US Real Estate Insights

US Real EstateInsights

June 2012

www.pwc.com/us/realestate

US Real Estate Insights

PwC

Encouraging trends revive interest in industrial assets ..................... 1Highlights the findings and opinions of investors from the recent PwC Real Estate Investor Survey

Investment property entities ................................................................. 5Summarizes the proposed IPE proposal and explains the potential effect on financial reporting

Ownership profile of public lodging REITs .......................................... 9Addresses hotel marketing, the percentage of existing hotel inventory owned by REITs and implications arising from REIT ownership

Contacts ................................................................................................ 13

Contents

While many investors remain focusedon how to capitalize on the burgeoningapartment sector, a growing number ofbuyers are revisiting the reboundingindustrial sector as it continues todemonstrate positive signs of recovery.“Warehouse demand is rapidly pickingup, especially in coastal markets withinternational port access,” notes aninvestor participant of the PwC RealEstate Investor Survey. In fact,industrial absorption levels have beenimpressive even though US economicgrowth has been weak.

In 2011, leasing demand for industrialreal estate grew significantly, allowingthis sector to reabsorb all of the spacevacated during the recent recession.Moreover, nearly all US industrialmarkets reported positive absorptiontrends in 2011 with big-box warehouseactivity outperforming the sector as awhole. Many surveyed investors feelthat leasing demand for distributionspace will remain strong in the comingmonths despite short-term concernsabout economic woes in Europe andthe sluggish US economy.

Investors’ upbeat outlook forwarehouse space is tied to the healingUS labor market, which will lead togreater consumer spending and theconsumption of more goods. “For us,the underlying positive trends, while

sluggish, outweigh the negative onesfor this sector going forward,” states asurveyed investor. When combinedwith the limited amount of new supplyadded to this sector over the past fewyears, a main reason for acquiringindustrial assets now is the potentialfor rent growth. Overall, rent growthassumptions for the Survey’s nationalwarehouse market have increasednearly 235 basis points over the pasttwo years (see Chart 1).

The bullishness expressed bywarehouse investors with regard torent growth potential comes as morewarehouse tenants are staying put. Asshown in Chart 1, the average tenantretention rate for the Survey’s nationalwarehouse market has rebounded overthe past two years, rising from 61.0%at year-end 2009 to 64.8% at the startof 2012. In 2009, when underlyingfundamentals were much softer, thetenant retention rate plummeted asmany warehouse tenants eitherdownsized or relocated due to “betterdeals.” As tenant retention approachesits five-year average (65.4%), thenumber of surveyed warehouseinvestors using rent spikes in their cashflow analyses has jumped from 25.0%in the first quarter of 2010 to 60.0% inthe first quarter of 2012.


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Encouraging trendsrevive interest inindustrial assetsBy Susan Smith

While the desire to acquire warehouseassets at this point in the cycle is notunusual for many investors, the currentinvesting environment is far from“normal.” So, while investors areintently monitoring an array of factors,including the US economy and itsimpact on this sector’s fundamentals,they are also closely watchingdevelopers. Even though additions tosupply have been constrained, ashortage of quality bulk warehousespace is spurring speculativeconstruction and build-to-suit activity invarious markets. As owners of industrialassets know, too much new supplycould easily undermine the recovery ofthe entire sector, as well as many of itstop-performing markets.

Overall cap rate trends

In the first quarter of 2012, the averageoverall capitalization (cap) rate, theinitial return anticipated on anacquisition and a reflection of aninvestment’s anticipated ownershiprisk, decreased in 18 Survey markets,increased in seven of them, and heldsteady in six. Over the past year, thenumber of markets posting quarterly

declines has fallen while the numberreporting either increasing rates or nochange has increased. These trendssuggest that investors see much of thecommercial real estate industrystabilizing. Over the next six months,most Survey participants expect overall cap rates to hold steady in allSurvey markets.

Sector overview

Office

Even though the positive USemployment reports may take sometime to benefit the underlyingfundamentals of the national CBD officemarket, the numbers have instantlybrightened the viewpoints of manyinvestors in the office sector. Evidenceof an improved outlook is reflected inthis Survey market’s initial-year marketrent change rate assumption, whichreported a 300-basis-point increase inits low end of the range in the firstquarter of 2012. In addition, theaverage of this key cash flowassumption increased for the sixthconsecutive quarter, reaching 2.19% inthe first quarter of 2012.


