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Morningstar | Initiating Coverage on Park and Pebblebrook While Lowering Host's FVE; Stocks Slightly Undervalued

We are initiating coverage on two new hotel REITs, Park Hotels & Resorts at a fair value estimate of $31 and Pebblebrook Hotel Trust at a fair value estimate of $39. We are also reducing our fair value estimate for Host Hotels & Resorts to $19.50 from $20.00. We assign all three companies a no-moat rating. These companies compete primarily in the upper upscale segment of hotel brands in urban, gateway markets and their portfolios are located primarily in central business districts or near convention centers. As a result, the majority of their bookings come from business travelers or group business, which are both relatively insulated from the rise of alternative accommodation competition from platforms like Airbnb. Host was spun-out from Marriott in the 1990s and, despite an attempt to diversify brand concentration by acquiring Starwood hotels over the past two decades, owns almost entirely Marriott-branded hotels since the merger between Marriott and Starwood. Park was spun out of Hilton at the end of 2016 and its portfolio is still entirely Hilton branded. Pebblebrook was formed in 2009 as a blind trust and has built a portfolio of mostly independent and boutique hotels. Pebblebrook just completed a merger with LaSalle Lodging Trust, a portfolio of complementary independent hotels that was mainly built by Pebblebrook's CEO as he previously founded and ran LaSalle before leaving to found Pebblebrook. All three companies are trading at slight discounts to our fair value estimates, though we also recognize that there is high uncertainty present in the fundamentals of the hotel industry.

We raised the uncertainty rating for Host to high from medium and set the uncertainty for Park and Pebblebrook at high due to hotel industry entering the late stages of the economic cycle. We also lowered Host's moat trend to negative from stable and set the other two companies at negative due to hotel operators losing the pricing power they typically enjoy at the top of an economic cycle to outside forces. NOI growth has slowed to inflationary levels and expense growth has started to overtake revenue growth, leading to flat to negative margins. The hotel industry is currently at all-time peak occupancy levels, so there is little room left for occupancy gains. High occupancy levels typically result in pricing power for hotel operators, allowing the hotels to push daily rate and sustain solid revenue growth. Considering that pushing rate doesn’t incur any higher variable costs, the revenue gains should fall entirely to the bottom line. This scenario of occupancies plateauing as operators shifted to pushing rate to gain margin growth played out at the top of the past three economic cycles.

Unfortunately, the hotel owners thus far have been unable to push rate at this late stage. While occupancies are at all-time highs, rate growth is limited due to the increased price discoverability provided to consumers by online travel agencies and review websites. Supply levels in many key markets keep revenue growth down even as demand growth remains healthy. While the impact of alternative lodging options like Airbnb on the urban, high-quality and business-focused portfolio owned by these companies is limited most nights, it does limit their ability to push rates on nights where they would have typically generated their highest profits. Increases to the minimum wage in many major metropolitan areas are increasing labor costs above inflationary levels. Real estate taxes are also increasing as many cities look for ways to generate additional revenue. These factors all lead us to conclude that the hotel owners are facing a negative moat trend as it becomes increasingly difficult for them to generate excess economic returns. We contemplate that the hotel owners may regain some of their pricing power if their markets start to push rate in unison in our bull-case scenario. However, we also recognize that we might be near the next recession and that these companies will experience several years of negative revenue and NOI growth and that they might struggle to return to their current level in our bear-case scenario. Thus, we believe there is a high level of uncertainty surrounding the hotel REITs considering the wide range of outcomes possible for these companies.

We do recognize that there is some upside to both of Park's and Pebblebrook's story as we rate the management teams for both companies as Exemplary and both companies have a new portfolio to manage. Park's management team built a portfolio that outperformed in both RevPAR and margin growth compared with similar peers. While the Hilton portfolio it took over has lower RevPAR and margins than its peer Host, we think that as management continues to execute on renovations and implement industry-leading best practices that it should be able to close the gap with Host. Pebblebrook's management team built a portfolio that led the industry in RevPAR and margin at LaSalle during the prior economic cycle, and then turned around a portfolio of "broken toy" hotels into one that had even higher RevPAR and margins than LaSalle. Considering that LaSalle saw minimal growth over the past decade under that company's prior management combined with Pebblebrook's proven track record of maximizing operations at hotels and its knowledge of the LaSalle portfolio, we think that Pebblebrook has an opportunity to create more value for shareholders by maximizing the potential internal growth of the acquired LaSalle portfolio.