R&R REIT
An obscure nano-cap REIT trading at 4.6 times free cash flow and 1/3rd of liquidation value
Disclaimer: None of what I write is a recommendation to buy or sell a stock. I am an internet stranger writing about random businesses with no successful track record in investing. This is a selfish endeavor to grow as an investor myself and to document my research as I do not have a good memory. Please do your own research before buying a stock.
If you like reading pdfs, here is a pdf version of this writeup.
Thesis - The Shorter Version
An REIT, trades at 4.6 times free cash flow, half of book value and close to one-third of liquidation value(with conservative property value estimates) and contains hotels in pretty good locations, with conservative amounts of debt(for a real estate company). This REIT is operated by a self made billionaire hotel operator, with proven success in this business.
This is the crux of the thesis and pretty much covers my reasons for investing in this company that you can stop reading right now to save yourself some valuable time. If you are interested in knowing more, keep reading on.
Warning: This company is a highly illiquid nano-cap, so any trades should be placed as limit orders.
Introduction
R&R REIT is a hotel REIT, which owns 17 hotel properties in different parts of the US(the stock with ticker $RRR.UN trades in Canada). The hotel properties consist of budget hotels(Red Roof Inn brand) and extended stay hotels(HomeTowne Studios brand), split roughly evenly between the two in number.
Economics of Hotels
Real estate is quite new to me, especially hotels. So I tried to understand the economics of real estate(and hotel businesses) which I summarize below. Location is the most important factor for a conventional hotel to do well. One of the important aspects of location is ease of access. Proximity to highways, airports are pretty important for air and road travelers. The customer segment can be divided into two categories - tourists and commercial travelers. People generally prefer hotels in the town/city’s central business district and the ones situated near tourist attractions. Apart from location, good enough quality at a cheap price is also important for budget hotels.
In extended stay hotels, people usually stay for 3 weeks or longer vs 2-3 days for conventional hotels. Extended stay hotel properties may not be located on a major highway, instead it may be located a few miles from a highway. Given the length of the stay, lower costs are more important vs a conventional hotel and quality is also more important vs a budget hotel. Guests expect a bigger room area, with a kitchen(including refrigerator, stove, microwave, sink) so that they can cook their own food.
Useful metrics for valuing real estate are replacement cost and supply-demand dynamics. Replacement cost can be thought of as a ceiling for real estate valuation. If real estate values in a market increase above replacement cost, then new properties will start coming up in the area, until the valuation gets back down to replacement cost. Often this leads to overbuilding and supply getting out of line with demand, thus leading to property values falling below replacement value. Hence property values staying at or below replacement cost inhibits new competition. Real estate values can fall below replacement costs as well, for example, in times of recessions(where demand falls out of line with supply) or overbuilding as described above(where supply increases out of line with demand). Typically, over a shorter time period(say 5 years or so), supply demand imbalances can affect property valuations. However, over the very long term, supply and demand tend to adjust, with replacement costs being a reasonably good approximation for value on average. Thus, if I am a real estate investor, looking to buy properties, buying below replacement costs is vital to do well. This is very much applicable for hotels as well. According to data from Cushman & Wakefield, in the approximately 30 year period from 1995-2023, supply in the US hotel industry has increased at 1.5% CAGR and demand has increased at 1.4% CAGR.
Two important metrics used in the hotel industry are Average Daily Rate(ADR) and Occupancy rates. ADR represents the rate paid per hotel room per night and occupancy rate mentions the percentage of room nights occupied in a year. For simplicity, if a hotel has 1 room and it is occupied on 183 days in a year, it has an occupancy of 50%. Another important metric often used is RevPAR(Revenue per available room) which is simply a product of ADR and occupancy rates. According to the same Cushman & Wakefield report, ADR has increased at a CAGR of 3.2% while inflation has been an average of 2.5%. Historically, occupancy rates tend to be cyclical in nature - recessions causing dips and a strong economy with less unemployment causing highs. However, occupancy rates more or less remain constant, over the very long term.
Are hotels great businesses?
Hotels(and real estate in general) have low returns on capital, which are typically enhanced with a high use of debt to make returns on equity attractive. Hotels have high fixed costs - employee costs, maintenance costs, construction costs(depreciation), utility costs, interest expenses, property taxes, insurance. Such high fixed costs can cause bankruptcies during recessions when occupancy drops drastically - highly levered properties are especially at risk. In addition, hotels sell a perishable product(a hotel room which goes unoccupied for a night cannot be reclaimed and brings down overall occupancy rate, similar to an airline seat which is unoccupied for a given flight).
