Morningstar recommends investors reject takeover offer on A-REIT

We recommend rejecting the Charter Hall consortium’s uncompelling takeover offer for no-moat Hotel Property Investments, or HPI, providing this advice is consistent with your individual investing goals. The $3.65 per share all-cash offer price is near the middle of our 3-star band. It represents an insufficient 4% premium to our unchanged $3.50 per share fair value estimate, and a 10% discount to net tangible asset backing.

HPI is in sound financial health, revenue is defensive thanks to long leases and relatively good quality pubs, and rents are expected to grow at 3.7% per year on average in the medium term. Yield at the current price, which is broadly in line with the offer, is a solid 5.3%. We see no compelling reason to sell. HPI directors plan to recommend rejecting the offer when they release a target’s statement, including an independent expert’s report, in due course.

After buying a 15% stake in March, Charter Hall Retail REIT and a fund run by Charter Hall on behalf of industry superfund Hostplus have launched an off-market takeover for HPI. Security holders will be mailed an acceptance form shortly for those wanting to accept the offer. The offer is conditional on the bidders gaining at least 50.1% of HPI, among other things. If the bidders secure more than 90% of HPI securities, which we think is unlikely, they will be entitled to compulsorily acquire the rest at the same price.

HIP business strategy and outlook

A key attraction of Hotel Property Investments is favorable lease terms that provide predictable, growing rental income from long-term leases to Queensland Venue Co. QVC is a joint venture between supermarket giant Coles and private equity-owned Australian Venue Co. AVC manages the day-to-day operations of the hotels, with Coles needing the hotel licences to operate its liquor retailing business under restrictive Queensland laws. There is ongoing uncertainty around Coles' longer-term strategy regarding its liquor business following competitor Woolworths' decision to exit its liquor and hotel businesses.

Close to 90% of Hotel Property's freehold properties are in Queensland, predominantly pubs that are leased to QVC. The joint venture leases generate about 90% of Hotel Property’s rental income. Rental income is highly defensive, underpinned by long leases to a solid tenant. Rents on most properties grow at the lesser of 2 times CPI or 4%. Most properties are on attractive triple-net lease terms where the tenant is responsible for most expenses other than land tax in Queensland, which recently increased. The portfolio currently has a weighted average lease term of about 9 years.

Hotel Property is the ultimate holder of hotel licences on most properties. These licences allow the sale of liquor at up to three detached bottle shops within 10 kilometers of the main premises. Licences revert to Hotel Property at the end of the lease term with respect to most pubs. Where the joint venture owns the licence but opts to terminate the lease, Hotel Property has right of first refusal over the licence at a preset price tied to trading data at that time.

HPI bulls say

• Hotel Property Investments' distribution yield is higher than most Australian REIT peers'.
• Rental income is underpinned by long lease terms and contracted annual rental increases of the lesser of 2 times CPI or 4%.
• Liquor and most gaming licenses are retained by Hotel Property when leases expire. This is a contingent asset that should be a draw card for potential pub tenants in the absence of adverse regulatory changes.

HPI bears say

• Potential changes to Queensland's alcohol regulations could hurt pub profitability and the value of pub real estate.
• Pub profitability hinges largely on gaming, and this could be a target for higher taxes to bolster the income of state governments.
• Hotel Property is susceptible to macroeconomic factors such as higher interest rates and tightening of credit conditions

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Terms used in this article

Star Rating: Our one- to five-star ratings are guideposts to a broad audience and individuals must consider their own specific investment goals, risk tolerance, and several other factors. A five-star rating means our analysts think the current market price likely represents an excessively pessimistic outlook and that beyond fair risk-adjusted returns are likely over a long timeframe. A one-star rating means our analysts think the market is pricing in an excessively optimistic outlook, limiting upside potential and leaving the investor exposed to capital loss.

Fair Value: Morningstar’s Fair Value estimate results from a detailed projection of a company's future cash flows, resulting from our analysts' independent primary research. Price To Fair Value measures the current market price against estimated Fair Value. If a company’s stock trades at $100 and our analysts believe it is worth $200, the price to fair value ratio would be 0.5. A Price to Fair Value over 1 suggests the share is overvalued.

Moat Rating: An economic moat is a structural feature that allows a firm to sustain excess profits over a long period. Companies with a narrow moat are those we believe are more likely than not to sustain excess returns for at least a decade. For wide-moat companies, we have high confidence that excess returns will persist for 10 years and are likely to persist at least 20 years. To learn about finding different sources of moat, read this article by Mark LaMonica.