HVS INTERNATIONAL NEW YORK

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1 REIT or Wrong? An examination of Real Estate Investment Trust stocks and C-Corporation stocks as investment vehicles during times of uncertainty in the lodging industry Gisle Sarheim, Consulting and Valuation Analyst HVS INTERNATIONAL NEW YORK

2 2 The cyclical nature of the hospitality industry, as well as its sensitivity to external events and economic downturns, as seen over the past five years, warrants the following question for investors - is this a safe place to put my money? This article examines the turbulent lodging market from 2000 through 2005, and observes the impact on a sample of lodging REITs and C-Corporation stocks. The article further concludes whether lodging stocks, and particularly lodging REITs, are viable investment vehicles during times of uncertainty in the lodging industry. REITS WHY THE TALK? Real Estate Investment Trusts, or REITs, have been both loved and shunned over the past few decades. They have been referred to as creatures of the tax code and carry with them a here today gone tomorrow stigma, as their fate is dependent upon the goodwill of the IRS and the lawmakers in Washington. Over the past decades, scores of legal counsel and tax experts have tried to circumvent new sets of tax reformation bills, giving rise to a number of new structures with names out of an OfficeMax catalog ( stapled REITs, paperclip REITs). None of this one would think, would inspire investor confidence. The desirability of REITs is simple it is called money. REITs, as long as they follow certain rules, can act as a pass-through entity and avoid taxation at the corporate level. The pro is no taxation the con is you have to give all your earnings away as dividends (95%). Although a review of the legal structure surrounding a REIT is outside the scope of this article, table 1 presents the fundamentals. Table 1 REIT 101 O O O O 75% of Annual Gross Income must originate from real estate related sources 95% of Annual Gross Income must originate from real estate related sources plus passive sources such as dividends and interest 75% of assets must be comprised of real estate, cash or cash items, or Government securities 95% of REIT taxable income must be distributed annually as dividends

3 3 A GLANCE AT THE HISTORY OF REITS 1 The US Congress created REITs in 1960 by passing the Real Estate Investment Trust Act. The act would allow the average investor to partake in the benefits of real estate investments without being subject to the great capital requirements that follow large-scale commercial real estate developments. The REIT Act established REITs as pass-through entities, which allowed them to distribute the majority of their earnings to investors as dividends, without taxation at the corporate level. Although slow at first, the REIT industry gained pace in the late 1960s, as financial institutions could not meet the growing demand for construction and development financing. Rising interest rates, and the 1973 oil crisis temporarily slowed the growth of REITs, followed by a period of restructuring in the late 1970s and early 1980s. This restructuring can be attributed to the tax reform acts passed in 1976 and 1981, coupled with the monetary regime change in In 1986, another tax reformation act proved to be a blessing for the REIT industry. The Tax Reformation Act of 1986 eliminated many of the tax advantages applicable to taxdriven investments such as real estate limited partnerships, and thereby increasing the desirability of REITs as investment vehicles. The early 1990s proved to be another period of growth for the REIT market, fuelled by the demise of the savings and loan industry, and the subsequent dumping of bank-held REIT shares at highly desirable prices. The Revenue Reconciliation Act, passed in 1993, proved to be another turning point for REITs. Effective in January 1994, it permitted institutional investors such as pension funds to be treated as a group of investors, rather than individual investment entities. For the most part REITs had a relatively small market capitalization, and were subject to the five or fewer rule, which did not permit five or fewer investors to own more that 50% of the value of the outstanding shares of the REIT. The entry of institutional investments into the REIT market provided another wave of capital to fund various real estate projects. REITS AND THE LODGING INDUSTRY For the hospitality industry, the gold rush started in 1995 with Barry Sternlicht s acquisition of Hotel Investor s Corp., one of four paired-share REITs whose grandfathered structures predated Congress 1984 ban of this type of REIT. The acquisition, and subsequent creation of Starwood Hotels and Resorts Trust, 1 The discussion of the history of REITs draws on: M. L. Lee & M. T. Lee, Institutional involvement and the REIT January effect over time, Journal of Property Investment & Finance, Vol. 21, No. 6, 2003.

