The Strange Case Of Lodging REITs

Marriott is one of the most famous hotel brands in the world. A significant portion of Marriott’s hotels are owned by Host Inc., a lodging REIT that reports around $3 billion in revenue but effectively pays no taxes, has only 163 employees, an abnormally low CEO-to-median pay ratio, and a replacement-proof board of directors. Remarkably, their books look as though Host owns and actively operates their hotels.

My earlier piece on muscle-lite companies such as Marriott that seem to leave much of their labor force in off-balance sheet (OBS) entities generated quite a few inquiries and requests for a deeper analysis of the issue. Marriott is affiliated with the largest lodging real estate investment trust (REIT) in the country named, Host Hotels and Resorts Inc. Lodging REITs are strange muscle-lite animals and suffer from several reporting and governance deficiencies, as detailed below. I had meant to cover the strange case of lodging REITs in my earlier piece when I reviewed Marriott’s practices, but ran out of space and time. Before we get to that, let us try and understand what lodging REITs are and how Host, the largest one, is organized.

What are lodging REITs?

Before my review of Marriott, I initially understood REITs to be passive investing vehicles that enjoy tax-free income that is passed through and hence taxed in the hands of the investees. Internal Revenue Service rules require that for REITs to maintain their status as tax-free entities, they are prohibited from operating and managing hotels. So, how does Host Inc, the largest publicly traded REIT, get around this? By creating a subsidiary known as Host Limited Partners (L.P).

As per the organizational structure depicted in the figure below from its 2021 10-K, Host Inc is registered as a publicly traded REIT and its only major asset is its ownership interest of Host Limited Partners (L.P.), which is not publicly traded. So, Host Inc. by itself does not conduct any of the lodging business. Host L.P. owns the hotel properties and contains several unconsolidated joint ventures. Almost 99% of the L.P.’s ownership is held by the publicly traded REIT.

REITs are restricted from earning more than a tiny percentage of their income from non-qualifying activities such as management fees. To get around that restriction, Host Inc. leases several hotel properties to taxable REIT subsidiaries (known as TRS), as shown in the figure below. Because IRS rules do not allow Host Inc. to operate and manage hotels, the TRS entities have contracted with third party hotel managers such as Marriott and Hilton to conduct the day-to-day operations of the hotels. Ironically, as I have written before, Marriott itself relies heavily on OBS labor to run its ecosystem of hotels.

The taxable REIT takes the profits from the hotel operations. Host approves the budgets that these third-party managers can spend in running the hotels.

Remarkably, Host’s books look more or less as they would if Host Inc. owned and operated their hotels like any other standard business. Why? Because GAAP (Generally Accepted Accounting Principles) works well if an entity owns 50% or more of another entity in that the subsidiaries’ books are required to be consolidated or the legal veils shielding off balance sheet protection are pierced. This improved financial reporting practice was put in place after the Enron debacle.

As of December 31, 2021, Host Inc. reported roughly $10.5 billion of owned and leased properties and $800 million of cash on its balance sheet. These assets are financed by $5.3 billion of debt and the rest with equity. Host Inc. reports revenue of $2.8 billion, comprising of $1.8 billion from room rent and $674 million from food and the rest from other sources. These revenues look fairly similar to that of a regular hotel operation.

Why weave such a complex web?

You must rightly wonder why weave such a complex web. I suspect this elaborate legal engineering fetches the following advantages:

Tax savings

As stated clearly in its risk factors on page 26 of its 10-K, if Host Inc. and Host L.P. fails to qualify as a REIT, the two entities will have to pay federal and state income taxes on its income. REITs are not taxed on the dividends distributed to their shareholders, which have to be at least 90% of their taxable income.

The years 2021 and 2020 are unrepresentative of the economics of the hotel industry, on account of Covid. Hence, I went back to 2019 to gauge what profitability looked like in normal times. In 2019, Host Inc. reported $3.4 billion in revenues, $800 million in operating profits, and $932 million in net income. Of course, these numbers are almost identical to that of Host L.P. whose balance sheets and income statements are also disclosed.

At the appropriate federal tax rate, footnote 7 of Host’s 2021 10-K states that Host would have paid $202 million in taxes in 2019. Instead, Host Inc. reported a tax expense of $30 million at an effective tax rate of barely 3% — because 90% of that income was distributed as dividend and escaped corporate taxes.

