REITs and hotel investment
The problem
The Government is introducing the real estate investment trust (REIT) as a new pooled property investment vehicle from
1 January 2007. This will be in the form of a UK tax-resident listed company available to both private and institutional investors.
Its main attraction will be exemption from tax on rental income and capital gains on property. It is hoped this will enable more money to be spent on updating or renewing the buildings in which businesses are run. But will the hotel sector be able to benefit from this new opportunity?
The law A distinction must be drawn between pure property investment REITs and those where some element of business operation, and therefore operational risk, is retained within the REIT structure.
A pure investment REIT may be applicable to the hotel sector provided it owns the property and leases that property out to third-party operators, meaning that it is not itself providing goods or hotel services to customers. The rent payable under the lease can be partly or fully variable.
On the other hand, the requirement that the REIT should receive rental investment income and not hotel operational income will mean that the combination of property together with operational risk in a hotel will be difficult to fit within the REIT structure. Owner-occupied hotels or those managed by an operator give rise to trading income and thus are not, on the face of it, REITable.
Expert advice So how could an operating hotel REIT be structured?
We expect that hotel and leisure REITs will mirror the structure already popular with hotel and other operating assets held by foreign investors, namely, the property holding company/operating company (propco/opco) - bricks and brains - split. The REIT would be the propco and it would have a subsidiary, the opco. The propco owns the hotel building and grants a lease to the opco, which then operates the hotel itself or does so through a professional hotel manager.
This structure allows greater operational risk to lie within the REIT, albeit through its subsidiary.
Under the new regime, REITs will have to adopt structures where the REIT holds just less than 75% of the opco shares. This means there will be some element of outside investment. However, economically this should be acceptable, as it is not expected that the opco will make huge profits. In any event, as ever with awkward technical legal requirements, more artificial share structures might develop and clients will need advice.
So, with all this in mind, can we envisage hotel REITs?
The answer is yes, but with a few caveats:
- Will the REIT be able to compete, in days of high asset valuation, against leveraged private equity or offshore investors? In other words, will its tax exemption be enough to give it competitive edge?
- Will the investors' expectations of dividend yield be low enough to make the REIT worthwhile for its sponsors?
- Will a variable rent be attractive and reliable enough to investors?
- Will the covenant of the opco tenant and the hotel manager be of high enough quality to avoid a discount of its net asset value at flotation or later?
We do expect hotel REITs, but not immediately. They may have most use as exit vehicles for recent entrants into the hotel sector, particularly if they allow a higher valuation methodology by focusing on dividend yield rather than net asset value, as has historically been the case in the UK listed property company sector.
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