|Bull or Bear Market?|
|A Force for Consolidation|
|Meanwhile in Wasington D.C.|
Property Trusts -
New Legislation Brings Regulatory Change
|By Roger S. Cline New York - Summer 1998
Hotel property in the United States has been bought and sold at a feverish pace in recent years, and the development scene in 1998 will produce more new rooms than at the peak of the 1980s. Yet one of the biggest stories at mid-year is the performance of hotel Real Estate Investment Trusts (REITs) Launched onto the scene in their "modern form in 1993, hotel RElTs early on produced sterling comparative returns for investors And with access to a ready supply of capital, hotel RElT companies proceeded to buy up property at a rapid pace Last year hotel RElTs represented 12 percent of all RElT spending on property - an impressive record for the hospitality industry that not too long ago was the black sheep of the U.S. real estate market.
At mid-year, however, the RElT market had stumbled. Equity RElTs at the close of 1997 lagged behind the Standard & Poor's (S &P) 500 index on a total return basis for the second time only in seven years. Nor did performance improve this year. RElTs have trailed the general market during the first half of this year with the decline of the real estate bull market.
Hotel REITs have likewise suffered. Hotel and office RElTs outpaced other types of RElTs in 1997 with returns of 30 percent and 26 percent respectively. Indeed, some hotel RElTs posted spectacular results. Starwood Lodging, for example, produced returns of 61 percent. But what a difference six months can make. Performance reported for the first half of 1998 signaled a turning point for those public hotel companies that have tied their growth story to acquiring properties at sharp discounts to replacement costs. The easy money, as they say, has been made. With development activity increasingly on the agenda for some RElT managers, it would seem that the risks in the business are set to increase. How these RElTs mitigate the risks and satisfy an investment community generally focused on quarterly earnings will he a significant challenge during the next several years. RElT companies will be focusing on how to realize the considerable promise and avoid the peril of the financial markets.
Hotel RElTs became a significant market force this decade beginning in 1993 with a small, $30 million Initial Public Offering (IPO) by RFS Hotels. RFS's imaginative lease arrangement designed to cope with regulations restricting RElTs from generating revenue by operating properties - paved the way for other hotel RElTs. Four years later, new structures pioneered rapid expansion of the hotel RElT industry. The "paired share" REITs (Starwood Lodging and Patriot American) and "paper-clipped" MeriStar Hospitality Corp. have led the way in the consolidation of the hospitality industry. Paired share RElTs with their own brands. for example, benefit from the elimination of management and franchise fees (so-called "leakage"), allowing enhanced flow through to the bottom line or in RElT parlance "Funds From Operations' (FFO).
Going forward, large and 'well-managed hotel RElTs will continue to play a prominent role in the acquisition and consolidation scene in the U.S. hospitality industry with their advantages of size and liquidity. But the RElT industry already is suffering from diminished access to capital resulting from the decline in RElT stock prices. With RElT shares down, market observers are posing an important question. Es this a market correction or the start of a hear market for REITs? RElTs are under performing compared to a year ago. Returns on 16 hotel RElTs representing $18 billion of total market capitalization are off 2.3 percent from one year ago and off 10 percent since late April, 1998. The reason - deteriorating real estate fundamentals. In recent years, RElTs would buy property for say a 10 multiple, while trading at say 11 or 12 times FFO - accretive deals that sent the stock price up. But with property prices escalating, going- in yields have declined. Market wisdom suggests that RElTs have been popular not because of their unique structure, hut because property values were going up so fast. RElTs were great vehicles for investors to buy into the industry's basic story for the 1990's - escalating occupancies and room rates driving up property values as demand growth exceeded supply growth.
In an escalating stock market cycle, hotel RElTs were furthermore able to offer sellers stock for assets. By transferring real estate into an UPREIT (or umbrella partnership RElT) for shares instead of cash, some sellers have been able to defer capital gains taxes. With the recent decline in share prices, the attitude of sellers to taking RElT stock in lieu of cash may have soured for some, while others may see this as an opportunity for further capital gain.
