The Future of Hotel Reits; in Particular, Under Which Set of Conditions It Is Preferable for a Hotel Operating Company to Elect REIT Status
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HOTELS AND REAL ESTATE INVESTMENT TRUSTS: ARE THE CONFLICTS WORTH IT? by R. King Burch B.S. Zoology, University of South Florida, 1970 M.S. Oceanography, University of Miami, 1979 M.B.A., University of Hawaii, 1987 and R. Steven Taylor B.S. Building Construction, Texas A&M University, 1987 M.B.A., Texas A&M University, 1989 SUBMITTED TO THE DEPARTMENT OF URBAN STUDIES AND PLANNING IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT AT THE MASSACHUSETTS INSTITUTE OF TECHNOLOGY SEPTEMBER 1996 © R. King Burch and R. Steven Taylor. All rights reserved. The authors hereby grant to MIT permission to reproduce and to distribute publicly paper and electronic copies of this thesis in whole or in part. Signature of A uthor: ........................ ............................ - ---- --- ------------ Department of Uan Studies and Planning August 13, 1996 Signature of Author:.... .............................. Dept 1 9Planning August 13, 1996 C ertified by :............................................................ ... .. W. Tod McG5 Center for Real Estate Thesis Supervisor A ccepted by:.................................... .................... William C. Wheaton Chairman Interdepartmental Degree Program in Real Estate Development (F ECHNL 4 SEP 1 6 1996 ThAi HOTELS AND REAL ESTATE INVESTMENT TRUSTS: ARE THE CONFLICTS WORTH IT? by R. King Burch and R. Steven Taylor SUBMITTED TO THE DEPARTMENT OF URBAN STUDIES AND PLANNING ON JULY 31, 1996 IN PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT Abstract Since 1993, numerous lodging or hotel-related companies have gone public raising billions of dollars in the public equity markets. Companies going public have used primarily two organizational structures: the taxable C-corporation and the real estate investment trust (REIT). The objectives of this thesis are to: (i) evaluate the structural evolution of hotel real estate investment trusts, (ii) compare the hotel REIT structure to that of a the taxable C-corporation, (iii) compare the investment performance of hotel REITs to that of taxable public hotel corporations, and (iv) to identify those situations in which one organizational structure is preferable to the other. Chapter 1 presents a brief discussion of the history of REITs and the statutory requirements that an entity must satisfy to maintain its preferential tax treatment. Chapter 2 compares hotel REITs to their taxable public counterparts on the basis of five specific investment and operating criteria. Chapter 3 presents examples of the costs to REIT shareholders generated by the complex structures imposed upon hotel REITs, followed by an analysis of evolutionary changes that have occurred to improve them. Finally, chapter 4 presents some considerations relating to the future of hotel REITs; in particular, under which set of conditions it is preferable for a hotel operating company to elect REIT status. Several appendices follow chapter 4. Appendices A and B provide a general overview of the hotel industry and a discussion of hotel investments in public and private markets. Appendices C, D, and E describe REIT qualification requirements; the history and evolution of REITs; and publicly-traded hotel REITs and taxable C-corporations, respectively. Thesis Supervisor: W. Tod McGrath Center for Real Estate Table of Contents ABSTRACT.............................................................................................................................................2 PREFACE ............................................................................................................................................... 4 CHAPTER 1: HISTORY OF HOTEL REAL ESTATE INVESTMENT TRUSTS (REITS).......6 INTRODUCTION......................................................................................................................................6 DEFINITION OF REITs............................................................................................................................8 HOTEL REIT STRUCTURES...................................................................................................................12 CHAPTER 2: A COMPARISON OF ORGANIZATIONAL STRUCTURES OF PUBLIC HOTEL COM PANIES........................................................................................................................................24 CONFLICTS OF INTEREST ...................................................................................................................... 25 FLEXIBILITY AND GROWTH...................................................................................................................29 SHAREHOLDER CONTROL.....................................................................................................................31 TAX STATUS........................................................................................................................................32 REIT VS. TAXABLE HOTEL COMPANY RETURNS....................................................................................42 CHAPTER 3: CURING THE CONFLICTS....................................................................................53 COSTS OF THE CONFLICTS .................................................................................................................... 53 CURING THE CONFLICTS......................................................................................................................60 CHAPTER 4: THE FUTURE OF HOTEL REITS..........................................................................65 TO REIT OR NOT TO REIT? ...... ...... ............................ ..................................................... 66 INVESTOR RETURNS ............................................................................................................................ 69 M ODIFIED HOTEL REIT STRUCTURE.....................................................................................................74 CONCLUSION ..................................................................................................................................... 78 APPENDIX A: OVERVIEW OF THE HOTEL INDUSTRY ............................................................. 80 APPENDIX B: OVERVIEW OF HOTEL INVESTMENT.................................................................94 APPENDIX C: REIT QUALIFICATION REQUIREMENTS..........................................................109 APPENDIX D: THE HISTORY AND EVOLUTION OF REITS.....................................................113 APPENDIX E: HOTEL REITS & TAXABLE HOTEL CORPORATIONS....................................124 W ORK S CITED..................................................................................................................................129 Preface Since 1993, numerous lodging or hotel-related companies have raised billions of dollars in the public equity markets. Companies going public have primarily used two basic organizational structures: taxable C-corporations and real estate investment trusts. The objectives of this thesis are to: (i) evaluate the structural evolution of hotel real estate investment trusts, (ii) compare the hotel REIT structure to that of a the taxable C-corporation, (iii) compare the investment performance of hotel REITs to that of taxable public hotel corporations, and (iv) identify those situations in which one organizational structure is preferable to the other. Chapter 1 presents a brief discussion of the history of REITs and the statutory requirements that an entity must satisfy to maintain the preferential tax treatment afforded them under sections 856 - 860 of the Internal Revenue Code. The unique challenges that hotel companies face in qualifying for REIT status are discussed, followed by an outline of the organizational structures that have evolved to address these challenges and the function of different parties in these structures. The three structures evaluated for hotel REITs are the basic REIT, the UPREIT, and the paired-shares or stapled shares structure. The REIT organizational structures presented in chapter 1 create certain operational challenges not faced by taxable C-corporations. Chapter 2 compares hotel REITs to their taxable public counterparts on the basis of five criteria. The first criterion is the presence and effects of conflicts of interests between management and shareholders. The second is the degree to which the organizational structure restricts or enhances the firm's flexibility to pursue growth opportunities. The third, is the degree to which shareholders can influence the actions of management and thereby, the operations of the company. The fourth, is the income tax consequences of the choice of organizational structure. And the fifth is the financial performance of their common stock. One of the primary criticisms of the public hotel REITs organized in the last three years is the potential created by the REIT structures for the interests of REIT senior management to conflict with those of the REIT shareholders. Chapter 3 presents examples of the costs to REIT shareholders generated by these conflicts. This is followed by an analysis of evolutionary changes that have occurred to mitigate or eliminate the presence of such conflicts. These changes have been concentrated in the areas of eliminating related-party dealings, expanding the lessee market and increasing competition for leases on hotels owned by the REITs, and refining the terms of the agreements