Investors in Sunstone Hotels: Earn 6.8% Return with Safe Preferred Shares (NYSE:SHO)

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Introduction

Sunstone Hotel Investors (NYSE: SHO) is yet to report Q2 earnings, but wanted to take a quick peek under the hood before Q2 results are released as the REIT’s favorite Stocks have done very well as they are up about 15% from their low a short time ago. I liked Sunstone and its preferred stock because SHO has one of the strongest balance sheets in the hospitality industry So I thought preferred stocks offered a better risk/reward ratio than other preferred stocks.

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Preferred shares are recovering well, but how high are the coverage ratios?

I currently own Sunstone Preferred Share Series I, which trades at (NYSE:SHO.PI). These preferred shares have a preferred dividend of 5.70%, which equals $1.425 per year based on the principal value of $25 per preferred share. This means that the yield based on the current stock price of just under $22 is around 6.48%.

I will be looking at Sunstone from my perspective as a Series I owner but maybe I should consider changing my exposure to H shares which trade at $22.58 but have a much higher preferred dividend of 1 $.53125/share, meaning the current yield is just under 6.8%. H shares can be called from May 2026, I shares can be called from July 2026, so there is hardly any difference.

As expected, business has really picked up for Sunstone, with demand for hotels picking up again. The REIT’s revenues more than tripled from the first quarter of last year, as did operating expenses.

income statement

Sunstone Investor Relations

The income statement shows net income of $15.1M thanks to the gain of nearly $23M on the sale of an asset, and after deducting payments to non-controlling interests and preferred dividend payments , reported net income attributable to common shareholders was $10.2 million or $0.05/share.

It goes without saying that net income is never (really, never) a good indicator for deciding whether a REIT is a worthwhile investment or not. FFO is a much better measure because it excludes capital gains realized on the sale of assets, but it also excludes non-cash depreciation expense.

As you can see below, in Sunstone’s case, the FFO was $17.5 million while the AFFO was $16.4 million. This already includes the $3.8 million in preferred dividend payments. Which means that the preferred dividends cost the REIT less than 20% of its AFFO.

FFO and AFFO calculation

Sunstone Investor Relations

Keep in mind that we cannot simply extrapolate Q1 results to determine the preferred dividend coverage ratio. After all, the hospitality industry is a very seasonal business and the combination of seasonality and fewer COVID restrictions should result in much higher FFO and AFFO per share in the coming quarters. So once we’re able to look back on the full year, I think the preferred dividend coverage ratio will be well above the 500% based on the AFFO result for the full year.

Sunstone is a buyer in the current market

One of the main reasons I liked Sunstone preferred stock was the very strong balance sheet. At the end of March, Sunstone’s balance sheet contained $255m in cash and restricted cash and just over $560m in debt (excluding leases) for net debt of just over $300m. Based on $3 billion in total assets (including $1.07 billion in accumulated amortization), debt was negligible, which meant that the $215 million in preferred stock ranked above the $1.95 billion remaining in Sunstone equity. A very good position to be in, and that’s why I kept adding favorite Sunstone stocks as the stock price fell.

Balance sheet

Sunstone Investor Relations

Having an exceptionally strong balance sheet also means Sunstone has had the ability to act quickly on M&A opportunities while some of its competitors are still nursing their wounds.

Comparison with peers

Sunstone Investor Relations

And Sunstone jumped in with both feet. In June, it completed the acquisition of the Confidante Miami Beach hotel for $232 million. SHO will invest $60 million to reposition the hotel under a new brand, which should result in an operational return of 8-9% on the total investment.

In addition, the REIT also acquired 25% of the Hilton San Diego Bayfront Hotel from Park Hotels & Resorts for $102 million in cash and by assuming a $55 million mortgage. This implies a cap rate of 6.6% based on expectations for 2022.

Confident Miami

Sunstone Investor Relations

The acquisition of Confidante will be reflected in the second quarter balance sheet. And even if the acquisition of the San Diego Bayfront was to close by the end of the second quarter, I don’t think that has happened yet, so the impact will only be visible in the third quarter financials.

Investment thesis

Sunstone Hotel Investors spent quite a bit of money repurchasing shares in the early months of the second quarter as the REIT repurchased 1.9 million shares at $11.01/share, bringing the total amount spent on share buybacks at $64.6 million since the start of the program. This means that Sunstone has just over $435 million under the existing authorization. I’m a little surprised the company isn’t redeeming its preferred stock at less than par, but I guess having to pay only 5.7-6.125% for what is essentially a perpetual security isn’t bad. And maybe there is a rule preventing SHO from redeeming preferred stock before it can be called.

Either way, I remain very confident in the risk/return profile of Sunstone’s two preferred share issues. I’m currently “stuck” with the low yielding Series I, but I think it makes sense to start buying the Series H as the yield is 30bps higher. Unfortunately I hold my Series I with a full service broker so from a transaction fee perspective it doesn’t make much sense to sell the I shares and buy the H shares as it would take me about 7 -8 years to offset transaction fees.

Both preferred stock issues are attractive, and at this point I would rather buy Series H than Series I for a higher yield.

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