As long as hotel rooms satisfy a basic value proposition(as mentioned earlier), they are more or less a commodity, hence pricing power is limited and typically is a result of supply/demand dynamics. This business has somewhat low barriers to entry(although high fixed costs can be a barrier) and high barriers to exit - hotels in most cases cannot be converted to be used for other purposes(like residential uses), so if a market is oversupplied, the situation remains permanent until demand outgrows supply again. Demand is sensitive to how the economy is doing with factors like higher unemployment leading to lower occupancy rates than normal. New supply takes 1.5 to 2 years to come online - hence demand forecasting mistakes are common. Hotel developers often forget “regression to the mean” and often extrapolate good times to last forever. Because of this, more new supply comes in as hotels which were started during good times may get completed during recessions, thus exacerbating the demand drop problem with even more supply. One can easily see why hotels in general are not great businesses.
Management
R&R REIT is 80% owned by Majid Mangalji, the owner of Westmont Hospitality Group. 10% is owned by Michael Klingher, CEO of R&R REIT. Westmont Hospitality Group, a company which owns and manages hotels, was founded by the Mangalji family when they moved to Canada from Uganda in 1973. They started with a single hotel and have grown to become one of the largest owner/operators of hotels in the world, by currently owning close to 500 hotels. If you have read “Dhandho Investor” by Mohnish Pabrai, their modus operandi seems very similar to the Patels. The hotel business is a tough business, so anybody who has achieved such a huge success is likely to be an outlier and should be doing things very differently from competition. There is not much information to be found about the Mangalji family or Westmont Hospitality as it is a private company. Nevertheless, in an interview, Mangalji says the following(emphasis mine):
“Due to political problems in Uganda [my family] was forced to leave and we moved to Canada in 1973. We got into the business in a very small way. We started with one little hotel, we managed it well, we created value in that, and we were able to make enough to get another. From that hotel in the Pacific Northwest we moved to the Sun Belt, then to the Rust Belt. We’ve gone from market to market, then back to Canada and acquired assets there . . . We wanted to diversify outside of the U.S. so we started our initial foray into Europe in the late ’80s-early ’90s . . . and for us the last area was Asia. We built up teams in all the markets we are in and we did it step by step.”
He also goes on to say this(emphasis mine):
“Generally speaking, our model has been in the developed economies. We haven’t done a lot of new development. Generally we acquire assets below replacement . . . so I think because of the volatility in this business, we’ll see lots of opportunities in our existing markets”
This is terrific! The key point is the acquiring of assets below replacement. That is key to creating value in this business. As I had mentioned earlier in the business economics section, replacement value is a good proxy for the value of a hotel on average. Mangalji waits for the bad times in real estate(like periods of overbuilding or highly leveraged operators forced to sell during economic downturns), and scoops up properties at values less than replacement value.
Westmont had formed an REIT in the past called Innvest REIT, which owned hotels in Canada, and was sold in 2016 for $2.1B. This REIT had assets worth $1.4B of assets on its balance sheet at the time of its sale. After debt, this was more than a 3x return on equity(although Innvest arguably owned some higher quality luxury hotels, so not directly comparable with R&R). I am not saying R&R will achieve such an outcome, but currently investors get to buy shares in R&R at a price which is extremely cheap with respect to its current liquidation value, that we do not have to assume any grandeur exit price for these properties to make a great return.
R&R’s hotel properties
R&R has bought all of its properties from entities controlled by Mangalji, most of which came from 3 acquisitions(in 2017, 2018 and 2019). All of these acquisitions were made by issuing a combination of approximately two-thirds of debt, one-thirds of a new type of limited partnership units called ‘Exchangeable Units’. These exchangeable units can be converted 1:1 to REIT units and have the same economic/voting rights as the REIT units. For our purposes, it is fair to just club these exchangeable units with the REIT units. In all of these acquisitions, these exchangeable units were issued at a price of CAD 0.20 per unit, which was close to the REIT’s book value, even though they were trading on the market at far less than book value(the REIT units currently trade at CAD 0.14 per unit). So far at least, Mangalji seems to have treated minority shareholders fairly in these transactions. So, why did Mangalji sell these properties from entities controlled by him to R&R? I do not have a very good answer to this question.
R&R’s properties are located in small cities like Louisville(KY), Canton(OH) etc, which I believe primarily attract commercial travelers and very little leisure travelers. There is not much scope for demand growth in these towns, in terms of volumes, with population either, more or less remaining constant or growing at modest rates in most of R&R’s hotel locations. Red Roof Inns seem to be located well strategically, on important highways and close to airports. R&R’s hotel properties have been performing very well, with steadily increasing ADRs and maintaining occupancy rates close to 70% in the last 5 years, including an occupancy of 68%, even during the pandemic year of 2020. Extended stay properties were resilient during the pandemic with high occupancy rates coming from traveling nurses, first responders and vacationing families.
