The Wall Street Pendulum - REIT or C-Corp
By Kapila K. Anand, Partner and George C. Gudgeon, Supervising Senior, Summer - 1996
A significant percentage of the capital used to fuel the recent hotel investment boom has been raised through Wall Street.
Hotel companies raised approximately $2 billion in public equity during 1995: nearly $800 million by hotel companies using a taxable corporate structure (C-Corp) and more than $1.2 billion through hotel real estate investment trusts (REITs).
In 1995, approximately 60 percent of the REIT capital was raised through secondary offerings versus initial public offerings. This reverses the mix that prevailed in previous years. In 1996, through May, this trend for REIT offerings has continued.
However, the real story for 1996 has just started to unfold, and rumors abound as to other hotel owners and management companies waiting in the wings hoping to cash in on the public markets when the time is right. The basic structure and performance of the hotel REIT versus the C-Corp holds the secret as to which way the Wall Street pendulum will swing in 1996.
The tax advantages available to hotel REITs come at a cost. Since hotel REITs are constrained from operating a trade or business, their hotel assets must be leased to a third-p[arty operator, usually for a percentage of revenues with no participation in the net income of the leased asset. This arrangement has been viewed by some investors as an inherent conflict of interest as they question the economics involved in the lease arrangements and incentive to maximize gross revenues versus net income and shareholder value. REITs are also required to distribute 95 percent of their taxable income in order to maintain their tax status. On the other hand, C-Corps, while taxable, are able to retain structural integrity and are more traditional. That means C-Corp structures are easier to understand, and can retain earnings for corporate growth and are better positioned to fund capital expenditures in maintaining their hotel portfolios.
REIT shares provided dividend yields of approximately 7 percent and the average funds available for distribution payout percentage averaged approximately 88% in 1995. Hotel REIT stocks are outperforming most other REIT stocks. But, the increasing REIT payout rates and declining cap rates used to purchase properties have reduced the incentive spread for sponsors to form REITs - in some cases encouraging investors to return to traditional C-Corps.
As long as supply remains under control and lodging forecasts remain optimistic Wall Street is expected to remain bullish on hotel transactions. Institutional investors will continue to put a premium on size and market capitalization at the expense of smaller REITs or C-Corps, which may be forced to evaluate consolidation or merger options. Hotel REITs will look for ways to minimize the inherent limitations of the REIT structure. last year saw the emergence of certain trends, including structural changes in the relationship of the REITs with their third-party hotel operators, and a move toward multi-tenant lease structures. These trends, as well as the development of new strategic alliances, are expected to pick up steam in 1996.
The C-Corp structure is expected to become more favored on Wall Street in 1996. Secondary offerings are expected to dominate the marketplace as the means to fund the continued growth of public companies.
The Real Estate Report is published by KPMG's National Real Estate, Hospitality, and Construction Practice. © 1996 by KPMG Peat Marwick LLP All rights reserved. For additional information email KPMG.
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