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Hotel Property Investments is a AU$501m small-cap, real estate investment trust (REIT) based in Melbourne, Australia. REITs own and operate income-generating property and adhere to a different set of regulations. This impacts how HPI’s business operates and also how we should analyse its stock. In this commentary, I'll take you through some of the things I look at when assessing HPI.
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REIT investors should be familiar with the term Fund from Operations (FFO) – a REIT’s main source of cash flow from its day-to-day business activities. FFO is a higher quality measure of earnings because it takes out the impact of non-recurring sales and non-cash items such as depreciation. These items can distort the bottom line and not necessarily reflective of HPI’s daily operations. For HPI, its FFO of AU$42m makes up 97% of its gross profit, which means the majority of its earnings are high-quality and recurring.
Robust financial health can be measured using a common metric in the REIT investing world, FFO-to-debt. The calculation roughly estimates how long it will take for HPI to repay debt on its balance sheet, which gives us insight into how much risk is associated with having that level of debt on its books. With a ratio of 15%, the credit rating agency Standard & Poor would consider this as significantly high risk. This would take HPI 6.55 years to pay off using operating income alone. Given that long-term debt is a multi-year commitment this is not unusual, however, the longer it takes for a company to pay back debt, the higher the risk associated with that company.
I also look at HPI's interest coverage ratio, which demonstrates how many times its earnings can cover its yearly interest expense. This is similar to the concept above, but looks at the upcoming obligations. The ratio is typically calculated using EBIT, but for a REIT stock, it's better to use FFO divided by net interest. With an interest coverage ratio of 3.21x, it’s safe to say HPI is generating an appropriate amount of cash from its borrowings.
In terms of valuing HPI, FFO can also be used as a form of relative valuation. Instead of the P/E ratio, P/FFO is used instead, which is very common for REIT stocks. HPI's price-to-FFO is 11.93x, compared to the long-term industry average of 16.5x, meaning that it is undervalued.
Next Steps:
Hotel Property Investments can bring diversification into your portfolio due to its unique REIT characteristics. Before you make a decision on the stock today, keep in mind I've only covered one metric in this article, the FFO, which is by no means comprehensive. I'd strongly recommend continuing your research on the following areas I believe are key fundamentals for HPI: