Why Hospitality REITs May Not Be Worth the Risk

While Real Estate Investment Trusts (REITs) are a popular way to generate passive income for retirement in Singapore, we need to recognise that not all REITs are created the same.

As investors, the stability of our dividend income is closely tied to the stability of the rental income and distribution of the REIT which can be vastly different depending on the type of properties that the REIT invest in.

Across the different types of REITs – Office, Retail, Healthcare, Industrial and Hospitality – the one category of REITs that I am not a fan of is Hospitality REITs and in this article, I will share with you my stance on this particular category of REITs and why you should consider their risk carefully before investing.

Higher DPU Volatility

The primary issue with hospitality REITs is their heightened sensitivity to economic cycles and this is largely due to the type of their tenants and the nature of their tenancy contract.

Contrary to other REITs that mainly cater to commercial tenants and are less impacted by their tenants' financial performance across economic fluctuations, hospitality REITs primarily cater to corporate and leisure travellers. Their rental revenue largely depends on the demand from travellers for their properties such as hotels, resorts, and serviced apartments.

These properties are often operated under master lease agreements with the hotel operator which typically includes a fixed and variable rental component. This unique structure exposes the REIT to the performance of the master lessee which is a double-edged sword to REIT investors.

During the expansionary economic cycle where both corporate and leisure travel demand increases, the REIT is positioned to enjoy higher rental income from the variable component which ultimately drives up the distribution per unit.

However, during the contractionary economic cycle where both corporate and leisure demand decreases, the REIT may only receive the fixed rental component which typically accounts for around 20% to 40% of the gross revenue of the REIT.

According to the data disclosed in the 2023 annual report of the hospitality REITs listed in Singapore, the proportion of minimum (fixed) rentals to the total gross revenue is as shown below:

While it is unlikely that the REIT will not receive any variable rent at all, the fact that around 60% to 80% of the REIT distribution is variable means that their revenues are significantly tied to the performances of their properties.

This makes the distribution of the REIT far more vulnerable to changes in consumer demand, which is inherently volatile and can easily change overnight as we’ve seen from the COVID-19 pandemic.

Are They Still Worth Investing?

That said, I do not completely rule out hospitality REITs. While I am not a fan of their inherent risk, there can be opportunities to invest in this sector under the right circumstances.

For example, if a well-managed hospitality REIT with a strong balance sheet and high-quality assets is trading at an attractive valuation, I am open to adding it to my portfolio. The key is to ensure that the higher operating yield justifies the risks involved.

Given the increased volatility in the DPU of hospitality REITs, I would demand a higher operating yield to make it worth the increased uncertainty. In comparison to other REIT categories like industrial or healthcare REITs, which offer more stable and predictable cash flows, hospitality REITs need to provide significantly higher returns to compensate for their added risk.

One important point to remember is that hospitality REITs do have a place in a well-diversified REIT portfolio. If valuations are attractive, and the potential upside outweighs the risks, hospitality REITs could add a boost to your portfolio dividend income during periods of economic growth as the DPU would increase at the back of higher contributions from the variable rental component.

However, the timing of your entry and exit points is crucial given the cyclical nature of the sector. A well-timed entry would ensure higher dividend yields during normal operating conditions while providing an acceptable yield during times of economic recession or uncertainty.

Conclusion

In summary, while I am not a fan of hospitality REITs due to their higher sensitivity to economic cycles and volatile consumer demand, I would not avoid them entirely.

Instead, I would approach them with caution, ensuring that the valueations are attractive and the operating yield is sufficient to compensate for the added risk.

Hospitality REITs should be considered as part of a broader REIT strategy and should only be included if they offer compelling value at the time of purchase.

Investing in REITs is about balance, and hospitality REITs require careful consideration and strategic timing to ensure that you are not overexposed to unnecessary risk in pursuit of yield.

If you’re looking to invest in hospitality REITs, always remember that higher risk should come with higher rewards.

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