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Chart 1– Tenant Retention and Rent Growth ExpectationsNational Warehouse Market

2.0%

2.5%

3.0%

68.0

70.0

72.0

et

Ren

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on

Rate

(%

)

Tenant Retention Rate

Average Initial-Year Market Rent Change

Rate Assumption

-1.0%

-0.5%

0.0%

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1.0%

1.5%

60.0

62.0

64.0

66.0

4Q07 4Q08 4Q09 4Q10 4Q11 1Q12

Avera

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Source: Pwc Real Estate Investor Survey

In the national suburban office market,overall vacancy was lower at the end2011 than at the start of the year.However, several individual areascontinue to contend with oversupplyissues. “This office market segment isstill weak, but it is stabilizing,”comments a Survey investor. In fact,individual vacancy rates declined in 25of the 37 suburban office areas trackedby Cushman & Wakefield during 2011.In 2010, only 18 individual suburbanoffice markets reported annual declinesin vacancy rates.

As the national suburban office marketshows signs of improvement, certainSurvey investors are becoming moreaggressive with their market rentgrowth rate assumptions. In addition, agrowing number of these investors areusing rent spikes.

Retail

The national regional mall market isstarting 2012 off on a pleasant note,reporting a 20-basis-point decline in itsvacancy rate in the fourth quarter of2011, as per Reis. The decline to 9.2%marks the first downward shift in thepast fourth quarters and comes after the retail sector’s “decent” holiday sales report, as well as positive year-over-year same-store sales growth formany retailers.

In the first quarter of 2012, movementsin this Survey market’s key indicatorssuggest that investors are optimisticthat market conditions will continue toimprove during the year. As the retailsector continues to strengthen and

recover, many regional mall owners arelooking to acquire strong-performingassets. Unfortunately, one Surveyinvestor notes that “very few qualitymalls will be coming to market in theforeseeable future” as most owners arelooking to dispose of less-productivemalls. Such offerings are not likely to be met with much enthusiasm frombuyers given the retail sector’s slow-moving recovery.

Despite ending 2011 with a stagnant USvacancy rate, the national stripshopping center market could be poisedfor a rebound in 2012 due to a lack ofnew supply and steady improvement inthe US economy. Leading this propertysector’s rebound will likely be thegrocery-anchored asset class, whereoccupancy on a national basis isreportedly outpacing other retailproperty categories. As a result,investment demand is expect to heat-upfor centers anchored by dominantsupermarket names.

In the national power center market,dark big-box anchor stores remain aconcern for both existing andperspective owners. While somelandlords have been successful atretenanting empty big-box spaces, theyare filling spaces with nonretail uses,such as medical office space. Investorslooking to acquire power centers assetsreport that prices range from 70.0% to120.0% of replacement cost andaverage 96.7%. For potential buyers,tenancy, location, and quality are keyinvestment criteria.


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Industrial

With tenant demand for warehousespace on the rise, some investorparticipants report less of a need toprovide free rent, as well as a decline inthe amount of the free rent awarded. A year ago, certain landlords wereproviding as much as 12 months of freerent on a ten-year warehouse lease. Inthe first quarter of 2012, the high end ofthe range stands at nine months.

Of particular interest to warehousebuyers are properties located in hot-bedenergy and high-tech markets, likeAustin and San Jose-Silicon Valley,where job gains, leasing demand, and rental growth are expected to leadthe country.

In the national flex/R&D market, therecovery remains very mixed with tech-driven cities, such as San Jose, SiliconValley, and Seattle, seeing the bulk ofleasing demand and declining vacancyrates. For investors looking to acquireflex/R&D assets, most Surveyparticipants believe that marketconditions favor buyers while theremainder believes that conditions areneutral - - equally favoring buyers andsellers. In terms of pricing, investorsreport that prices range from 60.0% to100.0% of replacement cost andaverage 83.5% of cost.

Apartment

Investors are flocking to the nationalapartment market in search of both coreand value-added assets due tostrengthening demand and controllednew supply. As this sector continues to

heat up, investor sentiment has shifteddramatically over the past two years.Then, 87.5% of Survey investorsbelieved market conditions favoredbuyers. Now, 77.8% believe apartmentmarket fundamentals favor sellers, whoare eager to capitalize on a sector whererents are rising.