On the buy-side, RElTs will, of course, increasingly view the transfer of stock as an expensive relative currency and retreat from this strategy as circumstances dictate.
With RElT prices in retreat, the premiums of total market capitalization to underlying property values have narrowed.
Last year most RElTs were trading at 25-30 percent premiums to their net asset values. These spreads have shrunk as RElTs have been caught between declining share prices (their primary acquisition currency) and increasing property acquisition prices (their principal growth medium). In this kind of an environment, it is clearly those companies with management solutions and franchise values that will trade at premiums over time. Those RElTs that add little value other than representing a vehicle for owning real estate will tend to trade at or near their net asset values.
Nevertheless, increasingly conservative investors who focus on income are considering RElTs for good reason. The average equity RElT generated a 6 percent dividend yield last year - the same as the 30-year Treasury bond and 3.5 times the S&P. And a number of RElTs have increased their dividends or are likely to do so during the next 24 months. These RElTs have had earnings growth and some are getting close to the minimum 95 percent dividend payout required to maintain their tax status. This is in contrast to recent years when RElTs reduced their dividend payout to a minimum to avoid returning to equity markets with follow-on offerings.
Building a Strategic Growth Story
The financial clout and purchasing power of RElTs have left many private buyers at a distinct disadvantage in recent years. I Intel REITs have been no exception. With significant lines of credit, RElTs committed to deals quickly and closed fast in the rush to acquire properties. With the buying currency of RElTs now significantly weakened, however, this advantage has diminished. With lower stock prices, it is not clear how many RElTs will raise money for their ambitious growth plans for the next 12 months. And grow they must to satisfy the financial markets.
RElTs are actually an awkward vehicle for owning real estate. These companies are required to distribute 95 percent of their taxable income to shareholders each year, producing a painful conflict. RElTs must generate the capital required to expand while maintaining the dividend payout to shareholders. The implicit assumption is that cash flow will grow every year and support an annual increase in dividend payout. In today's market, however, financing growth through earnings isn't an option for most RElTs. Many have lowered dividends but are now up against the 95 percent requirement for pay-out to shareholders. Some RElTs find themselves in a box. They cannot raise more equity. And raising debt may be out of the question because of their current leverage.
With RElT prices stuck in a downdraft, there is some difficulty in determining the exact impact of lower RElT prices on FFO. since lower stock prices will affect not only the volume of acquisitions but the degree to which they are accretive to earnings. If RElT stock prices recover, however, we will likely see a quick return to the equity markets in a rush to sell shares to raise acquisition capital.
The decline in RElT stock prices is encouraging hotel RElTs to look at property disposition and stock buybacks. Yields on capital at the margin can actually be improved by allocating more capital to investment in depressed RElT shares than in elevated hotel property prices. It is also an opportune moment for hotel REITs, especially those that have been part of a consolidating process, to clean up their portfolios and sell off properties that have no strategic fit. They may also dispose of assets and re-deploy them into higher yielding ventures. And they may step up their leverage. In the early 1990s, RElTs limited the ratio of leverage to encourage investors to buy into the real estate story. Now RElTs may be tempted to increase their debt loads because of low interest rates, despite the concerns of negative investor reaction to higher leverage.
In today's property market, it has become more difficult to do deals that are accretive to earnings. RElTs issue stock to pay for their asset purchases and many may not be able to afford deals if they don't add to earnings. RElTs are thus far less aggressive in snapping up real estate than in the not so distant past. As a result, management at many RElTs are faced with the prospect of learning how to develop profit growth at the properties they own. This means that RElT managers will need to become less deal focused and more operationally attuned. RElT managers will need to concentrate on same store" growth, making sure they're getting the economies of scale and benefits from all of the "bulking-up" of property in recent years. Future growth for hotel RElTs may be less about acquiring growth and more about squeezing additional income from existing properties.