4 4 allowed Sternlicht to swiftly acquire Westin, Ciga, and ITT, which included Sheraton, Dessert Inn and Caesars. Realizing the potential of the paired-share REIT structure, Patriot American Hospitality acquired another one of the four sought-after paired-share REITs California Jockey Club. While Congress quickly put at stop to paired-share REITs by restricting acquisitions of incremental assets, other hotel companies explored the potential of a paperclip-structure. The paperclip structure was another method of circumventing the asset requirements imposed by the IRS, while limiting the leakage of revenue experienced when leasing hotel assets to a separate operator or management company2. Since then, many new REITs have been created, some of which have later converted back to their original C-Corporation structure for added flexibility and control. As of September 2005, the lodging sector of the REIT industry amounted to a total of 19 REITs with an estimated equity market capitalization of $17,617,000,000. Despite recent news reports of the conversion of several REITs into C- Corporations, the reality is that the lodging REIT sector has grown substantially from only 15 REITs in September 2000 with an estimated equity market capitalization of $7,528,500,000. The most recent addition to the lodging REIT scene was the initial public offering of DiamondRock Hospitality Company (DRH) in May DiamondRock is not only run by former Marriott executives, but enjoys an investment sourcing relationship with Marriott International, and access to off-market transactions. Marriott International is also a major shareholder in DiamondRock. This is particularly interesting considering that another Marriott affiliated entity, Host Marriott, is already the largest player in the market, with an estimated equity market capitalization of $5,956,900,000, or more than a third of the total equity market capitalization of the entire REIT lodging sector. Other major players include Hospitality Properties Trust (HPT), Sunstone Hotel Investors (SHO), La Salle Hotel Properties (LHO), and FelCor Lodging Trust (FCH). 2 For a full discussion of REIT structures and the concept of leakage, see: P. Beals & J. V. Arabia, Lodging REITs, Cornell Hotel and Restaurant Administration Quarterly, Vol. 39. No. 6, 1998.

5 5 Table 2 - The Lodging REIT Sector Equity Market Capitalization Company Ticker Symbol Investment Sector Millions of Dollars Percent of Sector Host Marriott Corporation HMT Equity $5, % Hospitality Properties Trust HPT Equity $3, Sunstone Hotel Investors Inc. SHO Equity $1, LaSalle Hotel Properties LHO Equity $1, FelCor Lodging Trust Incorporated FCH Equity $ MeriStar Hospitaltiy Corporation MHX Equity $ Strategic Hotel Capital, Inc. SLH Equity $ Equity Inns, Inc. ENN Equity $ Innkeepers USA Trust KPA Equity $ DiamondRock Hospitality Company DRH Equity $ Highland Hospitality Corporation HIH Equity $ Ashford Hospitality Trust AHT Equity $ Winston Hotels WXH Equity $ Boykin Lodging Company BOY Equity $ Hersha Hospitality Trust HT Equity $ Eagle Hospitality Properties Corporation EHP Equity $ PMC Commercial Trust PCC Hybrid $ MHI Hospitality Corporation MDH Equity $ Supertel Hospitality, Inc. SPPR Equity $ Sector Totals $17, Source: National Association of Real Estate Investment Trusts (NAREIT) - As of October THE US LODGING MARKET To say that the US lodging market has faced difficulties in recent times would be an understatement but in retrospect the US lodging industry as a whole has proven to be resilient to a number of adverse events; a softening economy in 2000, the terrorist attacks in 2001, the SARS epidemic and the Iraqi war to name the obvious ones. As with any industry that is dependent on a healthy economic environment, the financial wellbeing of companies, and strong business and leisure travel, the impact of many of these events was swift and strong. Based on data provided by Smith Travel Research we have plotted average daily rate, occupancy and RevPAR for the entire US lodging market which includes independent and chain affiliated hotels, on a monthly basis from January 2000 through December The most apparent trend to be noted is the seasonal nature of the US lodging market. Occupancy tends to be at its lowest during the first and the last months of the year, and strongest during the summer months.