The Mid-Atlantic, Pacific, and Southeastapartment regions each reveal signsassociated with the recovery phase ofthe market cycle including positivemarket rent growth. In the first quarterof 2012, the Pacific region posted thehighest initial-year market rent changerate average of the three regions,followed by the Mid-Atlantic andSoutheast regions. Despite theseincreases in this key indicator, a fewinvestors note that upcoming cuts in thefederal budget could result indiminished job growth locally and areduction in demand for apartments inthe Mid-Atlantic region.

Roughly 83.0% of Survey investors viewcurrent market conditions in the Pacificregion as favoring sellers whereas theother two Survey regions exhibit a moreequal division between favoring buyers,sellers, or neither party in the currentinvestment environment. For investorslooking to acquire apartment assets, theSurvey indicates that prices range from60.0% to 125.0% of replacement costamong the three regions. The averagesale price is the lowest for the Southeastregion at 94.2% of replacement cost,followed by the Mid-Atlantic and Pacificregions with an average price of 102.0%of replacement cost.


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Susan Smith is a Director inPwC’s Real Estate practiceShe can be reached [email protected]

More information on the PwC Real Estate Investor Survey™can be found at www.pwc.com/us/realestatesurvey or bycalling 1-800-654-3387.

In October 2011, the FASB issued anexposure draft related to investmentproperty entities (“IPE”). The proposalwould fundamentally change financialreporting for many owners of andinvestors in rental real estate. It couldimpact not only traditional real estateinvestors (including both public realestate investment trusts (REITs) andprivate real estate funds) but also non-traditional real estate and integralequipment owners, such as owners ofpower plants, cell towers, andpipelines. In February 2012, the FASBheard from constituents on this project.In short, the proposal was not wellreceived. Although intended to betteralign US GAAP with IFRS and reducediversity in accounting for investmentproperty, most respondents believe theproposal will not accomplish these

goals in its current form. Beforeanalyzing the responses and how theymight impact the future outlook for theproposal, let’s start with some historyand interaction between this proposaland other emerging standards.

History of the project

The impetus for the proposed IPEstandard was twofold: (1) to betteralign US GAAP with IFRS as part of theFASB and IASB’s joint lease accountingproject, and (2) to narrow the diversityin practice related to accounting andreporting by certain real estate entities.Under the lease accounting project asoriginally exposed in 2010, entitiesthat report under IAS 40, InvestmentProperty, and elect to measure all oftheir investment property at fair valuewould have had a scope exception from


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Investment propertyentitiesBy Lou DeFalco

Comment letter trends for investment property entities

6%

62%

24%

88%

3%

52%

6%

35%

24%

Support proposal in

current form

Support current IFRS

model

Support fair value for all

real estate

Yes No Unclear

applying the proposed lessoraccounting model. That reflected theIASB’s view that fair value is moreinformative and represents a preferredmodel for accounting for these types ofinvestments, including their relatedleases. Earlier in its lease project, theFASB agreed to a similar scopeexemption for real estate lessorsmeasuring investment property at fairvalue. However, without the proposedIPE standard, there would be no USstandard allowing most entities tomeasure investment properties at fairvalue and no basis for excludinginvestment properties from proposedlessor accounting. To address thisdichotomy, the FASB added theinvestment property entities project toits agenda.

The proposed standard also representsan attempt to narrow diversity inpractice by certain real estate fundentities. Significant diversity exists inmany areas including, incomerecognition, consolidation, andpresentation and disclosure becausethere is no authoritative guidance tosupport the different methods used byreal estate investment funds to reportfair value. In recent years, differentways to address this diversity wereexplored. For example, in 2007 theAICPA undertook a project to amendthe definition of an investmentcompany and determine when a parentor equity method investor should retainthe specialized accounting to accountfor an interest in an investmentcompany. That project resulted in theissuance of SOP 07-1. However, anumber of implementation issues arosewith the SOP and the FASB deferred itindefinitely. On other occasions, boththe AICPA and the EITF triedunsuccessfully to tackle this diversity.The current project on IPEs and asimultaneous project on investmentcompanies are now considered thesolutions to address that diversity inpractice by real estate investment funds.

