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Pass the bricks - when it's time to make a break in the hotel business.
By Neale Redington and Pete Hackleton
Thursday, 16th March 2006
 
Is it better to separate the business of running the hotels from owning the bricks and mortar, or to keep them together under one enterprise? This is a question that has occupied the hotel industry for decades.

Those in favour of a division have pointed out that real estate investments tie up capital and that the stock market tends to value management companies higher than those involved in real estate. Many believe the property ownership element of an integrated hospitality company can drag down an organisation's overall value. They cite several clear benefits for breaking away.

Breaking away allows hotel operators to improve the return on their assets by partnering with property investors who bring in asset management expertise and capital. They can also secure long-term management or franchise tenure over their portfolio and improve their debt rating. Critically, they can stay focused on the hotel brand.

Real estate owners also prefer dealing with longer-term investors and benefit from better tax planning and longer-term capital appreciation. A property company can drive up the value of the hotels through professional asset management, and expand the business with further acquisitions and developments.

The underlying rationale that the sum of the parts is greater than the whole was illustrated perfectly by Marriott Corporation when it decided to divide up its hotel business in 1992. The split created two separate entities - Host Marriott, which is today the world's largest hotel Real Estate Investment Trust (REIT), and Marriott International, which now mainly manages and franchises hotels on behalf of owners such as Host Marriott.

The split enables each team to focus on its core skills - but although the corporate finance aspects of this initiative were enticing, few operators initially decided to follow suit.

Operators were concerned about the tax implications of selling, relatively low property prices, and the relinquishing of control of their property portfolios. However, over the past decade there has been a sea change of opinion.

Now, no operator can ignore both the opportunity to free up capital to fund further expansion - and market sentiment.

Today, there are several good reasons why hotel properties are now more widely regarded as an asset class. For instance, the strength of the real estate market; the search for a balanced portfolio of investments; growing confidence in the hospitality industry as a source of sustainable income; and, the expansion of tax efficient property acquisition vehicles to enhance returns.

The growth of REITs worldwide - who are willing to pay generously for hotel property and looking for a hotel operator to do business with - is now significant.

Tracking the changes

REITs can be traced right back to the 1880s in the US, but they didn't become popular until the 1960 real estate investment trust tax provision gave them advantageous tax status. Through these trusts, investors could avoid double taxation, as they were not taxed at the corporate level if income was distributed to beneficiaries. This has continued to be the main pull ever since.

As tax is usually paid at both the vehicle and investor level, and generally eats up around a third of total profits, there is still a big incentive to qualify for REIT status.

Initially, trusts were extremely limited, but the Tax Reform Act of 1986, which enabled them to broaden their activities, combined with the subsequent US real estate recession, provided the catalyst for growth.

The first signs came in 1993 when a small public offering by RFS Hotels used a lease arrangement to sidestep regulations that restricted REITs from generating revenue from operating properties. New structures rapidly followed, including the 'paired share' set up that enabled Starwood to outbid other contenders in the race for ITT Sheraton.

The beneficial 'paired share' status enjoyed by the biggest hotel REITs - Starwood, Patriot American Hospitality and Meditrust - was then severely restricted by Congress in 1998. Meristar Hospitality started a new trend with the 'paper-clipped' structure, where the operating company and REIT are independent but closely aligned, and there are now 19 similar lodging/resort REITs in the NAREIT listing.

Investment in REITs has rocketed, despite the property boom in the late 1990s. In 2004, more than $300bn was listed in REITs by market capitalisation - around 5% of that in lodging/resorts. Recent data shows $17.1bn by market capitalisation invested in the sector - up from $15.6bn at December 2004.

The bigger picture

Important though it is, the US story is only part of the global picture. More and more countries are updating the rules to enable similar investment trusts to enjoy the same benefits.

Although each country has developed its own version, many have followed the successful US example and have maintained broadly the same structure. For instance:

• Provided certain conditions are met, property trusts are generally exempt from taxation; subject to a 0% tax rate; or can deduct dividends paid from taxable profits. Investors are taxed at the marginal rate on dividend income and unit appreciation.

• Most countries require that all or most of the trust's earnings must be distributed to investors within a certain period after the end of the financial year during which earnings are generated.

• All have investment and income restrictions covering qualifying investments and activities, what percentage of the total pool can be invested in a single property, and income streams.

Many countries have limitations on gearing and have other restrictions that can cover listing requirements, internal/external management and the need for regular property valuations. Despite this, trusts have flourished - particularly while global capital markets remain volatile and investors search for more balanced portfolios containing larger slices of property.

