New U.S. tax legislation, signed into law as last year ended, marks significant change in the growth opportunities for real estate investment trusts (REITs) in the years ahead. 

Management of hotel REITs should take note since the legislation will make it possible to retain more income generated from hotel properties.

The Tax Relief Extension Act of 1999, signed by President Clinton last December, modifies the rules governing REITs in several ways. The most significant provision, however, is creation of a new type of corporation—a “Taxable REIT Subsidiary”—which will allow REITs to create new incremental income streams. With new growth opportunities, shareholders should be rewarded with higher stock prices since companies with increased growth rates typically trade in the market at higher earnings multiples.

Historical background

Prior to the law’s enactment, REITs were able to form subsidiaries, provided that they owned less than 10% of the voting stock , to generate non-REIT qualified income. However, the activities of these subsidiaries were restricted in ways that limited their ability and, therefore, the REIT’s ability to develop income streams fully.

These restrictions prevented the subsidiary from providing non-customary services to the REIT’s tenants (e.g., services that are not customarily provided by owners of real estate to their tenants). The subsidiary also could not pay rent to the REIT. And the value of that subsidiary could not exceed 5% of the value of the REIT’s gross assets.

These rules forced hotel REITs to lease their hotels to unrelated parties, who retained a significant share of the earnings of the REITs’ hotels. Accordingly, these rules placed significant restrictions on a REIT’s ability to grow, which in turn limited the growth in shareholder value.

Legislative changes

Under the terms of the 1999 legislation, Taxable REIT Subsidiaries can provide non - customary services to tenants through their subsidiaries. This legislation should enable REITs to provide better customer service, create stronger customer loyalty and sell new, non-customary services to tenants.

In addition these new subsidiaries can lease lodging facilities from REITs. However, the lodging facilities must be managed by an independent contractor that is actively engaged in the trade or business of operating lodging facilities for any person other than the REIT.

In spite of these REIT-friendly changes, there continue to be limitations on these subsidiaries. First, the value of these subsidiaries cannot exceed 20% of the value of the REIT’s gross assets. Second, the value of all of the non-real estate assets cannot exceed 25% of the value of the REIT’s gross assets. Accordingly, when the value of these subsidiaries cause the REIT to exceed these limits, the REIT may be required to sell or distribute all or a portion of these subsidiaries.

New opportunities

With these changes, hotel REITs will be able to reorganize their structure in order to retain more of the income generated by their hotels. For example, FelCor Lodging Trust Inc., a hotel REIT based in Irving, Texas, currently leases its hotels to two tenants: 1) a company owned by its executives and directors; and 2) Bristol Hotels and Resorts, a publicly traded company.
With the new legislation, FelCor will be able to form a new Taxable REIT Subsidiary and transfer the leases of its hotels to this new subsidiary. Accordingly, the net income of the existing lessee would be transferred to the new Taxable REIT Subsidiary. However, a management company (not owned by FelCor) must manage the hotels and must be actively engaged in the trade or business of operating lodging facilities for any person other than the REIT.

RFS Hotel Investors Inc., a hotel REIT based in Memphis, Tennessee, is an example of a REIT that is taking advantage of these opportunities. On January 27, 2000, RFS announced that it has entered into an agreement with Hilton Hotels Corp., under which RFS has the right, for approximately US$60 million, to terminate 51 leases with Hilton on or before January 31, 2001.

Hilton has the option of requiring RFS to repurchase convertible preferred stock of RFS currently owned by Hilton for approximately US$13 million. RFS estimated that approximately US$8 million in annual earnings (before interest, taxes and depreciation) will be generated when the leases are terminated.

Preparing for the new legislation

The 1999 act becomes effective on January 1, 2001. Until then, REITs cannot form these new Taxable REIT Subsidiaries.  However, during the remainder of the year, REIT management should take steps to assure future benefits from the legislation, including:
developing new strategic plans to take advantage of the law, and completing the start-up phase of these new business opportunities.

If these steps are undertaken, REITs will begin the year 2001 poised to create significant value for their shareholders.

©Arthur Andersen