HPI’s happy hour

The price of this pub owner has soared in recent weeks, is it time to call last drinks?

We’ve always maintained that it’s a lower quality company than its peer ALE Property Group, but that hasn’t held back the performance of Hotel Property Investments (HPI). Members who followed our recommendation to buy back in March 2014 have enjoyed a return of almost 70% including dividends.

The last few months have been particularly good for HPI shareholders. The share price has surged since March, eventually hitting an all-time high of $3.27 in early June – before settling back around our $3 sell price. So is it time to bag the profit and move along?

Key Points

  • HPI is up almost 70% since we recommended buy

  • Recently breached our sell price

  • Continue to recommend HOLD

Thirsty for yield

The main driver of the recent performance is the fall in interest rate expectations. In May, the RBA cut the cash rate to a historical low of 1.75%. The bond market sees little room for improvement, with the 10-year government bond yield also around record lows of 2%.

In the first instance, the lower yields available elsewhere makes relatively high yielding equities look attractive. For most companies, though, this has to be offset against the prospect of lower growth. That’s less the case for HPI, because its growth is already restricted by leases that typically stipulate rental increases of the lower of two times inflation rate or 4%. Investors have therefore been fully focused on HPI’s yield and they clearly like what they see.

Under-leasing?

In a March presentation to retail brokers, though, HPI was keen to stress that the underlying earnings of its pub operations have been growing faster than rent — particularly gaming income, which has grown by over 10% in the past year.

This isn’t money that flows directly to HPI, but it might – management inferred – flow into the value of its properties. It would mean that, like ALE Property, its properties are rented below market levels. The trouble for this line of argument, though, is that HPI has no market rent reviews structured into its leases, so there is no way for this gap to be closed while its tenant (Coles for all but one of its pubs) remains.

HPI can get this money back when the leases expire — at which point HPI will become the owner of all liquor and gaming licences along with any improvements to the properties funded by Coles. However, this looks like being a long way off.

Queensland liquor laws require a commercial hotel licence in order to sell alcohol through a retail channel. Therefore, unless this law changes, Coles wouldn’t be able to sell alcohol at these locations without HPI’s pub licence. It would also forfeit any benefit from the capital invested to improve the property.

On that basis, Coles seems likely to exercise all the available extensions on the leases, meaning that they won’t revert to HPI for another 25 to 30 years or so. We’re long-term investors, but the longer it is before the uplift to full market rents, the less that uplift is worth.

No need to sell

ALE Property remains our preferred stock in this sector, largely because its market rent reviews take place in two and 12 years’ time – although the market seems to have largely cottoned onto this fact. There may come a time when we take a much different view of the value of HPI’s rental uplift than the market, but at the moment the value is so small that it doesn’t make much difference. 

ALE’s portfolio of mainly metropolitan properties is also better located and more geographically diverse. ALE also has lower costs as, unlike HPI, it doesn’t need to fund structural repairs to the properties meaning more money is available to be paid out as distributions.

For all that, though, HPI’s distribution yield of 6% is still 1.5% higher than ALE’s, and we agree with the market that it looks more attractive with the bond yield lower. Lower interest rates will also reduce HPI’s interest costs.

On that basis, we’re raising the Sell price to $3.50, which would represent a yield of just over 5%. Our Buy price also rises, to $2.50, although that’s somewhat academic at the moment. HOLD.

Note: The Intelligent Investor Equity Income Portfolio owns securities in ALE Property and HPI. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.