6 6 Shoulder months are apparent in April-May and September-October. Although average daily rate (ADR) for the most part exhibits smaller variations, some trends can be noted. ADR appears to be greater during times of strong corporate demand due to the higher-rated nature of this segment, namely in the spring and fall, while it subsides somewhat in the summer months due to pressure from the more rate-sensitive leisure segment. Revenue per available room, a combination of ADR and occupancy, for the most part mirrors occupancy on a trend-basis, as the changes in ADR are much smaller then the changes in occupancy. The year 2000 has been recognized as a benchmark year in the lodging industry, with exceptionally strong occupancy and ADR results. The effects of the softening US economy had yet to impact the lodging industry, resulting in a stellar year for most US lodging markets. The year 2001 set out to be a relatively strong year with occupancy results slightly down from the previous year, but with moderate gains in average daily rate. The impact of the September 11, 2001 terrorist attacks was immediate. Flights were grounded, travel plans were cancelled, major metropolitan areas were avoided, and the US lodging industry received a wake-up call as to what the immediate future would bring. While key metropolitan areas were most affected, secondary markets also experienced a marked decrease. The major hurdle for hotel managers and management companies would prove to be the coming year. In an effort to attract demand, rates were lowered substantially, and third-party Internet intermediaries became the channels of choice to attract guests, while trying to maintain some rate integrity. A combination of declines in occupancy and average daily rate resulted in weak 2002 RevPAR results throughout the industry. Weak fundamentals continued through the first half of 2003, but saw moderate gains towards the latter part of 2003, a trend that continued in Overall, 2004 proved to be a year of strong recovery, although RevPAR still remained below the levels experienced in The lodging industry completed its recovery in 2005, with occupancy results on par with the 2000 benchmark-results, and continued rate growth, resulting in strong RevPAR levels, exceeding 2000 levels.

7 7 Table 3 - US Lodging Market - January 2000 through % 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% Occupancy Rate Average Daily Rate RevPAR Source: Smith Travel Research REIT AND C-CORPORATION SAMPLES 3 Samples were selected based on the investment choices that would have been available to US investors in January 2000, and disregard historical performance during the sample period. Samples were further restricted based on the following: Time listed on a major US exchange Size (and size of US held assets or interests) Geographic spread of assets or interests within the US Variety of brand affiliations, and representation in more than one segment Based on these requirements the samples were chosen, as listed in the proceeding table. 3 Stock and REIT data was provided by Yahoo Finance, and represents the adjusted closing price on or about the first day of each month of the period examined. The author notes that the data presented are for illustrative purposes only, and should be construed as such. The author accepts no responsibility for the quality or accuracy of the data presented.

8 8 Table 4 - Samples REITs Ticker Symbol C-Corporations Ticker Symbol FelCor Lodging Trust Inc. FCH Marriott Hotels and Resorts International Inc. MAR MeriStar Hospitality Corp. MHX Choice Hotels International Inc. CHH Equity Inns Inc. ENN Interstate Hotels & Resorts IHR Hospitality Properties Trust HPT Hilton Hotels Corp. HLT Host Marriott Corp. HMT Starwood Hotels and Resorts Worlwide Inc. HOT REIT AND C-CORPORATION PERFORMANCE The following table illustrates the compounded change in RevPAR, as well the cumulative compounded change in the REIT and C-Corporation samples. While the US RevPAR is highly seasonal, with distinctly weak periods from November through February, lodging stocks bear no correlation to these seasonal swings. We note, however, that in the case of strong external influences such as the September 11, 2001 terrorist attacks, there exist a high degree of correlation between the impact on the national RevPAR and the change in price of both the REIT and C-Corporation samples (circle 1). Both hotel management companies and hotel property owners (REITs as well as C-Corporations) are vulnerable to declines in RevPAR, and the resulting declines in revenues. Companies whose income is primarily derived from management or franchise fees are likely to be less affected, as base fees are calculated on revenues, rather than on net income. Hotels are subject to a significant amount of fixed expenses (real estate taxes, insurance), as well as non-operational expenses (A&G, S&M, Property Operations and Maintenance etc.). While operational expenses vary somewhat with the level of occupancy (30% to 40%), many of the costs associated with operating a hotel are fixed. For property owners, including REITs, this implies that declines in revenue are likely to result in proportionally greater reductions in net income. In this respect, the majority of management and franchise companies will still maintain their base fees, although lowered by declines in revenue, while the overall hotel operation may result in a net loss for the property owners. Prior to September , the stock market was already experiencing the impact of a softening economy (as represented by the S&P graph 2), and the fears of weak hotel fundamentals resulted in significant declines in both REITs and C- Corporation shares. Following the terrorist attacks, the immediate efforts of hotel companies to curtail expenses by reducing service levels and trimming payroll,

