Service Properties Trust: Bonds Yielding 10% With Challenges To Its Dividend

Service Properties Trust (NASDAQ:SVC) is a real estate investment trust (REIT) that specializes in hotel properties and net lease commercial properties. While income investors may be attracted to the company’s 10% dividend yield, Service Properties Trust also has five bond issuances, maturing between 2025 and 2028 who are yielding just under 10% to maturity. With a return 170 basis points higher than peers of its credit rating, I believe Service Properties bonds may be a good alternative to investing for the company’s common stock dividend.

Like all hotels, Service Properties Trust is trying to get back on its feet following the COVID-19 pandemic. In the first nine months of 2022, the company showed a strong recovery, with revenues of $330 million higher than the previous year. Combined with an expense increase of less than $120 million, Service Properties Trust managed to reduce its net loss from $345 million to $100 million year-to-date from 2021 to 2022. When looking at the third quarter alone, the company managed to eke out a net income gain, with hotel revenue accounting for 80% of the business.

Service Properties Trust’s balance sheet shows that 2022 has been a transformative year. The company sold more than $500 million in assets and used those proceeds combined with its nearly $1 billion in cash to pay down %1.5 billion of debt. Shareholder equity declined by $100 million, but the move to pay down reduced the company’s debt-to-equity ratio.

The cash flow statement not only solidifies the company’s ability to support its bondholders but appears to show the company’s ability to fund its dividend. Service Properties Trust generated $147 million in cash flow from operations in the first nine months of 2022 compared to virtually zero in the same period last year. After deducting real estate improvements, the company still had nearly $80 million in free cash flow, easily covering the $5 million dividend obligation to common shareholders.

There is a caveat to the company’s ability to pay a dividend. Service Properties Trust faces more than $2.8 billion in debt maturities between now and the end of 2025. This is nearly half of the company’s interest-bearing liabilities. The company already used cash on hand to pay off its 2022 maturing notes and unfortunately is more than $400 million short to cover the bonds coming due this year.

Fortunately, Service Properties Trust has over $700 million in liquidity available under its recently paid-down revolving credit facility. The facility would be able to absorb this year’s debt maturity, but looking further out is where things get complicated. The revolving credit line has covenants, one of which is the maintaining of at least $125 million in liquidity (later modified to $150 million). Subsequent to the end of the quarter, Service Properties Trust amended its credit agreement to require that it maintain a larger liquidity balance to cover its upcoming maturities, and restrictions on dividends and secured debt issuance were removed, opening the door to cover future refinancing and pay dividends.

Based on the subsequent debt covenant amendments, I believe Service Properties Trust will seek secured debt financing to cover its upcoming maturities. A summary of the company’s debt covenant ratios shows that its secured debt is 40 times lower than what is currently allowed. While the company is close on its total debt-to-adjusted assets ratio, swapping unsecured debt for secured debt should leave that ratio unaffected. There is a chance, however, that a secured debt lender may require dividends to be suspended, which is why I am preferring the fixed income opportunity over the dividend.

I believe Service Properties will continue to show financial improvement over the next twelve months, as the company’s hotel occupancy just hit the same level that the U.S. averaged right before COVID in the third quarter, with robust revenue growth. Additionally, the net lease portfolio is 98% occupied, and only 6.4% of the company’s rent is expiring from the fourth quarter of 2022 to the end of 2025.

While the conditions or covenants of a new lender may cast a cloud over the future of the Service Properties Trust dividend, the underlying cash flow generation combined with the rebound of Service Properties Trust’s hotel assets, stability of the net lease portfolio, and bonds yielding the same levels as the dividend, leads me to take the high-yield bond over the shares.