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Morningstar | Lower Interest Rates Positive for Hotel Property but Key FVE Driver is 2021 Lease Renewals

The recent steep fall in interest rates, which supports property values through lower capitalisation rates and interest costs, prompts an increase in no-moat Hotel Property Investments’ fair value estimate to AUD 3.15 per security from AUD 3.05. Notwithstanding, the key near-term driver of Hotel Property’s fair value estimate will be the attitude of Australian Venue Company, or AVC, and Coles to investing in Hotel Property’s pubs and exercising lease options. Coles have now completed the recently announced joint venture with AVC. The latter will manage the day-to-day operations of Spirit Hotels and receive the economic benefits of these businesses, including properties owned by Hotel Property. At our fair value estimate, the REIT has a fiscal 2019 and fiscal 2020 distribution yield of 6.3%. At the current price of AUD 3.55 per security, the REIT screens as overvalued.

We assume lease expiries will result in about 15% of the REIT’s total rents requiring re-lease in fiscal 2021. About 40% of the properties are subject to the option of renewal in fiscal 2021. It’s still early and neither AVC nor Coles have provided an update about their intentions for Hotel Property’s assets. Hotel Property management has been in discussions with AVC. According to management the discussions have been positive, but no decisions have been made regarding individual properties.

Nevertheless, we expect the sharp fall in interest rates and recent easing bias of the Reserve Bank of Australia, or RBA, will likely lead to interest rates staying lower for longer, placing continued pressure on already historically low pub cap rates. Lower cap rates combined with favourable rental terms should support the value of Hotel Property’s portfolio. Most of the REIT’s leases provide for annual rental increases at the lower of 4% or two times the average consumer price index. Notwithstanding, the major near-term value driver of Hotel Property’s property portfolio will be the attitude of AVC and Coles on exercising options on leases in fiscal 2021. However, lower interest rates should unequivocally lead to lower interest rate expenses. With about 50% of the group’s debt on floating rates, the lower interest rates should reduce future interest expenses, providing some support for future distributions.

Given major competitor Woolworth’s recent decision to exit its liquor and hotel businesses, Coles’ intentions for liquor and hotels is a key uncertainty for Hotel Property investors. Woolworths will combine its drinks and hotels business and demerge them in 2020. The Woolworths decision may prompt Coles to review its own liquor and hotels business further, including at hotels owned by Hotel Property. However, given Coles just completed the transaction with AVC, we don’t expect any further major near-term changes. We also expect AVC to be a long-term operator of pub businesses, which we think mitigates some of the risks from Coles potentially exiting this business.

Woolworths management suggests the primary reason for separating its drinks and hotels business is to simplify the Woolworth’s overall business structure and facilitate more focus on its core food and everyday-needs retailing. Notwithstanding, we expect environmental social and governance, or ESG, concerns played a part, particularly over poker machine gambling at its hotels business. Institutional investors appear increasingly concerned about ESG issues such as excessive or addictive gambling and its potential effect on the reputation/brand of their asset management operations. Accordingly, we expect institutional investors, the media and broader community will continue to pressure firms to focus more on such ESG matters such as such as excessive or addictive gambling .