To The Moon

Summary

• RLJ Lodging Trust has offered a total return of 15% in the past 15 months, with a recent rally thanks to a dovish stance from the Fed.
• The REIT owns 96 high-end hotels with lean operating models and generates more than half of its EBITDA in the Sun Belt region.
• RLJ Lodging Trust is trading at a forward price-to-FFO ratio of only 7.1 and has a healthy balance sheet.

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Almost two years ago, I stated that RLJ Lodging Trust (NYSE:RLJ) would probably be an attractive stock to consider if the Ukrainian crisis worsened, as I expected the stock to be severely hit but then recover. Indeed, in late 2022, I recommended purchasing RLJ Lodging Trust for its exceptionally cheap valuation back then. Since my article, about 15 months ago, the stock has offered a total return of 15%. The stock was under pressure for most of last year but it rallied 29% in the last two months of the year thanks to the moderation of inflation and the dovish stance that the Fed has adopted lately. Nevertheless, the REIT remains attractive, as it is trading at a forward price-to-FFO ratio of only 7.1. As RLJ Lodging Trust also has decent growth prospects and a healthy balance sheet, it is not too late to buy this REIT.

Business overview

RLJ Lodging Trust is a REIT that owns 96 high-end, high-margin hotels, with more than 21,200 rooms in 23 states. Its hotels operate under well-known luxury brands, such as Marriott, Hilton and Hyatt Place, and have fewer than 300 rooms on average, thus resulting in a lean operating model, with superior EBITDA margins compared to the full-service competitors of the REIT.

RLJ Lodging Trust - Operating Model (Investor Presentation)

Source: Investor Presentation

Moreover, RLJ Lodging Trust generates more than half of its EBITDA in the Sun Belt region, which is characterized by superior economic and population growth when compared to the rest of the country. The REIT also generates approximately 75% of its EBITDA in the top 25 hotel markets of the U.S.

It is also important to note that the demand for hotels in urban markets, where RLJ Lodging Trust generates more than two-thirds of its revenues, is expected to grow faster than the supply in these markets, as the new supply is projected to remain low for several years.

Growth of Demand vs. Supply (Investor Presentation)

Source: Investor Presentation

Therefore, the REIT is likely to be able to raise its revenue per available room significantly in the upcoming years.

RLJ Lodging Trust is also in the process of redeveloping some of its hotels in order to enhance their value. In 2022, it redeveloped Wyndham Santa Monica, Wyndham Mills House and Embassy Suites Mandalay Beach, with an expected internal rate of return in excess of 40%. Management has stated that it will continue to invest in the enhancement of the value of its existing properties.

RLJ Lodging Trust also enjoys positive business momentum right now. The company released its latest earnings report on November 1st. In the third quarter, it grew its comparable revenue per available room by 3.4% over the prior year's quarter and thus its revenue per available room surpassed the pre-pandemic level for the first time since the onset of the pandemic. Management stated that the positive business momentum remained in place in October.

Moreover, in the first nine months of the year, RLJ Lodging Trust grew its revenue and its comparable revenue per room by 10% and 13%, respectively, over the prior year's period. It also reduced its net interest expense by 5%, as it paid off some debt, and thus it grew its FFO per share 27%. Thanks to the positive momentum of the REIT, analysts expect it to grow its FFO per share 19% this year, from $1.36 to $1.62.

It is only natural that RLJ Lodging Trust is recovering strongly from the coronavirus crisis, as it was hit especially hard by that crisis due to the collapse in tourist activity caused by social distancing. Now that the pandemic has subsided, the REIT seems to have ample room to grow thanks to the pent-up demand for its hotels, the promising economic prospects of its markets and the limited development of new hotels in its markets.

Analysts expect the REIT to grow its FFO per share by only 2% in 2024 and 6% in 2025. The expectations for accelerated growth in 2025 have probably resulted from the positive effect of lower interest rates on the interest expense of the REIT. Moreover, it is remarkable that the REIT has exceeded the analysts' estimates for six consecutive quarters. Given also its strong business momentum, it is safe to assume that the REIT will probably meet or exceed the analysts' consensus in 2024 and 2025.

If RLJ Lodging Trust meets the analysts' estimates, it will post FFO per share of $1.74 in 2025. This level is still 15% lower than the pre-pandemic FFO per share of $2.04, which the REIT posted in 2019. Given the aforementioned growth prospects of the REIT and the fact that the effect of the pandemic on tourist activity has greatly decreased, it is reasonable to expect the REIT to revert towards its pre-pandemic FFO per share in the upcoming years, particularly given that the share count of the stock is 3% lower than it was in 2019. To cut a long story short, the aforementioned analysts' estimates seem to represent a worst-case scenario for RLJ Lodging Trust.

Interest rates

The primary reason behind the poor stock price performance of RLJ Lodging Trust in 2022 and most of last year is the surge of interest rates to 16-year highs. As inflation skyrocketed to a 40-year high in mid-2022, the Fed raised interest rates at an unprecedented pace last year. The surge of interest rates exerted great pressure on the REIT sector, including RLJ Lodging Trust, as it greatly increased the interest expense of most REITs.