What would paying the full corporate tax rate do to Host Inc.’s valuation? Assuming the price to forward earnings ratio of 32 for Host Inc. does not change, the REITs market capitalization would probably fall from $14 billion on April 14, 2022 by about $5.5 billion (an estimate that comes from taking the $202 million in estimated federal taxes, minus the $30 million paid, and then multiplied by 32). In reality, the price-earnings ratio itself would also fall – suggesting that the loss of the tax advantage would hurt even more.

Page 81 of the 10-K, which explains Host Inc’s accounting policies, states that “the accompanying consolidated financial statements include the consolidated accounts of Host Inc., Host L.P. and their subsidiaries and controlled affiliates, including joint ventures and partnerships. We consolidate subsidiaries when we have the ability to control them.” The irony is that Host Inc. and Host L.P. are treated as interchangeable by U.S. GAAP as a classic hotel business, but not seemingly so by the IRS.

What about taxes of the TRS?

The word, “taxable” in the Taxable REIT Subsidiaries is a bit of a misnomer. By setting the leasing fee that the TRS pays to its parent REIT to all of the profits of the hotel the TRS manages, the TRS reports no profits. That is, the hotel’s profits have now been transferred to the REIT which, itself, is tax-exempt.

TRS are de-facto hotel operators?

TRS entities sound like de-facto hotel operators. If not, why devote extensive sections of the 10-K (see page 35 and 36) to discuss major hotel revenue generators? The filing includes long explanations of room revenues, food and beverage revenues, attrition and cancellation fees, resort and destination fees, parking, golf courses, spas, entertainment and other guest services, room expenses, beverage expenses real and personal property taxes, ground rent, equipment rent and property insurance, and depreciation and amortization expense on the hotel properties.

Hence, it appears as though TRS can continue to be de-facto hotel operators and the REIT that owns them can continue its REIT status. Page 27 of Host Inc.’s 10-K states that “a REIT may own up to 100% of the equity interests of an entity that is a regular C corporation for federal income tax purposes if the entity is a TRS. A TRS may own assets and earn gross income that would not be considered as qualifying assets or as qualifying gross income if owned or earned directly by a REIT, including revenues from hotel operations.”

Potential debt default and lower acquisitions

Host L.P has outstanding debt to the tune of $4.9 billion at the end of 2021. Host L.P. pays interest of around $191 million in 2021 at a miniscule average rate of 3.8% (191/4900). The cost of equity is surely higher. Losing the tax deduction will force Host Inc. to substitute some of its debt with risky and hence more expensive equity that would cost them around 8% (assuming the Capital Asset Pricing Model (CAPM) given that Host Inc.’s beta is 1.29, 10-year T-Bill rate is 2.7% and I have assumed a market risk premium of 5%). Moreover, paying taxes would further strain Host Inc’s ability to pay interest.

Host’s operating cash flows for 2019 were a healthy $1.25 billion after deducting interest. Losing the tax-exempt status for 2019 would have reduced cash flows available for acquisitions. Note that this cushion is not available to a standard hotel company that is not organized as a lodging REIT. Host is a voracious acquirer of hotels. Between 2019-21, Host LP made acquisitions of $2 billion of new properties.

Muscle lite and labor cost arbitrage

On the surface, Host Inc. has around 80 hotels, 45,000 rooms, $2.9 billion in revenues in 2021 but only 163 employees!

These 45,000 rooms do not clean themselves, of course. The employees who actually do the cooking and cleaning are effectively off-balance sheet (OBS) and somewhat untraceable.

Host Inc’s 2021 10-K states, “the employees at all of our U.S. and Canadian hotels are employees of our third-party hotel managers, who are responsible for hiring and maintaining employees.” Strangely, page 43 of the 2021 10-K states, “the most significant expense for the rooms, food and beverage, and other departmental and support expenses is wages and employee benefits, which comprise approximately 55% of these expenses in any year.” These labor costs do not appear as compensation on Host’s income statement because the labor is housed in the books of third-party hotel managers.

A curious statement was made by the American Hotel and Lodging Association (AHLA) in their April 8, 2020 letter to Congress while lobbying for payroll protection program (PPP) for TRS structures: “In the hotel and lodging industry, the eligible borrower for a PPP loan is the business entity responsible for employee payroll, benefit, and insurance expenses.”

