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Evolving Structures In U.S. Hotel Ownership
Jones Lang LaSalle Hotels recently published Hotel Topics – Changing Ownership Structures.
The report compares and contrasts hotel ownership structures in the
world’s primary regions – The Americas, Europe and Asia Pacific
– and explores future structures that will likely be implemented given
the requirements of investors.
“Hotel owners come in all shapes and sizes. More recently,
however, in the United States we have seen the development of mega-players
that have influenced the dynamics of hotel acquisitions and development,”
said Melinda McKay, Senior Vice President of Jones Lang LaSalle Hotels, who authored the Americas portion of the report. “The size, type and even
identity of top owners today looks very different from five years ago.”
The report explores the benchmarks in U.S. hotel
investment structures, as illustrated in the table below:
Top
Advantages of REITs
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Top Disadvantages REITs
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* Favorable tax treatment – conduit tax
treatment meaning income is not double-taxed i.e. distribution to shareholders without incurring corporate tax.
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O Restriction of retained earnings –
distribution of 95% of taxable income to retain preferential tax treatment.
Plus, REITs are unable to deduct losses in excess of the amount of investor
capital at risk
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* Liquidity and diversification – the
tradability of shares enables the REIT to tap a tremendously wide investment
pool. Plus, REITs offer a considerably more diversified portfolio than the
average investor/owner could obtain individually.
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O Forced growth – compelled so as to retain
share price power. But high leverage in most hotel REITs means that capital raising
is the only viable avenue, extremely difficult in this environment. In turn,
this inertia constantly places further pressure on share prices.
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* Access to capital – allows owners to tap into the wider capital markets to finance acquisitions and developments. The real
estate REIT market alone has a market capitalization of $163 billion.
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O Vulnerability to sentiment – the volatility
in share prices over the last 15 months is a clear demonstration. In
particular, this volatility limits the ability to pursue capital expansion
plans.
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Top Advantages of C-Corps
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Top Disadvantages of C-Corps
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* Limited liability - members only have exposure for
the assets they invest in the company, and are protected against personal
liability.
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O Unfavorable tax treatment – double taxation,
plus recognized as independent entity therefore losses retained at the
corporate level (which might not be valuable if the C-Corp does not have any
other income to offset the loss).
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* Multiple levels of ownership – greater
autonomy in structuring shareholder return by using common and preferred
stock with different rights, terms and conditions.
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O Administrative costs – formal requirements,
such as annual reports, accounting standards and directors’ meetings.
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* Accumulated income – although there is a
ceiling, this income can be passed through to shareholders, thereby
representing a capital gain when these shares are sold.
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O Shareholder restrictions – shareholders are
unable to assign earnings separate from their shares, although are able to assign shares at their discretion.
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Top Advantages of LLCs
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Top Disadvantages LLCs
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* Flexibility – there can be any number of
varieties of owners, and these owners can have disproportionate return
allocations.
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O Pressure to distribute profits - an LLC is unable
to accumulate income to fund future expansion.
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* Favorable taxation structure – avoids
double-taxation, plus deductible employee benefits and increased tax shelter
for qualified pension / retirement plans exists.
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O Lack of familiarity – this could stymie
investment and make going public more difficult (therefore turning off
venture capitalists).
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* Limited liability – members only have
exposure for the assets they invest in the company, and are protected against
personal liability. They can also be active in the management of the
business.
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O Limited legal precedents – the short lifespan
of this investment structure means a comparatively smaller body of case law,
creating uncertainty.
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Top Advantages of Lease
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Top Disadvantages Lease
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* Off balance sheet advantages – allows
companies to keep debt off its balance sheet, thereby satisfying low
debt-to-equity ratios.
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O Contingent liability – corporate accounting
scandals mean that this type of structure will come under rigorous
scrutiny.
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* Favorable exit strategy – for non-publicly
traded entities, a pre-determined sales price can be set with the tenant,
thereby increasing yields to the landlord.
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O Capped guarantees – generally not favorable
in a low interest rate environment where listed entities guarantee a fixed
return.
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* Security – guaranteed payments allows passive
institutional investors to diversify property investments into hotels without
the problematic volatility associated with this asset class.
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O Loss of upside – leasehold value diminishes
rapidly, representing a significant loss. In addition, loss of ownership
upon lease expiry means no share in asset appreciation.
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TRACING THE
HISTORICAL HEAVYWEIGHTS IN THE USA
The mega-owners of today have grown through a combination
of acquisition, development and mergers. In pure transaction terms, Host
Marriott dominated the 1998 table, swallowing $2.2 billion of hotel assets in
one year alone. In 1999, Strategic Hotel Capital was the most active buyer.
