Mr. Redington

Finance & Investment

Why Hospitality Operators are Losing Their Love of Real Estate

By Neale Redington, Partner, Deloitte

The corporate finance aspects of the transaction may have been enticing, but few operators followed the Host MI model. The operators considered factors such as tax implications of the sale, relatively low prices for the real estate, and the diminished ability to control the real estate after sale. They are, however, now reconsidering this option as a result of the strength of the real estate market, confidence in the hospitality industry, and expansion of real estate acquisition vehicles. The growth of Real Estate Investment Trusts ("REITs") that can pay generous prices for the hotel property and are required by law to hire a hotel management company has been significant.

Hotel operators can also realize other key benefits from an Opco-Propco split:

Real Estate Ownership Structures

Various structures are created to form the Propco entity acquiring the real estate assets. These include the previously described REITs, regular C-Corporations, and limited liability companies or partnerships formed by Private Equity Investors ("PEIs").

REITs

The main benefit of a REIT is that only one level of tax is paid by the owner of REIT stock - the REIT entity itself generally does not pay tax. In return for this favorable tax treatment, however, the REIT must comply with many tax rules and regulations, including a rule that it must distribute 90% of its taxable income to its shareholders.

REITs provide access to wider capital markets, as smaller investors can purchase shares in the REIT. Public REITs may provide improved liquidity, diversification, transparency and scrutiny.

The main disadvantages of REITs are that they are highly regulated and often subjected to greater limitations on operating activities and use of indebtedness. The requirement to distribute substantially all of its taxable income to its shareholders can also inhibit "organic" internal growth of the REIT.

C-Corporations ("C-Corps")

A regular C-Corp is not subject to the same tax rules as a REIT and some of the large hospitality REITs of yesteryear converted to C-Corp status to avoid such restrictions. These structures can be especially attractive to entities with overseas investors who are required to pay US taxes and do not want to file personal returns in the US.

The primary disadvantage of a C-Corp is that an owner pays tax twice on the income earned from the entity. The C-Corp's net income is taxed at a corporate rate, and then shareholders are required to pay personal income taxes on the dividends received. Additionally, many real estate companies record capital gains from the sale of property; in a C-Corp, such capital gains are taxed at the corporate tax rate, which is currently significantly higher than individual capital gains rates. In a REIT or PEI entity, these gains would be taxed at the lower individual capital gains rates, and paid by the owners.

Private Equity Investors

In addition to REITs, there has been an emergence of the PEI as a significant source of capital for the real estate transactions. The typical structure is in the form of a limited partnership or limited liability company, both of which are regarded as "passthrough" entities. 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 C-Corps are avoided and regulatory restrictions associated with REITs do not apply. However, the liquidity, transparency, and scrutiny of some PEI entities may not be as robust as the public reporting entities.

In Conclusion

Operating company/property company separations are becoming increasingly valuable to hotel operators as they allow the two groups to focus on what they do best: effectively manage their portfolios and maximize the value of their assets. As industry trends, financial markets, and potential tax opportunities converge to make such transactions more and more attractive, it is expected that even more hotel operators will consider making such structures an important part of their business strategy.

Neale Redington is National Partner in Charge of Hospitality for Deloitte & Touche LLP. He can be reached at 213-688-4762 or via nredington@deloitte.com

Neale Redington is National Partner in Charge of Hospitality for Deloitte & Touche LLP. He has been an advisor to major real estate firms for more than 17 years in the REIT and hospitality sectors. He brings opportunities for wealth creation to hotel owner/operators and management companies through performance of annual audits, operations reviews, due diligence procedures, and assistance with initial public offerings. Redington is co-author of the Hospitality chapter of the Real Estate Accounting Handbook. He frequently speaks on hospitality issues at trade events and with the media. Mr. Redington can be contacted at 213-688-4762 or nredington@deloitte.com Extended Bio...

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