They go on to say, “the property owner – or in the case of a REIT, a Tax REIT Subsidiary (TRS) who leases the property from the property owner – remains legally responsible, via the management contract, for reimbursing the third-party management company for all operating expenses, including employee payroll, benefit, and insurance. PPP loans are intended to provide a bridge for critical operating expenses, including payroll expenses. In the example provided above, the eligible PPP borrower would be the property owner or TRS, even though employees are employed by the management company.”

What are the implications of such a structure?

ESG statements sound hollow

Host’s 2020 sustainability report boasts of positive recognition from Dow Jones Sustainability Index, the CDP, ISS, the Newsweek list of most responsible companies, and among the 25% of the Green Street Advisors. One has to wonder whether these ratings agencies asked about the missing workers on Host’s books.

What about post Covid taxpayer funded concessions?

The CARES Act and subsequent pandemic relief bills provide significant benefits to public companies including REITs. The most important, among these, were enhanced carryback of NOLs (net operating losses) and accelerated depreciation allowance. The Treasury Department appears to have bought Host Hotels and Resorts corporate bonds during the early days of the pandemic.

For example, the Host 2021 10-K, p.44, says:

“In 2021 and 2020, we recorded an income tax benefit of $91 million and $220 million, respectively, due primarily to the domestic net operating loss incurred by our TRS. As a result of legislation enacted by the CARES Act in 2020, a portion of the 2020 domestic net operating loss was carried back to 2017-2019 in order to procure a refund of U.S. federal corporate income taxes previously paid. The remaining portion of the 2020 net operating loss, as well as the entire 2021 net operating loss incurred by our TRS, may be carried forward indefinitely, subject to an annual limit on the use thereof of 80% of annual taxable income.”

Greater need for workplace disclosures

I could not figure how many workers are involved in running the actual hotels and the 45,000 rooms, what these workers are paid and how they might be treated. The tragedy is that the “human capital” section of Host Inc.’s sustainability report goes to great lengths to present itself as a caring and nurturing employer. Without better workplace disclosures for the entire ecosystem of rooms, an investor would never fully know whether such care extends to the missing workers in Host’s ecosystem.

Replacement proof board?

Page 21 of the 10-K includes a rather strange statement: “Removal of members of the Board of Directors. Host Inc.’s charter provides that, except for any directors who may be elected by holders of a class or series of shares of capital stock other than common stock, directors may be removed only for cause and by the affirmative vote of stockholders holding at least two-thirds of all the votes entitled to be cast in the election of directors. Any vacancy resulting from the removal of a director by the stockholders may be filled by the affirmative vote of holders of at least two-thirds of the votes entitled to be cast in the election of directors.”

Does this effectively mean that directors can never really be removed as corralling 67% of the votes is very difficult? Blackrock, State Street, Cohen and Steers and Vanguard collectively own 39% of Host Inc as per its 2020 proxy statement. The combined might of these four black holders is insufficient to fire or appoint a director.

Abnormally low CEO pay ratio

The 2020 proxy statement states that the Host Inc.’s CEO pay (around $10 million) compared to the median employee pay (of $196,338) is a ratio of 51:1, which is among the lowest in the S&P 500. The median employee, of course, comes from the pool of 163 workers in the company. Surely, the CEO pay-to-median-employee ratio would be far higher if the median worker pay in the whole ecosystem of the 45,000 rooms were considered. The median worker in the 45,000-room ecosystem is unlikely to be paid $196,000.

The reported average median pay of Marriott and Hilton employees is $36,710. If we used that median pay for Host, the CEO to worker pay ratio would be 314:1, more than six times higher than what Host reported, a figure that could call into question much of Host’s ESG reporting.

Muscle Lite Companies Need More Scrutiny

In general, accounting, governance, and reporting deficiencies at legal arbitrages such as Host Inc. need to be scrutinized more closely by Main Street and ESG investors. And, before you dismiss Host Inc. as an isolated case, note that the NAREIT’s list of publicly-traded lodging REITs is quite extensive and includes at least 17 entities including Apple Hospitality REIT (NYSE:APLE), Summit Hotel Properties (NYSE:INN), Park Hotels & Resorts (NYSE:PK), Hersha Hospitality Trust (NYSE:HT) and Pebblebrook Hotel Trust (NYSE: PEB).

I suspect that investors will discover many more muscle lite, tax lite and asset lite structures in other industries, should they want to look carefully.