In Canada, REITs have been part of the investment landscape for 11 years, and - with the Mexican government making legislative changes - Latin America is also warming to them.

Within Europe, the Netherlands introduced its equivalent in 1969 and may soon update its position. Other countries - such as Belgium and Italy - followed in the mid¬1990s, with Italy bringing in more advantageous changes in 2003. France followed suit quite recently, and Germany is expected to introduce its own REIT structure in 2006.

The Asia Pacific REIT market was capitalised at over $87bn in June 2005, with the Australian Listed Property Trust (LPT) dominating, followed by the Japanese J-REIT, whose first hotel REIT came to market in 2005. Similar structures are now well established in Singapore, Hong Kong, Korea, and Thailand, with new rules recently introduced in Taiwan and Malaysia.

Important questions for the UK

The UK government, keen to encourage more efficiency in the property investment market, used the 2004 budget to launch a consultation document that considered the introduction of REITs.

Initially, it looked as though hotels would not be an allowable asset class, which would have been a disaster for the tourism and hospitality industry, but common sense appears to have prevailed and hotels were included in a further discussion paper issued in 2005.

The pre-Budget report of 5 December 2005 confirmed that the legislation to introduce a UK REIT will be issued in the near future with proposed introduction in 2006. The new vehicle will be in the form of a UK resident company listed on a recognised stock exchange, and will be based on the exempt company model, with exemption from tax on qualifying rental income and gains providing eligibility criteria and the requirement to distribute 95% of net taxable profits on rental income are met.

There are still a number of key questions remaining, however. Particularly as regards, the conversion cost; as the UK government, like other countries, does not want to give up the tax on capital gains accrued to date - or its transfer taxes.

Cross-border complexity

Although REITs have generally been a success story, they can be too complex for cross-border investments and accordingly other options must be considered.

While the tax-favoured structures do generally trade much closer to net asset value than other property vehicles, trans¬national issues such as withholding taxes on distributions and capital gains for non¬residents have limited their suitability.

Globally, private equity players and other types of public real estate companies have become increasingly prominent in the commercial property business, especially to meet the call for a balanced portfolio that spreads the risk and enhances returns. The private equity investor has become a significant source of capital for hotel transactions and private funding has competed fiercely in the property ring during recent months.

Interest in the sector was also heightened by anticipation from late 2001 until early 2003 among the so-called 'vulture funds', when hotel operators were rumoured to have cash flow difficulties. Consequently, there was an expectation that well-located quality properties would come onto the market at significantly discounted prices. Although the distressed selling situation largely failed to materialise, it may have ignited interest in hotels generally.

The aggressive investment in the hotel sector by Blackstone is an example of the increased interest. In 2005, it acquired Wyndham International for $1.44bn - and subsequently disposed of the brand and franchise system to Cendant - after earlier acquisitions of Extended Stay America and Boca Resorts.

Typically, private equity takes the form of a limited partnership or limited liability company, both of which are regarded as 'pass through' entities for tax purposes. This means that the entity itself does not pay income taxes, and that the owners of the entities include their share of capital gains and income on their own tax returns. The tax disadvantages of companies are avoided and regulatory restrictions associated with REITs do not apply.

However, the liquidity, transparency, and scrutiny of some private equity entities may not be as robust as those who report publicly.

It is important not to ignore the continuing trend of sale and leaseback - particularly in Europe. Good examples are the Royal Bank of Scotland's sale and leaseback with Hilton International and Norwich Union's sale and leaseback of Jarvis Hotels in the UK. Accor's continued sale and leaseback programme to a variety of institutional investors demonstrates the effectiveness of this policy on a regional basis.

More to come

Making the split between operators and property owners continues to be a logical and cost-effective decision - enabling both groups to focus on what they do best. The lodging industry, once considered less attractive than other types of commercial property, has seen record levels of activity from investors looking to buy hotel properties. The combination of a favourable real estate market, more customers with more leisure time, plus the resilience of the travel market to the many disasters over the past couple of years, has added to the allure of hotel assets. InterContinental Hotels Group, for instance, coming to the end of a $3.5bn asset disposal deal recently announced a further programme of $1bn of potential disposals. In the same month, Starwood Hotels & Resorts Worldwide announced a $4.1bn disposal of assets to Host, while the Hilton Group decided to dispose of a further $700m of assets.

Clearly, there are many more deals to be done and the trend will continue for some time.

www.hotelbenchmark.com


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