Interaction with other emerging standards

The proposed leasing standard

As the FASB and IASB continued todebate the lessor accounting model, asurprise tentative decision was reachedin October, 2011 to expand the lessoraccounting scope exemption to allinvestment properties, irrespective ofwhether such properties are recorded atfair value or historical cost. Thistentative decision caused many toquestion the need for an IPE standard.Public REITs and other similar entitieswould only tend to favor fair valuereporting for their investmentproperties if it was the only way toavoid applying the proposed lessoraccounting model. This is becausemany would argue that measuringinvestment properties at fair value isless complex (and provides betterinformation to financial statementusers) than applying the lessor“receivable and residual” approachunder the lease accounting proposal.Nevertheless, quarterly reporting of fairvalues for all investment propertieswould still be a significant undertakingand likely not supported by suchentities if not necessary in order toreceive a scope exception from theproposed leasing model.

Interaction with proposedinvestment company andconsolidation standards

An entity that is not registered underthe Investment Companies Act of 1940would first evaluate whether it is aninvestment property entity. If not, itwould then assess whether it meets thedefinition of an investment company.Many aspects of the two definitionsoverlap, but there are some differences.In addition, the combination of theproposed changes in consolidation,investment property entities, andinvestment companies could affectmany real estate funds. Today, theseentities often apply fair value

accounting, but substantial diversityexists in the application of thataccounting. The combination of thethree proposals could lead to moreconsistent financial reporting, althoughit may result in substantial changes forsome entities.

Key aspects of the proposal andspecific constituent feedback

Some of the key issues in this proposalarise in the areas of (1) scope; (2)measurement; (3) consolidationprinciples and (4) presentation anddisclosure. For more detailed analysisof the entire proposed standard, refer toDataline 2011-34: Investment PropertyEntities – The good, the bad and the ugly.

Scope, scope, scope

The FASB spent considerable timedeveloping the definition of aninvestment property entity to ensurethe “right” entities are within scope.However, the analysis is expected to becomplex, and may not meet the FASB’soriginal objectives. Certain definedcriteria related to an entity’s businesspurpose, activities, and capitalstructure must be met by an entity to bein the scope of the guidance.

Critical to the analysis is that the entitymust have a defined strategy to exit itsreal estate investment(s). Some believethat qualifying under the guidance maybe difficult for entities that do not planon selling properties in their coremarkets. This may be particularlychallenging for many current propertyREITs. Often, capital appreciation isrealized by investors in REITs throughtheir sale of the stock, rather than bythe entity from the sale of individualproperty investments.

Specific constituent feedback on scope

Many of the responses focused onpotential scope problems andattempting to understand whethercertain outcomes of applying the scope


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criteria were intentional or unintendedconsequences. In particular, the “natureof business” criterion—which requiressubstantially all of an entity’s activitiesto consist of investing in real estate—attracted a number of comments. Somenoted that investments made throughnon-controlled joint ventures would notbe included when measuring whether“substantially all” of the entity’sactivities consist of investing in realestate. Depending on the size of suchinvestments relative to the entity as awhole, this could be a determinativefactor in whether or not an entityqualified as an IPE. Many questionedwhy that would be the case.

In addition, constituents want someclarity around the requirement for anentity to have a defined exit strategy forits real estate investments. Specifically,what constitutes an exit strategy andhow must it be demonstrated?Accordingly, further clarification maybe necessary from the FASB todetermine how the test for a “definedexit strategy” for the entity would be applied.

Measurement—more changes ahead

The proposal outlines certainmeasurement requirements, many ofwhich are positive for real estateentities. Consistent with most realestate funds today, lease revenue wouldbe required to be recognized based onthe contractual terms of the leaseagreements (rather than on a straight-line or other basis) because future rentescalations are already considered inthe real estate valuation. However, thisdecision has the potential to getrevisited based on an IASB decisionunder the joint leasing project tomaintain the requirement to recordrental revenue on a straight-line basisfor investment property recorded at fairvalue under IAS 40. Based on that

decision reached in December of 2011,the FASB may re-explore whetherstraight-line rental recognition isrequired for investment propertymeasured at fair value. Another positivemeasurement change relates to theinitial measurement of real estateproperties acquired in a businesscombination. Entities would no longerhave to separate and allocate purchaseprice to lease intangible assets forexisting leases.

