Transacting with a Hotel REIT—What You Should Know
Sandman Savrann PLLC
Hotel REITs are prominent participants in the hotel industry. They act as hotel buyers, owners and sellers, and hold hotel debt. Stakeholders in the industry come into contact with REITS frequently, often without knowing any details about the nature of REITS or their unique attributes. What is a REIT? How are hotel REITs different? What are the special considerations when dealing with a hotel REIT? By understanding some of these basics, stakeholders can be more effective in their transactions and other dealings with hotel REITS.
What is a REIT?
A Real Estate Investment Trust (REIT) is a type of real estate company modeled after mutual funds. Congress created the REIT form in 1960 to give average Americans the opportunity to invest in income-producing real estate without actually having to go out and buy or finance property – much like a mutual fund gives individuals the opportunity to invest in wide range of companies without having to buy the stock of each company. Essentially, a REIT is like a mutual fund of real estate assets.
Like a mutual fund, a REIT is, to a large extent, a “pass-through” entity. A REIT is entitled to deduct from its corporate taxable income the dividends it distributes to its shareholders. The REIT form therefore avoids the “double tax” on corporate activities—unlike a REIT, a C-corporation normally must pay federal tax on its income, and then the corporation’s equity investors must also pay tax on the income they receive from the corporation. This REIT tax advantage is why the structure and activities of REITs are specifically defined and limited, and why some companies that aren’t in the traditional real estate business (e.g., data centers, billboards, and prisons) also seek REIT status.
One of a REIT’s central, intended activities is the buying, holding and selling of “income-producing real estate.” This phrase refers to land and the improvements on it—which includes a wide range of asset classes, such as shopping malls, apartment buildings, student housing complexes, homes, medical facilities, office buildings, cell towers, timberlands, and hotels.
REITs may also invest in mortgages or ç tied to real estate – much the same way that Fannie Mae purchases residential mortgages – thereby helping to finance the properties and generate interest income.
As a reflection of these two different permissible asset classes, REITs are often classified in one of two categories: equity REITs or mortgage REITs. Equity REITs derive most of their revenue from rent. Mortgage REITs derive most of their revenue from interest earned on their investments in mortgages or mortgage-backed securities. Ninety percent of listed REITs are Equity REITs; the remaining 10 percent are Mortgage REITs.
REITs can be publicly traded, but they don’t have to be. A REIT can publicly register its securities with the SEC and have its shares listed and traded on major stock exchanges. A REIT can also can be publicly registered without having its shares listed or traded on major stock exchanges. A REIT can also be privately held (not publicly registered, listed, or traded).
What Can (and Can’t) a REIT Do?
All REITs are subject to a complicated and detailed tax regulatory structure. These regulations are intended to make sure the tax-favorable REIT form isn’t abused by corporations engaged in non-qualified general business activities. In order to qualify for REIT status with the IRS, a company must:
- Invest at least 75 percent of its total assets in real estate;
- Derive at least 75 percent of its gross income from rents from real property, interest on mortgages financing real property, or from sales of real estate;
- Pay at least 90 percent of its taxable income in the form of shareholder dividends each year (as a result, REITs may not generally retain their earnings);
- Be an entity that is otherwise taxable as a corporation;
- Be managed by a board of directors or trustees;
- Have a minimum of 100 shareholders;
- Have no more than 50 percent of its shares held by five or fewer individuals.
Because REITs were intended to be passive investors of real estate—not active managers—several of the REIT requirements listed above create conflicts with some customary operation and ownership practices of the hotel industry.
First and foremost, the IRS rules governing REITs impose strict limitations on the income and activities of REITs that are at odds with hotel ownership and operation. As noted in the second bullet above, a REIT must comply with the so-called income test, which requires that at least 75 percent of its gross income from rents from real property, interest on mortgages financing real property or from sales of real estate. Revenue from hotel operations does not satisfy this test and is “unrelated business income”, or simply “bad income” for a hotel REIT. In addition, a REIT may not directly perform many services related to the management or operation of the hotel property or business because income from these services is also considered bad income.
To comply with the income test and avoid engaging in prohibited, non-real-estate-related activities, the typical hotel REIT leases the hotel assets to a separate tenant entity (known as a taxable REIT subsidiary or TRS). The use of the TRS as a tenant effectively converts the REIT’s prohibited hotel revenue into permissible rental income. Following the REIT Modernization Act of 1999, REITs are allowed to own, directly or indirectly, up to 100% of the stock of a TRS that can engage in businesses previously prohibited to a REIT, subject to certain limitations. In particular, these provisions permit a hotel REIT to own a TRS that leases hotels from the REIT, rather than requiring the lessee to be a separate, unaffiliated party. However, hotels leased to a REIT-affiliated TRS must be managed by an unaffiliated third party (i.e., a true third-party hotel manager.
The lease between the REIT (or its operating partnership) and the TRS must be a true lease with typical lease obligations on the part of the TRS – otherwise the REIT will fail to comply with the income restrictions on real estate activities, thereby resulting in the loss of REIT status and its favorable tax treatment. The lease cannot be a service contract or joint venture in the guise of a lease. Accordingly, a REIT’s possessory rights must 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. 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 lease is another critical factor.
