An Upscale Pick for the Value-Conscious

04/05/2013 9:45 am EST

Focus: REITS

Marc Gerstein

Editor, Forbes Low-Priced Stock Report

As the economy improves, so does the hotel business. This REIT is poised to reap the rewards...and also pay them out, in dividends to its shareholders, writes Marc Gerstein of Forbes Low-Priced Stock Report.

Income in general and real estate investment trusts in particular are not generally associated with the low-priced stock universe. But such situations do exist, and we find one here with MHI Hospitality (MDH), a hotel-oriented REIT that was launched in 2004.

The yield on the shares is 3.3%, which is well above that of the typical dividend-paying equity, but pretty much in line with what’s available among REITs perceived by the market to be of higher quality.

That alone is an eyebrow-raiser, given MDH’s small size, the fact that it is highly leveraged, and the fact that it found it necessary to slash its dividend during the late-2000s financial crisis.

Real estate is a business for which debt normally figures prominently, most being tied via security interest to specific properties (i.e. mortgages)—and in MDH’s case, preferred stock.

Some property owners, including MDH, use more debt than others. But high debt is a fact of life in this area and something to be managed. Indeed, that’s exactly what MDH will have to do as obligations associated with various properties approach maturity.

Given business fundamentals as they stand now, and are likely to stand going forward, there’s little reason to question MDH’s ability to do this. Indeed, there is reason to hope that the trust may be able to trim debt through profitable property sales or issuance of new equity (which would benefit existing shareholders, if diminished risk and lower interest cost can more than offset the impact of additional outstanding shares).

Note, too, that MDH is a property-owning REIT, as opposed to the much more risky kind of REIT that acts more like a bank and lives on the income it generates by making mortgage loans. That’s where you’ll find many of the highest REIT yields.

The property portfolio here consists of full-service hotels in the upscale segments of the market, located in the Mid-Atlantic and Southeastern US—often near the Atlantic coast—under such brands as Hilton Worldwide, InterContinental, Starwood, and Resorts.

MDH aims to have hotels protected by barriers to entry (such as brands that are exclusive to a market) and located near demand generators such as universities, office parks, sports arenas, airports, or convention centers.

It looks to pay discount prices to purchase underperforming properties that could be enhanced through upbranding or a “shallow-turn” (a structurally sound facility that could benefit from moderate renovation). It eschews the “deep-turn” underperformers (closed or functionally obsolete hotels).

Adding to the value investor-type strategy MDH pursues in building its portfolio, it should benefit from improving trends in economic activity and improved corporate profitability and cash positions, which ought to facilitate more business trips and conferences.

Besides improving demand, MDH should benefit from the fact that there has been a slowing of new supply in the upper segments of the market in which MDH competes, and by the fact that well-priced acquisition opportunities should arise as weaker operators find it harder to refinance debt that comes due.

The quarterly dividend was suspended in 2010, reinstituted at 2 cents in mid-2011, raised to 3 cents in mid- 2012, and is scheduled to rise to 3.5 cents in 2013. It’s well covered by “funds from operations,” the key operating metric for REITs. MHI Hospitality is a Buy.

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