However, some changes may be morechallenging to apply. One example: theproposal allows investors who reporttheir investments at fair value to reportthose investments at their “net assetvalue” (NAV) as a practical expedient,as long as investors in such entitiestransact at the reported NAV. Theproblem is certain open-end fundstructures may not always transact atthe reported NAV. Other entities maynot transact at all if they are closed-endfunds. This could preclude an investorin such an entity from using thispractical expedient. Another exampleincludes the measurementrequirements under the proposalregarding liabilities. An IPE wouldmeasure its financial liabilities (forexample, debt) in accordance withother applicable US GAAP, notnecessarily fair value.

Specific constituent feedback on measurement

As expected, the measurementprovisions described above as more“difficult to apply” were not favored bymost respondents. The requirement totransact at NAV is not supported by“investment entities.” Why? It mayreduce their ability to use the practicalexpedient, even if NAV approximatesfair value. Most respondents believe anNAV practical expedient is appropriateif the reported NAV is a valid

approximation of fair value, ascontained in the current literature.They do not believe an incrementalrequirement for an entity to transact atthe reported NAV is necessary. Many“investment entities” disagree stronglywith the requirements to measurefinancial liabilities in accordance withother applicable US GAAP. They citethat a fair value NAV is the mostrelevant metric for their users. Thepotential elimination of the option toelect fair value treatment for theseliabilities may cause significantconcerns for real estate “investmententities.” The inability to record suchliabilities (particularly property level,non-recourse debt) at fair value wouldcause large problems in presenting anNAV which was indicative of fair value.This also presents a carry-over impacton an entity’s ability to transact at thereported net asset value “NAV”prepared in accordance with US GAAP,and therefore, use of this NAV as a fairvalue practical expedient.

Consolidation requirements

The proposal would require that aninvestment property entity consolidatecontrolling financial interests in: (1)another investment property entity; (2)an investment company; or (3)operating entities providing services tothe investment property entity. Othercontrolling financial interests would bemeasured at fair value.

Specific constituent feedback on measurement

In general, “operating entities” supportthese requirements. The story isdifferent for “investment entities,”where there are mixed views regardingthe proposed consolidation rules. Somewould prefer that today’s consolidationguidance for investment companies beretained (that is, generally noconsolidation and reflecting controlling


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financial interests at fair value on a netbasis). Others, predominantly thosewho want to present real estate on agross basis, do support the proposedconsolidation rules.

Presentation and disclosure—fair value does not always mean“net” reporting

The FASB has proposed grosspresentation and disclosure principles.An investment property entity wouldpresent the fair value of investmentproperties held separately from anyassociated debt in the balance sheet. Inaddition, rental revenue frominvestment properties and relatedrental operating expenses would bepresented on a gross basis. Theseproposals will represent a significantchange for many fair value reportingreal estate funds that currently presentinvestments and related activity on anet basis.

Specific constituent feedback onpresentation and disclosure

Most “investment entities” seem to favoran option for gross or net presentationto allow flexibility to apply the mostappropriate presentation based on theinvestment strategy. Those preparerswould lean toward gross presentation

for “core” investments (that is, whereincome yield from the property is aprimary aspect of the investmentstrategy). For those investments thatare more “opportunistic” in nature (thatis, capital appreciation is the primarydriver of the investment strategy), netpresentation might be preferred and isperceived to be more meaningful to theinvestors in such funds. As for the“operating entities” most seem to favora gross presentation which is similar tohow such entities report results today.

What’s next?

The FASB held roundtable discussionsin the spring and is expected to beginredeliberating soon. Given the feedbackso far, it is unclear how the project mayproceed. The FASB’s emphasis appearsto be on finalizing the proposedinvestment companies’ standard firstand potentially incorporating some ofthe aspects of the IPE proposal into theinvestment companies standard,specifically for real estate funds. TheFASB will also likely revisit theinvestment property scope exclusion inits proposed leasing standard thissummer which could directly impact thefate of the IPE standard. Stay tuned inthe coming months as there is certainlymore to come on this topic.


