Hotel Property Investments: Calling last drinks

Pub owner Hotel Property Investments (HPI) first joined our buy list early in 2014. We noted that in terms of quality, ALE Property Group - another pub trust - was superior on almost every measure. But HPI proved more attractive on the measure that matters most: price.

HPI offered an 8% unfranked yield. Better yet, rental growth was written into leases to primary tenant Coles - with an average lease expiry of nine years. It seemed like a good bet the yield would rise and returns would be acceptable.

So far, that's been borne out by the results: members who bought on our initial recommendation have earned an annual return of around 23 percent. Much of that has come from a rising share price - only 10% from distributions - as yield-hungry investors have progressively bid up the price.

While it's always hard to leave the party when the music's still playing, if you step outside to see the cyclists about, it's probably time to limp on home. In HPI's case, we can hear the bells ringing in the distance, so we're calling last drinks.

Calling last drinks

The trust has benefited from leases mandating annual increases of two times inflation, capped at 4%. Due to subdued inflation, declining pokies revenue and less alcohol consumption, rents have probably risen faster than is justified - especially since there's been a relative lack of investment in the properties over the years.

We think it's likely that several of HPI's pubs are over-earning, and a day of reckoning is close. In 2021/22, two-thirds of the portfolio comes up for renewal. At this stage, KKR - which has taken control of the pubs from Coles - will have the option, but not the obligation, to extend the leases on the same terms.

If the pubs are over-rented, it's unlikely those options will be exercised at the current level of rent. What's particularly worrying is a 'first and last right' provision in the leases. If KKR rejects an extension, and HPI tries to re-tenant the property, then any terms offered to a new tenant would first have to be offered to KKR. KKR has little to lose by trying to negotiate lower rents.

If this were prime metropolitan real estate, we wouldn't be worried - HPI could simply redevelop the properties into apartments. But the regional nature of HPI's portfolio means this repurposing is not going to be easy.

Trump card

HPI does have a trump card, though. In Queensland - the home of most of HPI's pubs - a wacky law requires an operator of a bottle shop to hold a pub licence. Coles' liquor operations in the state, therefore, are reliant on HPI's pubs.

Coles recently handed over control of the pubs business to KKR, while retaining the rights to the pub licence for its retail liquor outlets. And we'd speculate that any deal struck would have been conditional on KKR maintaining those licences for Coles' use, although we can't know for sure. While this is likely to remain the case, there's a limit to how much this requirement can be exploited. Some liquor stores may not be profitable enough to support the case for continuing to rent an underperforming pub.

A forward distribution yield of around 5.8% with contracted rental growth sounds pretty good but, given our concerns around the likely outcome of several rent reviews, it's probably not as good as it sounds. HPI has done a good job of squeezing every bit of juice out of this lemon, but relying solely on regulatory requirements to justify the investment case requires too much faith. With lease reviews looming, it's time to take profits. SELL.