9 9 combined with increased domestic travel, soothed investor confidence somewhat. This caused share prices for both REITs and C-Corporations to regain momentum, despite weak RevPAR levels, in the first quarter of Uncertainty surrounding the war in Iraq, as well as the adverse impact of the SARS epidemic sent both the REIT and C-Corporation samples on another downward spiral, exacerbated by an already weakened economy. For the remainder of 2002, as well as the first quarter of 2003, hotel fundamentals remained weak. Both REITS and C-Corporations remained a tough sell in the equity market, accompanied by downgraded analyst ratings and credit ratings, leaving many hotel companies cash-strapped. While other sectors benefited from low interest rates and refinancing opportunities, many hotel companies suffered deteriorating credit ratings below investment grade. Circle 2 highlights the point of recovery, both for the US RevPAR, as well as for the REIT and C-Corporation samples, which occurred in the latter part of The fears associated with the war in Iraq, as well as the SARS epidemic subsided, and left investors increasingly comfortable. Improving fundamentals, coupled with rebounding business travel and a favorable outlook for the industry spurred investor confidence, resulting in notable gains in both REIT and C-Corporation stock prices. It should be noted that the lodging industry met its challenges at a time of minimal supply growth, which was further constrained by the lack of financing made available for new development projects. Thus, the lodging industry was able to recover at a faster pace than if faced with an expanding supply/declining demand situation. Improving fundamentals continued through 2004, with substantial gains in RevPAR and a strengthening economic environment. Favorable exchange rates drew international visitors, creating a further boost for hotel markets with a strong appeal to foreign tourists. The gains noted in the C-Corporation sample somewhat outpaced those experienced by the REITs, as revenue gains exceeded cash flow gains, and thus management and franchise contracts proved to be more rewarding. Deferred maintenance due to reduced capital expenditure reserves during the period, combined with increasing amenity levels trimmed flow-through of the strong revenue gains to the bottom line. Because of this, companies with a greater degree of management contracts and/or franchise contracts due to their fee structure (percentage of revenues) reaped the benefits of improving lodging fundamental faster than pure ownership entities such as REITs. Continued RevPAR growth in 2005 spurred further interest in both REITs and C-Corporations. Both debt and equity capital that had remained on the sideline during the 2001 to 2003 period was now actively seeking a match in the lodging industry. Low interest rates that previously had been unavailable to many lodging companies due to their credit

10 10 ratings now fuelled a massive resurgence in refinancing initiatives. The commercial mortgage backed securities market (CMBS), in particular, became an extremely active lender in the hotel market. According to data provided by Commercial Mortgage Alert, the issuance of CMBS in 2005 increased by roundly $76 billion, or almost 82%, compared 2004, of which the hotel sector was a large contributor to the increase. Improved access to capital resulted in a flurry of major transactions throughout Graph 1 Index of Performance RevPAR Comparison "REIT" "C-Corp" Revpar PERFORMANCE VERSUS THE BROADER MARKET While the C-Corporation sample exhibited a stronger recovery compared to the REIT sample, it is worth examining the overall performance of the broader market as exhibited by the S&P 500. The S&P 500 represents a more conservative investment model than what one would attribute to pure investments in the lodging sector, with a lesser degree of fluctuations and lower risk as measured by its standard deviation. However, investors in a S&P 500 index fund would not be