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Lou DeFalco is a Senior Manager inPwC’s National ProfessionalServices Group He can be reached [email protected]

During 2011, public lodging real estateinvestment trusts (“REITs”), were themost active buyers of hotel real estate,with $7.2 billion of acquisitionsrepresenting 37 percent of commercialreal estate transaction activity by dollarvalue, according to Real CapitalAnalytics1, a commercial real estateresearch provider. In 2012, throughMarch, public lodging REITs acquiredapproximately $551.0 million of hotelreal estate. Indeed, public lodgingREITs were the largest net acquirers ofhotels in both 2010 and 2011, whileother investors, including otherinstitutional investors such as privateequity firms, were net sellers.

This draws renewed attention to theimportance of public REIT ownershipin the lodging sector, and raises keyquestions. While estimates place theREIT ownership share of overallinstitutionally-owned commercial realestate at 10 to 15 percent on a propertyvalue basis2, specific information onREIT ownership of hotels is less readilyavailable. What share of the lodgingasset inventory in the US is currentlyowned by public lodging REITs? Whatare the characteristics of the REIT-owned hotel base, how does it differfrom the broader US lodging industry,and what are the implications for REITinvestors and other market participants?

To address these questions, PwCconducted a hotel-by-hotel analysis of1,036 hotels owned by public lodgingREITs in the US, which we refer to inthe remainder of this article simply asREITs (key terms, analytical steps, andsources are discussed in the ResearchBackground side bar). Results point to a focus of REIT ownership on upper-tier hotels in top markets, and showample room for further deployment of capital through this type ofownership structure.

Our discussion of these results followsa three-part structure, beginning witha look at market segmentation: Whattypes of hotels are currently owned byREITs? With this understanding of theprevailing REIT investment blueprintin mind, we examine marketpenetration by REITs along certain keyparameters to address the question:What share of the existing hotelinventory is already owned by REITs?Lastly, we close with comments on implications.

REIT criteria: Location, location, location?

Are there any specific characteristicsthat public REITs look for in hotels?Are the hotels owned by public REITs“typically” upper-tier or “almost


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Ownership profile ofpublic lodging REITs By Aran Ryan and Abhishek Jain

1 Real Capital Analytics (RCA), (April 2012) Hotels Trends & Trades report. Retrieved fromwww.rcanalytics.com/trendsandtrades.aspx2 National Association of Real Estate Investment Trusts (NAREIT). (2012, January 4). 2011 REIT Returns are FourTimes Those of S&P 500 [Press release]. Retrieved from http://www.reit.com/portals/0/PDF/NAREIT-2011-REIT-Market-Report.pdf

exclusively” upper-tier? Is REITownership concentrated in certainmarkets? Is there a “REIT-type” hotel?In considering these questions, wefocused on the following fundamentalhotel characteristics:

• Market type (whether the hotel islocated in one of the top 25 marketsin the US, another metro area, or in anon-metro area);

• Location type (whether the hotel islocated in a local area categorized asurban, suburban, airport, resort, or rural);

• Size (hotel room count)

• Brand affiliation (whether the hotel isaffiliated with a major brand, oroperates as an independent property)

• Market positioning (the hotel’spositioning in terms of characteristicssuch as price and facilities, asmeasured by Smith Travel Researchchain scale segmentation, e.g. luxury,upper upscale, upscale, uppermidscale, midscale, economy);

Location emerged as a key criterion inour research. Hotels located in metroareas offer investment characteristicsthat are often attractive to institutionalinvestors such as REITs. Major marketstypically offer a diverse base of demandgenerators, barriers to the entry of newsupply, potentially more favorableattributes for debt financing, andexpected depth in the potential pool of future buyers for the hotel asset upon exit.

The combined result of such locationbenefits is evident in the statistics onREIT ownership in the top 25 metroareas, measured by number of hotelrooms (“top 25 markets”). Based on ourresearch, 67 percent of REIT-ownedrooms are located in the top 25 markets.In comparison, only 31 percent of all UShotel rooms are located in these markets.

The concentration of REIT ownership issimilarly evident when considering thetype of hotel location, as 72 percent ofthe rooms owned by REITs are locatedin urban and suburban areas (comparedto 51 percent for the US overall), withanother 14 percent in airport locations(compared to six percent) and 11 percent in resort areas (compared to 12 percent), while only three percent ofREIT-owned rooms are located in rurallocations (figures reflect rounding),which includes small metros andinterstate locations (compared to 30 percent).

