Description

Quick Pitch

On the hunt for bombed-out travel and leisure securities that have a balance sheet to withstand the COVID-19 market dislocation, I present the Series E and Series F Cumulative Redeemable Preferred Stock (“SHO.PE” and “SHO.PF,” collectively the “Preferred Issues”) issued by Sunstone Hotel Investors, Inc. (“Sunstone,” “SHO” or the “Company”). While I also think SHO’s common is interesting (and own some as well), I believe the risk-reward on the Preferred Issues is extremely compelling with the likelihood of permanent capital impairment very remote. 

Sunstone is upper upscale focused lodging REIT that owns 20 mostly fee-simple, full-service properties in major U.S. gateway, convention and resort markets. Sunstone will undoubtedly face an extremely challenging 2020 (especially after one of its properties was shut down due to a coronavirus outbreak), where I expect the Company to burn cash. However, with net debt (including Preferred) to FY 2019 Adjusted EBITDAre of just 1.1x and ~$800mm of HoldCo cash against $425mm of recourse debt ($615mm including the Preferred Issues), I believe Sunstone’s fortress balance sheet will enable it to survive COVID-19 and potentially even take advantage of its beaten down share price to affect a buyback of its stock or Preferred Issues.

At a current levels of $14.75 and $15.08], respectively, the Preferred Issues offer a ~11-12% current yield (yes I believe the Company will continue pay preferred dividends), ~30% IRR to a April ’23 call or ~20% IRR to an April ’25 call. At par ($25), I estimate that the Preferred Issues represent an LTV of just 8-13% or $33k per key (<10% of replacement cost) for high quality hotel assets in good markets. If one believes that life and travel will return to something approaching normal over the next 3 – 5 years, I think the SHO Preferred Issues offer an attractive upside with limited downside for a long term investor.

Company Overview / History

Sunstone owns interests in 20 upper upscale hotels comprising 10,640 rooms across 9 states and DC. All but two of the hotels are branded (under the Marriott, Hilton and Hyatt banners). All of SHO’s hotels are operated by 3rd party managers, with Marriott managing 8 properties.

SHO went public in 2004 and after learning some hard lessons during the GFC (handing over the keys to lenders) with an overleveraged balance sheets and some mediocre assets in the last downturn, SHO has recycled capital from upscale hotels over the last decade into a handful of “Long Term Relevant Real Estate” properties. In particular, I estimate that 6 of the 20 properties (the “Top 6”) account for ~2/3rds of equity NAV. Since 2014, the Company has generated ~$1.2bn in proceeds from dispositions against ~$500mm in acquisitions. Some of these funds have been spent upgrading / repositioning assets (eg Wailea Beach Resort) while much of it has helped reduce debt to put the Company in an enviable position of being the least levered lodging REIT out there heading into a crisis.

ADR, occupancy, RevPar and margins at the Top 6 significantly outpace the rest of the portfolio (“Other 14”) resulting in ~$43k of 2019 EBITDAre per key for the Top 6 vs ~$25k for the Other 14. Of the Top 6, only one hotel has mortgage debt (Hilton Times Square, which is also the only Leasehold among the Top 6). Consequently, I am going to focus on these 6 properties.

Top 6 Details

Wailea Beach Resort

SHO acquired the 547 room Wailea Beach Resort in 2014 for Blackstone for $326mm ($595k per key) or ~17x EBITDAre. At the time, this property could be described as the “worst home on a great block” with its ADR of ~$275 representing ~40% of the ADR Index and EBITDAre per key of just ~$35k. Since then, SHO embarked upon on an ambitious repositioning, investing ~$110mm to update the property, bringing its total investment to ~$796k per key. This has resulted in a dramatic improvement in financial performance allowing the Company to increase ADR to ~$480 in 2019, which still represents just 70% of its ADR index (ie management believes there is room for continued ADR growth in a normalized environment) but nonetheless nearly trebling EBITDAre per key over the period to $90k in 2019.

Wailea Beach Resort is unquestionably SHO’s crown jewel and its most recent investor presentation included a slide suggesting management believes the property is worth $742 – 809mm (5.5 - 6% cap rate or $1,356 - $1,479 per key). For my NAV, I value the property using a range of 11 – 15x 2019 EBITAre, which represents $994 – $1,356k per key (Base Case of 12.5x and $1,130 per key). At this range, Wailea is worth $544 – 742mm to SHO (property has no mortgage debt) or ~[25%] – [35%] of SHO’s current TEV. I believe this valuation is also supported by Blackstone’s 2018 purchase of Grand Wailea for $1,312k per key.

