After more than two decades in equity research, longtime Robert W. Baird & Co. Inc. lodging analyst David Loeb is leaving the firm, and the sell side, at the end of 2016. In the second part of an interview with S&P Global Market Intelligence, Loeb talked about the potential for M&A among hotel REITs. The conversation has been edited for space and clarity.
S&P Global Market Intelligence: Do you think the dozen or so hotel REITs should be combining to form larger companies?
David Loeb, senior research analyst and managing director, Robert W. Baird & Co. Inc.
David Loeb: If you look at the brands, it's already happening, if you look at the operators, it's already happening. You wouldn't necessarily know that. You wouldn't know that Interstate bought four other operators in the last five years or less, but they have. Where we've not seen it, where it's been conspicuously absent, is the REITs. And I think that's going to change. I think the time for that is coming.
Why has consolidation not happened yet in hotel REITs?
In malls, for example, there's a really good reason for it to have happened, and it did, a long time ago. The same retailers need to be in every one of Simon Property Group Inc.'s malls, and that gives Simon a lot of power over rents nationally. There are true economies of scale for controlling that real estate. That's absent in hotels.
Plus, hotels are cyclical, plus the other times we've seen attempts at this there have been barriers, because of what people euphemistically call social issues. Executives are comfortable in what they do, and both CEOs want to run the company, both sets of directors want to stay on the board. So that creates some challenges.
But look, I don't really know. I think it should have happened a long time ago. Host Hotels & Resorts Inc. was in a great position, five to seven years ago, to go and buy a lot of their smaller REIT peers, and they didn't. Maybe now we will finally see it. And frankly, the fact that a couple of REIT leaders sold their companies and went off and started new ones, and that was accepted by the public market, that helped ease the fear of social issues. I think we're headed in the direction of a generational shift as well, which will help. The CEOs haven't changed a lot, and they're getting older, and maybe more willing to step away.
How much of this is specific to hotel REITs? Because I know there are people who think there are too many REITs in general.
Well look, Post Properties sold. Parkway Inc. and Cousins Properties Inc. did what I affectionately call a merge and purge — so they still had two companies, they solved some social issues that way. In the apartments, there have been two or three transactions in the last year, and we've seen that historically, in that sector and others. Prologis Inc.and AMB merged to become a larger Prologis, Equity Residential bought a lot of stuff, Equity Office bought other REITs when they were public, before they sold themselves entirely. It's happened in other sectors. I think it'll continue, and it's happened for a lot of similar reasons.
I've talked this through with investors, and they're all afraid of the near-term dilution. And I believe there will be a stock-for-stock deal one of these days where the premium will be announced and the premium will disappear, because the market trades the acquirer down. But nonetheless, what boards of directors need to think about is what's really best for company shareholders in the long run, and not just tomorrow and the next day, not just the week after announcement. In two years, are you going to have a better, stronger, larger company that can be more nimble and more active, have better access to capital markets, and therefore be worth more to investors down the road?
Is part of the appeal of consolidation also becoming a must-own company, like how every investor has to own Public Storage?
Yeah, Public Storage is huge, Simon is huge. But also, look at Equity Residential. Can you really afford to not own any Equity Residential during any part of the cycle, if you're a REIT-dedicated fund?
These companies are big, which means they're a bigger piece of the RMZ, and for dedicated managers, they have to look pretty carefully when they change their weighting really far from the index. So yes, I think if we could get in that $20 billion to $40 billion equity market cap range for a hotel company, it would really change investors' attitudes towards owning hotel companies in good times and bad. They might still own very little, but I would think they would own some, and that would show up in the valuation.
Right now Host Hotels is the largest hotel REIT. If there's consolidation that leads to one company attaining that kind of must-own status, is it going to have to involve Host?
I think the simple answer is no, because there's enough market cap you could roll up to get bigger than Host, especially with Park Hotels & Resorts Inc. and Apple Hospitality REIT Inc. being reasonably big today. It's just going to be harder, it's going to take longer if it's not Host. Host still has the best chance of getting there the quickest because of their size. But Apple could add other public or private equity-owned portfolios and get a lot bigger too.
You look at BRE Select, Blackstone Group LP's select service platform, something like $5 billion of enterprise value, and guess what's inside that? Three previously Apple nontraded REITs. Starwood Capital still owns a bunch of select service, even though they sold a lot, probably half, into their new fund with China Life. So there are ways to do this. If you get a cost of capital advantage, one of the benefits will be bringing into the public market a lot of the real estate that's been in the private market.
There are many paths to that goal, and I think including Host in that is the easiest way to get big. But it's possible we could get the Simon and General Growth Properties Inc. of hotels, with a couple of companies pursuing those same kind of strategies. Or the AvalonBay Communities Inc. and Equity Residential, both of which are $20 billion REITs.