Lodging real estate investment trusts (REITs) are in the early stages of what promises to be a multiyear recovery that is creating profit opportunities for dividend investors.#-ad_banner-#

A key hotel metric, revenue per available room (RevPAR), is forecast to rise 6% this year and next year, reversing a trend of double-digit declines during the recession. The premium hotel segment is expected to experience even stronger gains, according to a PriceWaterhouseCoopers study. These gains are being fueled by an improving U.S. economy, increasing business and vacation travel, and anemic growth in the supply of new hotels.

The lodging sector struggled during the recession, and difficulties in obtaining financing kept hotel developers on the sidelines. As a result, the domestic supply of new hotel rooms grew only 0.5% in 2011 and 2012, well below the 25-year average annual growth rate of 2.6%. There has not been enough new construction to replace demolished hotels. Industry insiders anticipate a 2.2% rise in lodging demand this year, but the supply of hotel rooms is expected to increase only 0.8%. The net effect will be a boost in hotel occupancy rates to above 62%, the highest level since 2007, and hotels raising room rates. 

These two high-quality lodging REITs are particularly well positioned to profit from rising occupancy and RevPAR rates because of their premium brands and assets in major urban markets. Both are delivering double-digit income gains along with generous yields and are reasonably priced compared with other REITs.

Chatham Lodging Trust (NYSE: CLDT)
Yield: 5%
Chatham invests in premium extended-stay and select-service hotels. Since its IPO in 2010, the company has spent $465 million to acquire 20 hotels. Premium brands in Chatham’s portfolio include familiar names such as Residence Inn, Homewood Suites, Courtyard, Hampton and Hyatt. Nearly 60% of Chatham’s hotels are located in major U.S. cities.

In addition, through a joint venture with Cerberus Capital, Chatham holds a 10.3% interest in 64 additional hotels. These assets were acquired at bargain prices during the bankruptcy-forced sale of Innkeepers USA Trust. Chatham contributed $37 million to the joint venture in 2011 and has already received $21 million of its cash back through mortgage refinancing, the sale of eight noncore hotels and joint venture cash dividends. 

Most of Chatham’s assets are extended-stay hotels with rooms offering a full kitchen and complete furnishings. Because of this, Chatham’s hotel occupancy rates have historically outpaced the overall lodging industry by 15 to 20 percentage points. Chatham posted an average hotel occupancy rate of 82% during 2012; most other lodging REITs had occupancy rates below 70%. 

RevPAR growth for Chatham was below the industry average in 2010 and 2011 due to an extensive renovation and remodeling program affecting 13 of the company’s properties. Chatham recently completed this program and was able to deliver 8% RevPAR growth in 2012, outpacing the 6.8% industry average. Chatham also had the highest EBITDA (earnings before interest, taxes, depreciation and amortization) margin in the lodging REIT industry last year at 37.4%. 

In addition to its above-average RevPAR growth, Chatham increased EBITDA by 81% last year, to $40.9 million. Funds from operations, which is the standard REIT measure for cash flow, improved by 46%, to $1.30 a share. Analysts think Chatham can boost funds from operations by 23% this year and maintain 28% average annual growth for the next five years. 

Chatham’s shares gained 43% in 2012 but still appear bargain-priced at a multiple of 11 times 2013’s estimated funds from operations. The company also delivers an industry-leading 5% dividend yield and converted from quarterly payouts to monthly this year. Chatham raised its dividend by 5% in December, to an annualized rate of 84 cents. This was the company’s second dividend increase since the IPO and 20% higher than its dividend two years ago.

Diamondrock Hospitality (NYSE: DRH)
Yield: 4%
Diamondrock owns 27 upscale hotels in top urban gateway cities and resorts. More than half of the company’s hotels are located in New York City, Boston, Chicago and Washington, D.C., the cities expected to post the highest RevPAR growth in the next three years. The premium brands in Diamondrock’s portfolio include Marriott, Hilton, Renaissance, Westin and Courtyard.

The advantage of Diamondrock’s urban market focus is that sites are harder to find, so new hotels are rarely built. As a result of constraints on new supply, long-term RevPAR growth for urban hotels such as those owned by Diamondrock has been consistently higher than in non-urban markets, at 3.8% and 2.9% a year, respectively. 

In the past 24 months, Diamondrock has repositioned its portfolio. The company made $1.3 billion of hotel acquisitions in its major city markets while divesting $300 million of noncore assets. Diamondrock is also spending $140 million in the next two years to renovate a third of its portfolio. Once the renovations are complete, Diamondrock expects RevPAR growth will accelerate to 7% a year. 

Diamondrock improved EBITDA by 17% last year, to $189.7 million. The company’s funds from operations per share rose 26%, to 78 cents. Diamondrock expects growth in funds from operations of only 1% to 3% this year, but analysts look for 19% growth next year after the renovation program is completed.

The company held its dividend steady at 32 cents in 2011 and 2012. In March, Diamondrock increased its payout 6% to a new annual rate of 34 cents. Analysts think another dividend hike is likely next year after the renovation program is done. Diamondrock shares have lost 6% of their value in the past 12 months, but they appear cheaply priced at a 1.1 times price-to-book value (P/B) ratio, a 35% discount to the lodging REIT industry’s average P/B ratio of 1.7.

Risks to Consider: As REITs, both of these companies are required to distribute the majority of their income to investors. As a result, these companies are forced to rely on debt or equity financings to raise capital for acquisitions. Diamondrock sold $200 million worth of stock last year, and Chatham is in the process of closing a $74 million share offering this week.

Action to Take –> I like Chatham for its robust FFO growth, generous yield and monthly payout. Diamondrock is attractive based on its current low price and prospects for accelerated growth from its renovated hotel portfolio.

P.S. — Lodging REITs are perfect for what we call the “Dividend Trifecta” strategy. Simply put, it’s a three-part approach to dividends that multiplies the effectiveness of every dollar you invest. Go here to learn more…