These location concentrations are a keycharacteristic of REIT ownership in theUS. However, concentrated ownershipin major markets also reflects the focusof REITs on large, brand-affiliated,upper-tier hotels, as such hotels are also most heavily concentrated in urban areas.

As background on these last three characteristics, we observed the following:

• Size: Over 75 percent of REIT-ownedhotels have more than 150 rooms,compared to 38 percent of all US hotels.

• Brand affiliation: Approximately 97 percent of the REIT-owned hotelinventory is affiliated with one of themajor lodging chains, compared to 69 percent of all US hotel inventory.

• Market positioning: REIT ownershiptends to focus on upper-tier hotels,with 55 percent of REIT-owned hotelinventory being classified by SmithTravel Research as being in the luxuryor upper upscale chain scalesegments, as compared to 13 percentof all US hotel inventory. Another 27 percent of REIT-owned hotels arein the upscale segment, compared to12 percent for the US overall.


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The relative concentration of REITownership of certain types of hotels isexpressed graphically in the chart above.

Recognizing the close connectionbetween location, size, brandaffiliation, and market positioning, weperformed a regression analysis. Thepurpose was to gain a betterunderstanding of the independentimportance of each characteristic, whileholding the other factors constant. Theresults support the overall pictureevident in the concentrationpercentages. In summary, hotels thatare most likely to be owned by REITsare those that are in urban, suburban orairport locations within metro area

markets; offer a greater number ofguest rooms; and which are affiliatedwith a luxury, upper upscale, or upscale brand.

Market penetration. What shareof hotel inventory is alreadyowned by REITs?

Have REITs achieved similar marketpenetration in the lodging sector as hasbeen achieved in other commercial realestate sectors? From one perspective,we can consider that REITs own onlyapproximately five percent of the totalUS hotel inventory. However, given thebreadth of US hotel inventory, thatstatistic is of limited relevance. To moredirectly address market penetration, we

sought to see if it was possible tonarrow the focus to a portion of thelodging sector that represents “REIT-type” hotels.

In particular, we considered the hotelcharacteristics that were common tomany REIT-owned hotels in the firstpart of our analysis. Based on thesecharacteristics, we set out ahypothetical definition of a REIT-type hotel as one that has thefollowing characteristics:

• More than 150 rooms;

• Located in an urban, suburban, resortor airport location; and,

• Affiliated with a lodging brand in the luxury, upper upscale orupscale chains.

Of the 1,036 hotels owned by REITs,459 fit all three criteria of thishypothetical definition, 312 meet twocriteria, and the remaining 265 hotelsmet one or none of the criteria. Thisindicates that while there are numerousREIT-owned hotels with a different mixof characteristics, almost half of REIT-owned hotels fit the hypotheticaldefinition of a REIT-type hotel.

Given this finding, we were curious toconsider it in context of the broader USlodging sector. Of the hotels that meetthis narrow, core, REIT-typeclassification, what share is alreadyowned by REITs? We analyzed all UShotels, and found approximately 2,755hotels would qualify to be a REIT-typehotel by this working definition,equivalent to 19 percent of total USroom inventory. Of these 2,755 hotels(approximately 911,000 rooms), theREIT inventory of 459 hotels(approximately 163,000 rooms), isequivalent to 18 percent by room count.Within the top 25 markets, REITs own21 percent of REIT-type hotel rooms.Similarly, REITs own approximately 19, 21 and 12 percent of all REIT-type


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Figure 1: Public REIT Ownership by Hotel Type – Premium to Fair Share

Airport

Urban

Upscale

Luxury

Upper Upscale

Fair share = 100

- 50 100 150 200 250 300 350 400 450

Top 25 Markets

More than 150 rooms

Chain Affiliated

Resort

Suburban

Source: Smith Travel Research and PwC

Note: Premium to fair share is calculated based on the share of a particular type of hotel in REIT portfolios relativeto the share of such hotels in the US. For example, the REIT ownership premium to fair share in the Urban hotelscategory is 238, which is calculated as the share of REIT-owned hotels that are urban hotels (37 percent) dividedby the share of all US hotels that are urban (15 percent), multiplied by 100.

rooms in the luxury, upper upscale andupscale chain scale segments,respectively. In many of these markets,major lodging C-corps also havesubstantial holdings.

