Since the first hotel real estate investment trust ("REIT") was offered to the public in 1993, a significant number of hotel owners have formed public hotel REITs. Given the currently attractive hotel market, and general success of hotel REITs with investors, hotel companies are looking to Wall Street for additional capital with greater frequency and it is very likely that significant numbers of new hotel REITs will be formed in the near future.
REITs are Tax Driven Vehicles
Potential REIT sponsors and investors should be aware, however, that REITs are essentially tax-driven vehicles that are subject to a complicated and detailed tax regulatory structure. Moreover, despite the current and growing popularity of hotel REITs, the provisions of the tax code governing REITs were almost certainly not written with hotels in mind, and several of these provisions are at odds with customary operations and practices of the hotel industry. As a result, special consideration regarding the structuring and operation of hotel REITs is required.
Tax Avoidance Structures
In order to avoid tax being due on the transfer of hotel properties by the current owners to a REIT, hotel REITs are frequently structured as an umbrella partnership real estate investment trusts ("UPREIT"). Under this structure an umbrella partnership is created between the REIT and the former hotel owner or owners to own the hotel properties. The REIT contributes cash raised from public investors to the partnership, and the hotel owners contribute their real estate interests.
Generally, the REIT is the sole managing general partner of the operating partnership, and the former owners (or roll-up partners) own the limited partnership interests. Because limited partnership interests are not as liquid as REIT stock, the limited partnership interests generally can be exchanged for REIT stock (or, in the sole discretion of the REIT, an equivalent amount of cash) after expiration of a certain period of time. As is discussed below with respect to REITs generally, an UPREIT may not operate or manage hotels without losing its REIT tax status.
In addition to providing a deferral of tax on the transfer of hotel properties by the former owners, the UPREIT structure ensures that the REIT satisfies the tax code provisions requiring
- diversity of ownership of the REIT, and
- that the REIT's rental income not be received from a related party tenant (as discussed in more detail below).
Under the attribution rules used to determine diversity of ownership, a holder of an interest in the operating partnership of an UPREIT is not considered an owner of REIT shares. Similarly, the partners are not considered a related party tenant because the operating partnership has the sole right of redemption to pay cash to the holder instead of delivering REIT stock.
Off-Setting Limitations on Income
The tax code provisions governing REITs impose strict limitations on the income and activities of REITs that are at odds with hotel ownership and operation. First, in order to maintain its status as a qualified REIT, all income to the REIT must comply with the so-called income test, which requires that all income must be derived from rents from real property, interest on real estate mortgages or other real estate-related revenue. Revenue from hotel operations does not satisfy this test. In addition, a REIT may not perform many services related to the management or operation of the hotel property or business because income from these services is not considered to be income from qualified real estate activities under the applicable REIT laws.
Lease Agreements to Comply with REIT Requirements
To comply with the income test and avoid engaging in prohibited non-real estate-related activities, the typical hotel REIT will lease the hotel assets to a separate tenant entity that manages the hotel or hires a third party manager and effectively convert its prohibited hotel revenue into permissible rental income. The tenant may manage the hotels itself or, in turn, hire a property management firm to carry out some or all hotel operations. The hotel operator may be an unrelated entity or an affiliate of the tenant.
The lease between the REIT (or, more likely, an operating partnership as described above) and the tenant must be a true lease with typical lease obligations on the part of the tenant in order for the REIT to comply with the restrictions on real estate activities. The lease cannot be a service contract or joint venture in the guise of a lease. Accordingly, the operating partnership's possessory rights will be subject to the tenant's leasehold rights, and the tenant must have all of the benefits and risks of hotel operations.
The true REIT lease will often provide for typical periodic fixed and percentage rent payments. The fixed rent payments must be paid without regard to the success or failure of the hotel. Percentage rent must be based on gross revenue, rather than profit or net income, or hotel net, although real estate-related costs, such as taxes, insurance and real estate operating costs may be deducted before determining the operating partnership's percentage of gross revenues. The percentage rent figure is set at lease execution (like a typical lease), and cannot be renegotiated if the changes are based on profit or net income. Of course, the duration of the leases is a critical factor in structuring.
The tenant to the REIT or operating partnership must be a true unrelated third party tenant. A related party tenant is a tenant in which the REIT has an ownership interest of at least 10%. Because of constructive attribution rules, if any owner of the tenant owns a 10% or greater interest in the REIT, the REIT may be deemed to have an ownership interest in the tenant. The tenant's owners generally are considered to own REIT shares held by family members and by entities in which they hold an ownership interest. If the corporate separateness of the tenant were disregarded, the operating partnership would be treated as operating the hotel either directly or through an agent, which would result in the loss of REIT status. None of the officers or employees of the tenant should be officers or employees of the REIT or advisors to the REIT, nor should either the REIT or the operating partnership loan money to the tenant.
Avoiding Conflicts of Interest
Perhaps the most challenging aspect of hotel REITs is the creation of a structure that avoids the various conflicts of interest. The usual conflicts are
- between the operator of the hotel and the REIT whereby the operator could conceivably place its interests before the REIT's thereby holding down REIT yields (this is especially true where the operator and the REIT are related); and
- the sponsor of the operating partnership may resist the sale of hotel assets to avoid the trigger of deferred gain, while a sale might be in the best interest of the REIT investors.
While not solving the problem, certain actions can and have been taken to reduce but not eliminate the conflicts. These ideas include (a) have separate directors and management for the REIT and the tenant, and (b) ensure that the tenant and the third-party hotel managers are independent and have sound reputations. Though these measures help, conflicts will remain a critical issue to investors.
Summary
Potential investors should recognize these inherent risks that are unique to REITs that invest in hotels as opposed to traditional real estate. These risks may be acceptable to investors in the current strong hotel market, but may not be acceptable in the future in poorer market conditions.