Boston Park Plaza

SHO purchased the Boston Park Plaza in 2013 for $250mm or $237k per key, which was 13.1x trailing EBITDAre. Like the Wailea, this was a “turnaround” in a “good neighborhood” (located close to Boston Common) as Sunstone invested ~$90mm post-acquisition (total cost of ~$323k per key) to reposition the hotel. The Park Place was a “2.5 star” property at the time of acquisition with RevPar at ~80% of peers with the goal being to get it closer to 3.5-4 star with ~90% of peer ADR. Through this transformation EBITDA per key has increased >70% since the acquisition. I value the Park Place using a range of 9 – 12x FY ’19 EBITDAre, which equates to $279 – 371k per key.

Hyatt Regency SF

Sunstone acquired the 803 room Hyatt Regency SF in 2013 for $263mm ($327k per key) or 15.6x trailing EBITDAre. The Hyatt Regency SF sits on prime SF real estate across from the Ferry Building in the Embarcadero / Financial District. I estimate that since the acquisition, SHO has invested an additional $50-60mm in the property adding 18 rooms and updating the lobby / meeting areas that have enhanced the hotel’s ‘curb appeal’ and bring SHO’s total investment to ~$400k per key. Since then, ADR has increased from ~$250 to ~$320 while EBITDA per key has nearly doubled to $40k. I value the unencumbered hotel using a range of 10 – 15x FY ’19 EBITDAre of ~$33mm, which results in a per key valuation of $398 – 596k. It is worth noting that the Grand Hyatt SF transacted in 2018 at $871k per key.

Renaissance Orlando at SeaWorld

This property was acquired by SHO as part of a $420mm portfolio, 6 property transaction with GIC in 2005. In 2018, Sunstone acquired the land underlying the property for $30mm. This is a large hotel (781 rooms) located adjacent to SeaWorld. The hotel underwent a $35mm renovation in 2011 as well as ~$25mm project in 2018 that added ~46k sf of meeting space. Since 2015, property EBITDAre has grown ~50% to $29mm in 2019. I value the hotel at 9 – 12x 2019 EBITDAre, which equates to $333 – 433k per key.

Hilton Times Square

Leasehold acquired by SHO in 2006 for $243mm ($546k per key), this is undoubtedly the most difficult to value of SHO’s Top 6. Despite having >99% occupancy for the last 5 years, EBITDAre has declined from $14mm to $8mm as it saw a $4mm increase in taxes. SHO is currently involved in a dispute with the City of New York (the owner of the land underneath the hotel) over a $3mm increase in ground rent expense. This is the only one of the Top 6 that has a mortgage ($78mm) that matures in November. SHO sold a neighboring hotel (also subject to a ground lease), the DoubleTree Times Square, in 2015 for $1,154 per key. I doubt SHO could get that now (or even in a normalized environment) so I use a wide range of $300 – 1,000 per key (Base Case of $650k per key). The Low Case effectively assumes a fire sale this year in conjunction with the mortgage coming due.

Marriott Boston Long Wharf

In the news recently for the COVID-related shutdown, SHO acquired the 415 room property in 2007 for $228mm ($568k per key) or 12.7x trailing EBITDAre. The hotel underwent a $35mm renovation ($84k per room) in 2018. I value the hotel using a range of 9 – 12x FY ’19 EBITDA, which equates to $504 – 672k per key.

Debt Overview

The Company’s Revolver and Unsecured Term Loans operate under a common credit agreement (the “Credit Agreement.” The Credit Agreement contains a number of negative covenants including a 6.5x total leverage test. This test can be waived for up to four quarters so long as total leverage does not exceed 7.0x. I believe that absent any adjustments that it is possible that SHO will exceed these ratios. That being said, the Credit Agreement EBITDA definition includes some pretty loose language that SHO could probably wiggle through during COVID as the Company has the ability to add back “extraordinary or non-recurring gains, losses, revenues and expenses.” However, even if it does need to obtain a waiver, the Company could easily repay the $185mm of term loans with cash on hand or more likely pay some amendment fee for a waiver (my guess is that the banks will have bigger fish to fry and probably actually want to keep what is effectively a cash collateralized credit outstanding). Fixed Charges include Preferred Dividends so there is nothing in my reading of the Credit Agreement to suggest that the Company would have to stop paying Preferred Dividends (though would be curious if others have a different reading). This is a long-winded way of saying, that given SHO’s low leverage position and fact it is sitting on a ton of cash, I think it is extremely unlikely that HoldCo lenders will be able to pull the rug out from under SHO’s Preferred Issues.

Summary and Returns

Bringing it all together, given SHO’s assets and cash position. I think the Preferred Issues are metaphorically covered ‘six ways from Sunday.’ While I expect COVID to result in near term challenges for SHO and the lodging industry as a whole, I believe that the SHO Preferred Issues give a patient investor the ability to earn equity-like returns with low risk of capital impairment.

Risks

COVID-19 permanently alters global travelling habits

COVID-19 lingers for longer than anticipated

SHO hands over keys for properties with mortgages

Catalyst

Resumption of Travel

SHO buys back Preferred Issues