hotel Services extracts $2-3mm of annual management fees through agreements that are not negotiated at an arms-length basis. I view this arrangement as a significant negative, but I note that the Sims brothers have 17.6% beneficial ownership in the stock worth ~$14mm at current prices (and worth substantially more at my target price), so there is a relative degree of shareholder alignment.
The looming expiration of a tax indemnity provides a potential catalyst. In SOHO’s 2004 IPO, the Sims family contributed five hotels to the Company in return for partnership units and a tax indemnity from the Company if any contributed hotel was ever sold during a 10 year “protected period”. This tax liability stood at $9.2mm at the end of 2012, or ~11% of the current market cap. When the liability expires in 2014 per the 10-year protected period, the five contributed hotels can be sold without triggering an indemnity payment, removing a major obstacle to value realization through asset disposals. NAV is likely higher than the current price. In a June interview with the WSJ, SOHO’s CEO said “we believe the underlying value for our hotels to be approximately $300 million, and if you subtract the debt of approximately $153 million, our net equity is plus or minus $147 million or just north of $11 a share”. If asset sales do not occur, I still foresee a path to value creation through rising dividends and greater investor attention.
I do not hold a position of employment, directorship, or consultancy with the issuer. Neither I nor others I advise hold a material investment in the issuer's securities.
Expiration of tax indemnity, asset sales, earnings / dividend growth