DiamondRock: 8.8% yield to redeem with preferred shares (NYSE: HRD)
Less than three months ago, I thought DiamondRock Hospitality Preferred Stock (NYSE: HRD) were a good bet. Even though they were trading at a premium to face value, the yield to be paid was still a very respectable 7.3%, which I thought it offered good risk/reward given the strong balance sheet and substantial amount of common stock, which ranks after preferred stock.
As interest rates continued to rise throughout the summer, preferred stocks, trading as (NYSE: DRH.PA) are now trading below par, making them even more attractive from an earnings perspective.
Q2 was strong and cash is flowing in now
Although the calculation of FFO and AFFO is obviously more important than net income for a REIT, I always like to take a look at the income statement because it provides useful information. It also helps in understanding how FFO is made up, as net income is usually the starting point for calculating FFO.
The income statement clearly shows that DiamondRock is profitable and it is a good starting point to assume that the FFO will be even higher given that the bottom line has not been boosted by one-time items such as the gain on the sale of assets.
The FFO and AFFO calculation below indeed shows a very strong result. FFO was $80.1 million before paying preferred dividends and after covering the quarterly preferred dividend, FFO attributable to DiamondRock shareholders was $77.6 million. This means that the REIT only needed about 3% of its FFO to cover preferred dividends.
Adjusted FFO was slightly lower but still quite high at $76.5 million, so preferred dividends are very well covered. Of course, we can’t just “annualize” Q2 results as the hotel business is quite seasonal (Q2 and Q3 are generally the best quarters for DiamondRock), but even if you look at H1 2022 FFO and AFFO ( which traditionally include ‘low in the first quarter), FFO and AFFO before making the preferred dividend payments were nearly $120M and over $112M, respectively.
The press release announcing the quarterly results also contains a very interesting chart which clearly shows that Q2 results in 2022 were actually better than in 2019, the pre-COVID year. While the REIT generated $65.1M in AFFO in Q2 2019, the current year result of $76.5M is significantly better and AFFO per share increased by around 10%.
Preferred shares are now more attractive than a few months ago
As explained in my previous article: Series A Preferred Shares are cumulative, offering an annual preferred dividend of $2.0625 per preferred share paid in four quarterly installments. The titles can be called from August 31, 2025.
As I already explained earlier in this article, the preferred dividend coverage ratio is excellent because DiamondRock only needs to use a fraction of its FFO and AFFO to cover preferred dividends.
And because DiamondRock only recently started paying dividends on common stock again, the vast majority of the cash flow generated in the first half of the year was added to the balance sheet. As you can see below, DiamondRock saw total equity grow from less than $1.52 billion to almost $1.58 billion, an increase of almost exactly $60 million as the number of shares remained unchanged. The increased share of equity on the balance sheet helped DiamondRock complete an acquisition in April.
The 1st of Aprilstit acquired the Kimpton Fort Lauderdale Beach for just over $35 million while it also plans to spend about $100 million on capital improvements on existing assets this year.
This means that based on the book value of assets, the equity value consists of approximately $1.56 billion in common stock and $119 million in preferred stock. I like the ratio of preferred stock to common stock, because it’s clear that there’s quite a significant cushion to protect preferred stockholders during tough times.
Additionally, the equity value is based on the $2.7 billion book value of the assets. This already includes over $1.1 billion in accumulated depreciation expense. The acquisition value of the land and buildings was approximately $3.3 billion. Even if the equipment and furniture have no value, it is difficult to imagine that the value of the land and the buildings has gone down since their respective acquisitions.
There is a caveat, however, one that is certainly more relevant to common stockholders than to preferred stockholders. About half of the debt consists of mortgages on specific properties. Most of these mortgages have a fixed interest rate, but as you can see below, four of these mortgages are up for renewal within the next seven months. While I don’t foresee any issues refinancing mortgages, we should expect a higher cost of debt. This will result in higher interest charges and lower FFO and AFFO unless DiamondRock is able to grow revenue and margins elsewhere.
I am very interested in DiamondRock Hospitality Preferred Shares as I believe the risk/reward ratio is excellent. While I understand I’m forgoing potential capital gains, I’m more than happy to consider these 8.4% yielding securities for my income portfolio. The current yield is around 8.4%, but the yield to redeem is around 8.87% because the preferred shares are trading around 1.5% below par and can be redeemed in just over 35 months.
I currently have no position in DiamondRock common stock or preferred stock, but I might pull the trigger sooner rather than later. I understand that further rate hikes by the Federal Reserve will continue to add pressure to fixed income prices, but I always make sure I have cash to add to my positions.