However, RLJ Lodging Trust is a bright exception in its sector with respect to interest expense. Its net interest expense has decreased by 18% vs. 2021, the year before the surge of inflation. In addition, the REIT has a manageable amount of debt. Its net interest expense consumes 52% of its operating income. This is high but decent, given the 16-year high interest rates prevailing right now and the lower interest rates expected in the upcoming years (more on this below). It is also worth noting that peers Pebblebrook Hotel Trust (PEB) and Xenia Hotels & Resorts, Inc. (XHR) have interest expenses equal to 213% and 79% of their operating income, respectively.

Moreover, RLJ Lodging Trust has a decent balance sheet. The net debt (as per Buffett's formula, net debt = total liabilities - cash - receivables) of the REIT is standing at $2.0 billion. This amount is 111% of the market capitalization of the stock and about 9 times the annual FFO and hence it is manageable, particularly given the positive growth prospects of the REIT.

Overall, RLJ Lodging Trust is sensitive to interest rates, though it is less sensitive than most REITs, which have a weaker balance sheet. In addition, the worse seems to be behind the REIT with respect to interest expense. The Fed has provided guidance for three interest rate reductions this year, four reductions in 2025 and another three reductions in 2026. In this way, the central bank intends to restore interest rates to 2.0%-2.25% by 2026, in line with its long-term target.

As inflation has cooled from a 40-year high of 9.2% in mid-2022 to 3.1% now, it is likely to revert to the long-term target zone of 2.0%-2.5% of the Fed at some point in 2024 or 2025. Therefore, the above guidance of the Fed appears to be reliable and hence the worse seems to be behind RLJ Lodging Trust with respect to interest rates. Whenever interest rates revert to 2.0%-2.5%, RLJ Lodging Trust is likely to see its interest expense decrease significantly and its bottom line to grow. Given also its cheap valuation (more on this below), the stock appears attractive for those who are confident that interest rates will significantly decrease in the upcoming years.

Valuation

As mentioned earlier, analysts expect RLJ Lodging Trust to grow its FFO per share by 2% this year, from $1.62 to $1.65. Therefore, the stock is trading at a forward price-to-FFO ratio of only 7.1. This FFO multiple is much lower than the 10-year average price-to-FFO ratio of 10.0 of the stock.

The cheap valuation has resulted primarily from the negative market sentiment over the impact of 16-year high interest rates on the interest expense RLJ Lodging Trust and on the present value of its future cash flows. However, RLJ Lodging Trust has a healthy balance sheet and can easily cover its interest expense. Moreover, as mentioned above, the Fed has finally provided guidance for several interest rate reductions during 2024-2026.

It is also important to note that RLJ Lodging Trust has a much cheaper valuation than the median REIT. The stock is trading at a price-to-FFO ratio of 7.1, which is much lower than the median price-to-FFO ratio of 13.1 of the REIT sector. RLJ Lodging Trust is much cheaper than the median REIT in other metrics as well, such as price-to-book value (0.89 vs. 1.47) and price-to-cash-flow (6.4 vs. 12.3). Moreover, the price-to-FFO ratio of RLJ Lodging Trust is much lower than that of its peers Pebblebrook Hotel Trust (10.7) and Xenia Hotels & Resorts (8.9).

The cheap valuation of the stock has not resulted from debt, as the REIT can easily service its debt. If the price-to-FFO ratio of RLJ Lodging Trust expands from 7.1 to 10.0, the stock will gain approximately 40% (=10/7.1 - 1) merely thanks to the normalization of its valuation. Even if the FFO multiple expands to 9.0, the upside of the stock (27%) will be material.

Risks

Before purchasing RLJ Lodging Trust, investors should be aware of two risk factors. If any of these risk factors materialize, it will probably prove short-lived, but investors should be well prepared in order to avoid losses due to panic-selling and maintain a long-term perspective.

The first risk factor is the unfavorable scenario of persistent inflation for years. If inflation rebounds, e.g. due to an unforeseen geopolitical event, the Fed will keep interest rates high for longer than currently anticipated. Consequently, the valuation of RLJ Lodging Trust is likely to remain under pressure for an extended period. Fortunately, the central bank seems to have tamed inflation and hence this adverse scenario is highly unlikely.

The other risk factor is the opposite scenario, i.e., a severe recession. In such a case, RLJ Lodging Trust will experience significant business deterioration due to the luxurious nature of its hotels. The REIT is more vulnerable to recessions than most of its peers, as the demand for luxury hotels decreases asymmetrically during rough economic periods.

However, there are absolutely no signs of an imminent recession. In fact, the Fed has been doing its best to cool the economy and restore inflation to normal levels. Predicting the time of the next recession has proved impossible and hence investors should not wait on the sidelines for this reason, particularly now that the Fed seems to have achieved a soft landing from sky-high inflation. Even if a recession materializes, RLJ Lodging Trust is likely to endure it without any problem thanks to its healthy balance sheet. Of course, its stock will temporarily come under pressure in such a case but the company and the stock are likely to recover whenever such a recession comes to an end.

Final thoughts

The stock of RLJ Lodging Trust has rallied 29% off its bottom in late October thanks to expectations for lower interest rates later this year. Many investors may think that it is too late to buy this REIT after such a steep rally but they should realize that the stock remains cheaply valued. As long as the economy remains healthy and interest rates moderate, the stock appears to have significant further upside potential.