11 11 as pleased with the performance of their fund as investors who placed their money in the REIT and C-Corporation samples detailed in this article. While both samples exhibited a greater degree of fluctuation, and thus greater risk (as measured by their standard deviation), the returns are notable considering that 2000 represented the most recent peak of the lodging industry. The rapid recovery of the US lodging industry is remarkable, and proves its resilience, despite the turbulent times and adverse events. While the limited new supply was a major contributor to the swift rebound, the lodging industry has proven to be more resilient to external influences then what industry analysts first expected. Graph 2 Index of Performance S&P 500 Comparison REIT C-Corp S&P 500 THE ROAD AHEAD Stephen Rushmore, President and Founder of HVS International predicts another three years of strong growth before supply additions will start to impact lodging fundamentals in some markets. The recent increases in construction costs (labor and raw materials) caused by the 2004 and 2005 hurricanes in Florida and

12 12 the Gulf region, as well as the rebuilding of Iraq, has put a further damper to new construction projects. Furthermore, access to capital for new construction projects will become a driving force and catalyst, determining the speed of an over-supply situation. Today s lodging market is red-hot, and everyone wants a piece of the pie while it is still on the table. Investors with no previous experience with hotel assets are actively seeking an entry-point into the lodging industry, with the aid of inexpensive financing. The lack of scrutiny and due diligence on the part of these investors is likely to result in unwise investments that cannot be supported in an over-supply situation. Anne R. Lloyd-Jones, Senior Vice President at HVS International warns against the purchase of older assets, as many do not conform to current chain standards without major reconstruction. These assets will require large capital infusions, or will succumb to the fate of lesser brand affiliations, which may not fare as well in an over-supply situation. Major hotel companies and lodging REITs with wide presence in most domestic markets, and the support of premium brands are likely to be the winners. Another noteworthy trend is the streamlining of C-Corporations such as Starwood as pure management companies, rather than combined ownership/management companies. Wall Street has not been favorable to a combined ownership/management model, showing a lack of understanding for the real estate s contribution to the overall value of the company. In a recent deal, Starwood committed to the sale of 38 non-strategic assets in the US, Europe, and Latin America to Host Marriott. The deal, valued at roundly $4 billion, represents a new course for the largest US lodging REIT, diversifying its portfolio to include non-marriott branded assets, as well as assets in foreign markets. The deal exemplifies the shortage of viable hotel deals for continued growth for major REITs. Shortage of new supply, combined with the conversion of hotel properties in major US markets to condominiums has resulted in a lack-luster asset pool. The future success of major REITs, particularly large-caps such as Host Marriott, Hospitality Properties Trust, Sunstone and LaSalle, will be dependent upon their ability to grow, meet investor expectations, and provide strong returns to their investors. Limited expansion possibilities might make this difficult, and result in weaker results compared to the unprecedented growth in the past 18 months. WHAT ABOUT REITS? The REITs examined in this article, without taking into consideration dividend earnings a major benefit of holding REITs as investments, showed remarkable strength and resilience during a period of turbulence in the industry. Although, their price growth fell short of that of the C-Corporation sample, the REIT sample illustrated the potential of this type of investment. HVS International, the leading

13 expert in hotel valuations, tracks hotel values throughout the US on an annual basis through the Hotel Valuation Index. The HVI illustrates that hotel values for the US market as a whole increased 33% in 2004, compared to Stephen Rushmore, President of HVS International and a principal of HEI Hospitality a hotel investment company - forecast 58% growth in hotel values in the US as a whole, between 2004 and REITs permit the average investor to partake in this value growth through the purchase of shares. As with any investment, due diligence and research into the management and strategies of the REIT is necessary in order to make the right investment decision. 13