DiamondRock: An 8.8% Yield To Call With The Preferred Shares (NYSE:DRH)

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Less than three months ago I thought DiamondRock Hospitality preferred stock (NYSE:DRH) were a good bet. Despite trading at a premium to par, the call yield was still a very respectable 7.3% Given the company’s robust balance sheet and significant amount of common stock, which ranks second to preferred stock, I felt the offer was a good risk/reward tradeoff.

As interest rates continued to rise throughout the summer, preferred stock, known as (NYSE:DRH.PA) are now trading below par, making them even more attractive from an earnings perspective.

Data from YCharts

The second quarter was strong and the money is now flowing

While the FFO and AFFO calculation for a REIT is obviously more important than net income, I always like to look at the income statement anyway because it provides useful information. It also helps to understand how FFO is composed since net income is usually the starting point for FFO calculation.

income statement

DiamondRock Hospitality Investor Relations

The income statement clearly shows that DiamondRock is profitable, and that’s a good starting point to expect FFO to be even higher, considering that net income isn’t impacted by one-off items like profit from the sale of assets was increased.

The following FFO and AFFO calculation shows a very strong result indeed. FFO before payment of the preferred dividend was $80.1 million and after covering the quarterly preferred dividend, FFO attributable to DiamondRock shareholders was $77.6 million. That means the REIT only needed about 3% of its FFO to cover preferred dividends.

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FFO and AFFO calculation

DiamondRock Hospitality Investor Relations

Adjusted FFO was a little lower at $76.5 million, but it’s still pretty high, so it covers the preferred dividends very well. Of course, we can’t just “annualize” the Q2 results as the hotel business is quite seasonal (with Q2 and Q3 typically being DiamondRock’s best quarters), but even if you look at the H1 2022 FFO and AFFO (the traditionally “weak Q1) FFO and AFFO before preferred dividend payments were nearly $120 million and over $112 million, respectively.

The press release announcing the quarterly results also contains a very interesting table that clearly shows that the Q2 results in 2022 were actually better than in the pre-COVID year 2019. While the REIT was $65.1 million in the second quarter of 2019 to AFFO, year-to-date earnings are much better at $76.5 million and AFFO per share is up about 10%.

Comparable to 2019

DiamondRock Hospitality Investor Relations

Preferred stock is more attractive now than it was a few months ago

As explained in my previous article, the Series A Preferred Stock is cumulative and offers an annual preferred dividend of $2.0625 per preferred share, paid in four quarterly instalments. The securities can be terminated from August 31, 2025.

As I explained earlier in this article, the preferred dividend coverage ratio is excellent as DiamondRock only has to use a fraction of its FFO and AFFO to cover the preferred dividends.

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And since DiamondRock only recently started paying dividends on its common stock, most of the cash flow generated in the first half has been added to the balance sheet. As you can see below, DiamondRock’s total equity increased from less than $1.52 billion to almost $1.58 billion, an increase of almost exactly $60 million, while the number of shares remained flat. The increased equity on the balance sheet helped DiamondRock complete an acquisition in April.

balance sheet

DiamondRock Hospitality Investor Relations

On April 1stStthe company acquired the Kimpton Fort Lauderdale Beach for a little over $35 million, while it also plans to spend about $100 million this year on capital improvements to existing assets.

This means that the equity value based on the book value of the assets consists of approximately $1.56 billion in common stock and $119 million in preferred stock. I like the preferred-to-common ratio, as it’s clear that there’s a fairly large cushion to protect preferred stockholders in tough times.

In addition, the equity value is based on the book value of the assets of $2.7 billion. That already includes over $1.1 billion in accumulated depreciation expense. The acquisition value of the land and buildings was approximately US$3.3 billion. Even if the equipment and furniture have no value, it’s hard to imagine that the land and buildings have gone down in value since their respective acquisitions.

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book value of the assets

DiamondRock Hospitality Investor Relations

However, there is a caveat, a point that is definitely more relevant to common shareholders than to preferred shareholders. About half of the debt consists of mortgages on certain properties. Most of these mortgages have a fixed rate, but as you can see below, four of these mortgages are up for renewal within the next seven months. While I don’t expect any problems refinancing the mortgages, we should expect higher debt costs. This will result in higher interest expense and lower FFO and AFFO unless DiamondRock is able to grow its revenue and margins elsewhere.

Existing Mortgage Debt

DiamondRock Hospitality Investor Relations

investment work

I am very interested in the DiamondRock Hospitality preferred stock as I believe the risk/reward ratio is excellent. While I understand that I forgo potential capital gains, I’m more than happy to consider these 8.4% yielding stocks for my income portfolio. The current yield is about 8.4%, but the call yield is about 8.87%, as the preferred shares are trading about 1.5% below par and can be called in just over 35 months.

I currently have no position in DiamondRock common stock or preferred stock, but I could pull the trigger sooner rather than later. I understand that additional rate hikes by the Federal Reserve will continue to put pressure on fixed income prices, but I always make sure I have cash on hand to add to my positions.

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