In 2000, a number of key players vied for top place, while 2001 clearly
belonged to Blackstone who acquired almost $1 billion in hotel assets in a
single transaction. The relative dearth of activity in 2002 has meant little opportunity
for high profile headlines, although CNL Hospitality remained active, acquiring
eight hotels, all but one from Marriott International. Indicative of the
inactivity in the REIT market, Host Marriott bought its first hotel since May
2000, the Boston Marriott
Copley Place for a reported $214
million in June 2002.
A look at the top 10 owners now versus five years ago underscores this transformation. Only three of the current top 10 owners were
ranked in the 1997 tally, Host Marriott, Tharaldson Enterprises and Lodgian.
Host Marriott has consistently ranked as the largest owner in the United
States, and despite the usual inertia of size, has achieved one of the
fastest growth rates over the period (much of which was concentrated in
1998).
THE
FUTURE OF U.S. HOTEL OWNERSHIP
“The
hotel industry has witnessed such prolific change in the composition of its
ownership structure over the last five years, the question of what the pattern
may look like in the future is compelling,” included Arthur Adler,
Managing Director and CEO-Americas, of Jones Lang LaSalle Hotels. “Since REITs became inactive in late 1998,
changes in tax laws have encouraged new forms of hotel investment techniques.
In the five years to come, the most important changes and new forms of hotel
ownership are most likely to be related to sources and cost of capital, liquidity
and returns.”
THE DEMISE OF TRADITIONAL REITS?
Although REITs in total own a relatively small percentage of investment
grade hotels in the United States, their impact on the ownership
landscape over the last five years has been dramatic. However, volatile stock
prices and reduced earnings have limited this group from conducting any
significant acquisition or development activity. Compounding this is their
somewhat restrictive structure that limits the amount of retained earnings for
ongoing capital costs and growth. As a result, it is unlikely that this
ownership structure will grow markedly in the future.
“REITs will remain popular to institutional investors who seek
liquidity and diversification, but who do not have the stomach (or experience)
for direct acquisitions,” said McKay. “REITs will remain popular
for individual investors and retirees, particularly when government bonds and
money market rates are at comparative lows, which is the current environment.
In particular, as the stock market recovers, REITs will regain expansion
capacity.”
PRIVATE PLAYERS TAKE THE EDGE
The majority of recent acquisition activity has been sourced from
private equity players, such as partnerships and LLCs. Their ability to raise
capital has not been stymied by share price devaluations. In addition, this
investment structure appeals to institutional investors familiar with hotel
investing given often superior rates of return.
According to Art Adler, in general, the industry is likely to witness
more private and institutional capital flowing to hotels. “The carrot is
the superior risk-adjusted return in comparison to other forms of real estate.
According to the NCREIF index over the long term (10 years) hotels well
out-performed all other forms of real estate, achieving an annual compound
total return of 12.3%, compared with 8.8% for all properties,” he added.
A FLOOD OF PENSION FUND MONEY?
Hotels represent a classic contrarian play for pension
funds. Currently however, the sector is not well understood by this
traditionally conservative investment source. But interest is growing. The
question therefore is how would their capital be best deployed? REITs
represent a viable alternative for these investors, at least initially, to access the high return potential of the sector without being exposing to too much volatility (and risk). Current investment by pension funds in hotel REITs
is limited.
“Alternatively, a return hungry pension fund could invest in
private equity funds, which provide the opportunity for greater return,”
stated McKay. “Knowledge of the vagaries associated with hotel
investment (or at least an advisor with such experience) remains
indispensable. Privatization of pension funds could provide the trigger to a
major influx of retirement dollars to the lodging industry.”
Canada is in just such a process and depending on its success,
this could be replicated not only in the United States, but also throughout the
world.
Jones Lang LaSalle Hotels, the
world’s leading hotel investment services group, provides clients with
value-added investment opportunities and advice. In 2001, its success story
includes the sale of 7,972 hotel rooms to the value of US$1.3 billion in 39
cities and advisory expertise on 100,550 rooms to the value of US$26.3 billion
across 255 cities. Jones Lang LaSalle Hotels’ services include transactions,
mergers and acquisitions, financial advice and capital raising, valuation and
appraisal, asset management, strategic planning, operator assessment and
selection and industry research. Jones Lang LaSalle (NYSE: JLL) is the
world’s leading real estate services and investment management firm,
operating across more than 100 key markets on five continents.
www.joneslanglasallehotels.com
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