Overall, these findings indicate that theconcentration of hotel ownership withinpublicly traded REIT structures isbroadly similar to the broader REITownership of 10 to 15 percent ofinvestment grade commercial realestate, as reported by NationalAssociation of Real Estate InvestmentTrusts (NAREIT).

Implications

We identified three key conclusionsfrom this analysis:

• The aggregate portfolio of REIT-owned hotels is heavily concentratedin the top 25 markets and upper-tiersegment of the market (luxury, upperupscale and upscale chain scalesegments). Because performancetrends in major metro markets, andluxury and upper upscale segmentsexperienced more extreme cyclicalpeaks and troughs in the most recenteconomic cycle than the broader USlodging sector, it’s important thatREIT investors follow not onlybroader US lodging performance, but also trends within relevant cross-sections.

• REITs own 18 percent of the larger,metro area, upper-tier hotels in theUS that met a working definition ofREIT-type hotels, and 22 percent ofsuch REIT-type hotels in the top

25 markets. This market penetration,and the fact that only a subset of allUS hotels is transacted each year,indicates that there is ample room forREITs to continue to account for asubstantial portion of hotelacquisition activity before reaching anunreasonably high market penetration.

• In addition to the acquisitionpotential within the base of large,upper-tier hotels in major markets,there are other segments of thelodging industry that remain largelyuntapped by public REITs. REITs ownsignificantly less than their fair shareof limited service, as well asindependent hotels, which includesproperties positioned as upper-tierboutique hotels. REITs own less thanone percent of all independent hotelrooms and approximately two percentof upper midscale and midscale hotelrooms in the US. The upper midscalesegment has experienced solid supplygrowth in the last 10 years, in partdue to evolving guest preferences.Though such properties havenumerous operating anddevelopment process differences fromhotels typically owned by REITs, therehave been recent signs that publicREITs are becoming more active inthe acquisition of both independent,as well as limited-service hotels. In2011, public REITs accounted forapproximately 32 percent and 37percent of limited service andindependent hotel acquisitions bydollar value, respectively.3


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Aran Ryan is a Director in PwC’sFinancial Instruments,Structured Products and RealEstate practiceHe can be reached [email protected]

Abhishek Jain is a Manager inPwC’s Financial Instruments,Structured Products and RealEstate practiceHe can be reached [email protected]

Research backgroundWe analyzed the ownership of theexisting inventory of hotel rooms inthe US on a hotel-by-hotel basis,based on data provided by SmithTravel Research as of March 2012. Intotal, the analysis included 52,153 UShotels, with approximately 4.9million rooms, including 225 hotelswith approximately 141,000 rooms inLas Vegas. Our analysis focused onownership by 17 publicly-tradedlodging REITs, and does not includehotels owned by other publicly-tradedorganizations, including lodging C-corps, and private REITs. Percentagesreported in the article are calculatedbased on room count, unlessotherwise specified. Chain scalesegments are a method by whichbranded hotels are grouped based onthe actual average room rates of eachbrand. Independent hotels, regardlessof average room rates, are included asa separate chain scale category. Thechain scale segments are: luxury,upper upscale, upscale, uppermidscale, midscale, economy andindependents. Additional informationon which brands are included in eachof the chain scales can be obtainedfrom Smith Travel Research.4

3 Real Capital Analytics (RCA), (April 2012) Limited Service and Boutique Hotels Trends & Trades report. Retrieved from www.rcanalytics.com/trendsandtrades.aspx4 http://str.com/documents/2011_STR_US%20Chain_Scales.pdf

Byron Carlock US Real Estate Leader (214) 754 7580 [email protected]

Tim ConlonUS Real Estate Assurance Leader (646) 471 [email protected]

Paul RyanUS Real Estate Tax Leader(646) 471 [email protected]

Mitch RoschelleUS Real Estate Business Advisory Leader(646) 471 [email protected]

Brian NessPartner, Real Estate Assurance Practice(646) 471 [email protected]

Martin SchreiberPartner, Real Estate Business Advisory Practice(646) 471 [email protected]

Justin FrenzelManager, Real Estate Assurance Practice(646) 471 [email protected]

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