Valuation
R&R REIT’s properties are valued on its books at $100M(by adding back building depreciation - look at the sidebar at the end of this section), with net debt of $45M. This implies an equity value of $55M. Even though properties are valued at $100M on its books, the true value of these properties should have increased since 2019(the last set of properties were purchased in 2019). Even assuming that the value of these properties just kept up with inflation from its purchase prices, these properties will be worth $120M(the value at which it is carried on its books is already quite conservative and many of these properties were acquired below appraised value which was also quite conservative). After accounting for net debt of $45M, the equity should be worth $75M and this already seems like a conservative estimate. The REIT’s free cash flow can be approximated to its reported AFFO(Adjusted funds from operations - this adjusts cash flow from operations for maintenance capex) which has been around $6M. The company does not pay any dividends, even though Canadian REITs are mandated to pay out 100% of their earnings as dividends. This is probably because of a tax loophole where the REIT’s assets are situated in the US whereas the REIT is domiciled in Canada.
The market cap of R&R REIT is just $28M currently. The REIT has about 284M units outstanding(includes exchangeable units) which is about 10 US cents per unit or 13.6 Canadian cents per unit. So, the company trades at half of book value and close to one third of current liquidation value calculated conservatively, without assuming any future growth in intrinsic value. The company also trades at a price to free cash flow multiple of 4.6(yield of more than 20%!).
A lot of commercial real estate debt is coming due in 2024 and 2025, with many hotel operators currently depressed as business travel has remained far below 2019 levels. Mangalji may get an opportunity to play offense in such an environment and grow R&R’s real estate value even further! I wish I could find more opportunities like this one!
SIDEBAR: Why should depreciation be added back for valuing real estate? Isn’t depreciation a real cost?
Investopedia’s page on assessing REITs has a simple one liner to explain this:
“For most businesses, depreciation is an acceptable non-cash charge that allocates the cost of an investment made previously. But real estate differs from most fixed-plant or equipment investments because property seldom loses value and often appreciates”
Let me pose this question. If you buy a house on the market, does its value keep decreasing year on year due to accounting depreciation? Practically, we know that a house is most often an appreciating asset. This is generally the case because of a simple supply-demand dynamic. Land supply in an area is limited(earth is finite) whereas the population keeps growing, hence due to increasing demand vs constant supply, prices often appreciate at rates above inflation. This should be applicable for hotel properties as well. Even though not a lot of population growth is expected in the areas where R&R REIT owns properties, it is fair to assume that R&R’s property values stay at least in line with inflation over time, as their hotels’ ADRs(Average Daily Rates) should keep up with inflation.(I do not expect any irrational expansions in hotel supply which could affect hotel values in cities where R&R’s properties are located since demand is more or less stable in these areas)
Pre-mortem
These are some of the ways this investment could go wrong.
Real estate being a business with high leverage(even though R&R has a conservative debt to equity ratio of 1:1), there is always a risk of “relying on strangers” during debt refinancing(All debt is against the properties owned, not at the REIT level). High fixed costs in the business, also add to the risk.
Minority shareholders may be taken advantage of, since insiders own 90% of the business. For example, in future acquisitions, more value may be given to the seller, in terms of R&R shares, than received in terms of the value of the properties, hurting R&R’s minority shareholders. Note that this would not do any harm to Mangalji himself, as any newly created shares go to himself anyways, assuming he is the seller(even though past acquisitions were carried out at
a fair value). Another scenario might be a case where share prices get beaten down, say due to a recession, and Mangalji decides to take the company private by making a tender offer at a price far less than fair value
Concluding Thoughts
The discount to liquidation value and free cash flow is steep and should correct itself over time, even though there is no conceivable imminent catalyst event. If Mangalji creates more value through new acquisitions, growth in free cash flow per share can be a possible catalyst but it is unclear at this point what Managlji intends to do. In 1955, when Benjamin Graham, the father of value investing, testified before Congress, he famously said this about what causes stock prices to move towards intrinsic value over time:
“That is one of the mysteries of our business, and it is a mystery to me as well as to everybody else. We know from experience that eventually the market catches up with value. It realizes it in one way or another.”
Bottom line is, if I am right on this thesis, the market value should move towards intrinsic value over time.
Disclosure: Long RRR.UN