Hotel REITs are often formed using a structure called an Umbrella Partnership REIT or “UPREIT.” The UPREIT structure is used for two reasons. First, an UPREIT allows the REIT’s founders to transfer the hotels they own into the REIT, but defer the tax gains that might otherwise arise from the transfer. Second, an UPREIT allows REIT management to buy hotels from other sellers using limited partnership units as another form of consideration, thereby offering the sellers an opportunity to defer the tax gains, as well. Under the UPREIT structure, the REIT and the hotel owner form a limited partnership (which is often referred to as the “operating partnership”). The REIT contributes to the operating partnership the cash raised from public investors, and the hotel owners contribute their hotels. Generally, the REIT is the sole managing general partner of the partnership, and the hotel owners receive limited partnership interests. Because these limited partnership interests are not as liquid as REIT stock, the limited partnership interests generally can be exchanged for REIT stock (or an equivalent amount of cash, in the discretion of the REIT) after expiration of a certain period of time.
To accommodate the above tax deferral objectives, as well as the avoidance of “bad income,” the corporate organizational structure of a typical hotel REIT looks something like this:
HOTEL UPREIT STRUCTURE
Special Considerations When Dealing With a Hotel REIT
Given the above, parties that seek to do business with hotel REITs—whether they are brands/franchisors, asset managers, management companies, other service providers, or sellers—should be aware of a number of issues and at least one opportunity.
- Service Providers
Service providers (such as hotel management companies, vendors, and franchisors) often contract directly with the hotel owner and rely on the credit of that ownership entity. When a service provider enters into a contract with an UPREIT, however, the REIT entity signing the contract will typically be a TRS. As indicated above, the TRS is only the tenant of the REIT, and doesn’t own the fee interest of the hotel. As such, the TRS does not typically have a strong balance sheet because its assets are often limited to its leasehold interest in the hotel. As a result, if the lease between the REIT and the TRS is terminated for some reason, the service provider may be left without a credit-worthy entity to sue for breach of contract.To address this risk, the service provider should consider the following:
- Insist on a nondisturbance agreement from the landlord (i.e., the REIT operating partnership). The non-disturbance agreement should cover the rights and responsibilities of all the REIT parties (the operating partnership, as well the TRS entity) in the event of a lease termination. If the lease is terminated, the landlord must step into the shoes of the TRS under the contract. This will ensure that at all times the agreement remains in place with an entity that has a possessory interest in the hotel.
- Ask for a guaranty from the landlord (i.e., the REIT operating partnership). Because the TRS is only a tenant, it is reasonable to ask for this guaranty to provide the service provider meaningful recourse for any breach of the agreement. The guaranty should include all of the customary provisions typically included in guaranties. Another, less common alternative is the “assignment option.” In this alternative, the service agreement is signed by the landlord, who then assigns the agreement to the TRS. If written correctly, the result is the same as a guaranty—the landlord remains liable to the service provider under the agreement.
- Ask for a subordination and nondisturbance agreement from the REIT’s lender. Although the TRS usually doesn’t have a secured lender, that doesn’t mean the service provider doesn’t have to worry about a loan default. The hotel financing is usually obtained by the landlord. If the service provider (such as a branded manager) expects to have nondisturbance protection, then this protection will have to come from the landlord’s lender. If nondisturbance protection is not obtained from that lender, then, after a loan default, the lender will be able to foreclose and essentially extinguish the service agreement.
- Clarify the rights and obligations of all parties regarding lease modifications, consents, notices and events of default. Because the controlling owner party is really the landlord entity, the service provider should seek the right to be notified and to approve any modifications to the landlord/TRS lease that may affect the service agreement. Also, the service provider should know and understand which entities must provide or be entitled to consents (e.g., for annual budgets) and notices, and which entities have rights/obligations in the event of a default.
Keep in mind, as well, that a hotel REIT often has the ability to structure a hotel purchase transaction in a way that results in a deferral of tax on the transfer of hotel properties by the former owners. As mentioned in the UPREIT discussion above, the seller of a hotel to an UPREIT may contribute the asset to the limited partnership controlled by the REIT in exchange for limited partnership units of the operating partnership, which can usually be converted to public shares of the REIT after a certain period of time. This option may not always be offered by a REIT, and the seller bears some financial risk on the sale price based the fluctuations of the REIT’s stock price, but it may be a worth considering for the hotel seller who has a large built-in gain.
The rules, requirements and regulations surrounding the REIT industry, and particularly the UPREIT structure employed by many hotel REITs, are intricate and complicated. With the proper advice and guidance, hotel sellers, brands, managers and other service providers can easily accommodate a hotel REIT’s complex ownership structure with little or no additional risk, and sellers may even find an advantage.
About Sandman Savrann—How We Can Help
Sandman Savrann PLLC is devoted to providing comprehensive, first-choice legal counsel to the hospitality industry. Our highly-regarded industry counselors lead an interdisciplinary team of professionals to deliver cost-effective, industry-informed counsel for local, regional, national, and international hotel companies.
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James A. Crolle III
Irvin W. Sandman
Russell C. Savrann
© 2014 Sandman Savrann PLLC.
This article is intended to provide a general overview of the basics of REITs, the industry-specific nuances of hotel REITs, and some of the issues that may arise when selling to or negotiating an agreement with a hotel REIT. This article isn’t tax or legal advice. Each transaction and material agreement involving a hotel is unique, and you should consult with your hospitality attorney advisor regarding the specific facts and circumstances of your particular situation.