There is also an inevitable pull to developing new property. With the hotel acquisition cycle maturing, some RElTs are turning to development in order to continue their growth with the same kind of zeal that they have deployed on the acquisition front. To generate capital for growth, some RElTs also may intensify joint venture efforts, raising money from institutions for development projects. As the development cycle matures in many markets, however, such a strategy for growth may not hold as much promise as heretofore.
Large RElT deals - like Starwood Lodging's acquisition of ITT Corp - have propelled hotel RElTs into the public consciousness and into the investment mainstream. Since the public markets prefer larger capitalized companies, the consolidation that is occurring in the hospitality industry at large is beginning to migrate into the hotel RElT sector itself. And while the focus in consolidation so far has been on public companies acquiring private entities, we are likely to see more public-to-public combinations particularly as the share prices of some hotel RElTs trade closer to their underlying property values.
While not a RElT-to-RElT combination, the proposed merger between CapStar Hotels (a C-corp) and American General (a REIT) is noteworthy for cutting new territory in the hotel industry RElT landscape. This merger will produce the nation's first lodging "paper clip" RElT. The merged company will have a market capitalization of approximately $3 billion. In a multi -step process, Capstar will spin off its hotel operations and management business into a new C-corp to be named Meristar Hotels and Resorts, Inc. It will then merge its real estate assets into American General and the RElT will be named Meristar Hospitality. Meristar will manage 202 hotels in 31 states, of which 110 properties will be owned by the RElT. The two companies will be independent, but "closely aligned." Shareholders can own stock in both, and the companies will share some directors. The structure bypasses the problems of the paired share RElTs; the two companies are tied together, yet remain separate.
Other major consolidations are changing the shape of the hotel RElT
As consolidation of the RElT sector continues, the market will be watching the economics of how the lessees of consolidated RElTs are treated. When the latest generation of RElTs were launched in the early 1990's, most were structured as sale -leaseback entities where the RElT was a passive capital provider. A privately-owned company (generally the original sponsor of the business) took back long-term leases and managed the property. The lessee was not designed to make significant profits. As they are brought public, however, the private "management company can be sold at high multiples taking up capital that would othewiise have been associated with the real estate - a switch that some market observers have not always appreciated.
House and Senate negotiators reached an accord on legislation overhauling the Internal Revenue Service, which includes provisions that would limit the ability of paired shared RElT's to use their "grand-fathered" tax structure to expand. The change would apply to assets acquired after March 26, 1998. This may prompt the paired-share RElTs (Patriot American, Starwood Lodging and Meditrust) to alter their structure if the legislation as proposed is finally enacted. If tax laws limit paired-share RElTs they could "de-pair" and move to a paper clip structure, or roll back into a C-corp to allow the retention of earnings with a broader range of strategic options. Meanwhile, the Federal Reserve has cautioned banks on lending standards to RElTs, observing that their loans are typically large, syndicated and unsecured, and represent an important concentration of credit risk at some banks. Needless to say, the banks and the RElTs probably do not share this sentiment.
The shift in real estate fundamentals underlying the hotel RElT market
signals a major change for the industry and a more difficult road ahead.
Regardless, hotel RElTs will continue as a formidable sector, promoting
consolidation and improved economies of scale in I he U.S. marketplace.
A number of trends will help to define this market in the near future:
At this point in the U.S. business and real estate cycle, the hospitality
industry and its investors clearly must take stock of hotel RElTs and where
they are heading. Acquisitions of well-priced hotel properties priced at
below replacement costs are a thing of the past. The halcyon days of opportunistic
acquiring of hotel properties have come to a close. hotel RElTs will need
to have an arsenal of strategic and operational capabilities to get the
most from their portfolios. Given the judicious use of such skills, hotel
RElTs will not only survive, but thrive, in this new economy.
Roger Cline is Director of Hospitality Consulting Services and a
Partner in the New York office of Arthur Andersen .
|Year 2000: A Business Issue
(Y2K) / Arthur Andersen / Summer 1998
Branding and Repositioning Food & Beverage / Arthur Andersen / Summer 1998
Urban Timeshare A New Wave in the Industry?/ Arthur Andersen / Summer 1998