Hotel REIT comes with reservations

BOSTON (MarketWatch) � Pete is a retiree in Plainfield, N.J. who is looking for yield. So he decided to add a real estate investment trust to his portfolio.

�I didn�t just say �Let�s pick the one with the highest yield,�� he explained, �because I know those things paying more than 10% are heading for trouble. And I didn�t want anything where they are really in the mortgage business, because that kind of scares me.

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�So,� Pete told me, �I found a REIT that specializes in hotel properties, where I thought business would stand up okay, and the yield is about 8%. It�s Hospitality Properties Trust. What do you think?�

Sorry, Pete, but that�s a bad way to pick a stock, and Hospitality Properties Trust HPT �is the Stupid Investment of the Week.

Stupid Investment of the Week highlights concerns and conditions that make a security less than ideal for the average investor, and is written in the hope that spotlighting how investors could be headed for trouble in one case will make it easier to sidestep danger elsewhere. While obviously not a purchase recommendation, the column is not intended as an automatic sell signal.

Early checkout

In addition to lodging across the U.S. and Canada, Hospitality Properties has substantial interests in roadside truck stops, known as �travel centers.� Shareholders have pocketed a lot of benefits, such as that fat dividend and a 20% annualized return over the last three years. The stock is up 2.5% so far this year, when the average hotel/motel REIT has lost almost as much. Read more: How to buy REITs in a crowded market.

The problem is that in blindly chasing yield � picking a stock because of its high payout � you may overlook or discount a company�s weaknesses.

Pete�s logic wasn�t entirely flawed. The reason he avoided the REITs with double-digit yields is that those numbers are something of a mirage. As Mag Black-Scott of Beverly Hills Wealth Management said on my radio show MoneyLife this week, if those 10%-plus yields were actually worth taking, �smart money would really be in there and they�d be pushing that yield down� as the stock price climbed.

/quotes/zigman/155578/quotes/nls/hpt HPT 24.84, -0.15, -0.60% /quotes/zigman/3870025 SPX 1,362.66, -13.85, -1.01%

Even a high single-digit yield may not be any more real or stable. It�s still an oversized payout that Wall Street would bid up � thus shrinking the yield � if it felt it was truly sustainable.

And that is the concern about Hospitality Properties.

Buying the stock based mostly on its yield means overlooking the financial figures behind the payout. Look at the company�s cash-flow and earnings and it�s not too difficult to predict a dividend cut in the future.

Last year, Hospitality Properties paid out $250 million in dividends but only made $190 million after tax.

A company can�t operate that way indefinitely; if a business doesn�t earn enough to cover its dividend, eventually the cash it�s been using to keep payouts high will dry up, and the distributions must be cut. Hospitality Properties does have a nice cash cushion, but it won�t for long if this trend continues.

The stock�s earnings per share were up massively year-over-year, but that was due to exceptional items that brought down the earlier numbers, making the latest gains look bigger than they really are. The debt-to-equity numbers look better than the industry average, but they would resemble the rest of the business if you included a big slug of off-balance sheet debt that can be found digging through the company�s footnotes.

While a case can be made that the stock could have a fair value of $33 per share if it traded at 10 times forward earnings, there�s still a lot of uncertainty for shareholders to shoulder. New Constructs, a Nashville-based investment research firm, gives Hospitality Properties a �dangerous� rating.

�The company�s earnings quality is mediocre,� said David Trainer, president of New Constructs. �The valuation is expensive: to justify the current stock price, the company has to grow [after-tax cash flow] at 10% compounded annually for 10 years. That is a very high growth rate for a company that has rarely achieved that level of growth on the top line.�

Heartbreak hotel

The problem for an investor like Pete is that by chasing yield in what he assumes will be a steady industry, he ignores what could happen next. If Hospitality Properties cuts its dividend, the stock will get hammered; the yield might remain in impressive territory � considering that the industry average yield is 2.6% � but the investors who went into the REIT seeking the big payout will flee.

If Pete follows, he will book a loss. Ironically, he might also have a stock worth buying and holding.

�If they reduce the dividend enough, it could be a good time to buy,� said Brent Wilsey of Wilsey Asset Management in San Diego. �But it�s definitely not something you want to have now � not unless the only thing you care about is the yield payout.�

Investors who chase yield without regard to the underlying financials are setting a trap for themselves. Pete may have thought he was smart to avoid the double-digit yielders, but there�s just as much potential for trouble in a security yielding three times the industry average as those paying five times the norm.

�At least with the double-digit payers, most people would know they were wading into dangerous waters,� Wilsey said. �Saying, �The yield is 8%, so that must mean it is safe� is arbitrary and dumb � Investors should remember that you can hide a lot of bad stuff with a high yield.