EXPLORING THE PAIRED SHARE REIT
and
QUANTIFYING ITS TAX ADVANTAGE
By
Julie D. Walpole
B.S. Mechanical Engineering
Case Western Reserve University, 1988
SUBMITTED TO THE DEPARTMENT OF URBAN STUDIES AND PLANNING IN
PARTIAL FULFILLMENT OF THE REQUIREMENTS FOR THE DEGREE OF
MASTER OF SCIENCE IN REAL ESTATE DEVELOPMENT
AT THE
MASSACHUSETTS INSTITUTE OF TECHNOLOGY
SEPTEMBER 1998
D 1998 Julie D. Walpole. All rights reserved.
The author hereby grants to MIT permission to reproduce
and to distribute publicly paper and electronic
copies of this thesis document in whole or part
Signature of Author:.
Department of Urban Studies and Planning
July 31, 1998
Certified by:
Accepted by:
W. Tod McGrath
Lecturer, Department of Urban Studies and Planning
Thesis Supervisor
I
~-'---
-
William C. Wheaton
Chairman, Interdepartmental Degree Program in Real Estate Development
MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
OCT 2 3 1998
LIBRARIES
ROTCH
EXPLORING THE PAIRED SHARE REIT
and
QUANTIFYING ITS TAX ADVANTAGE
By
Julie D. Walpole
Submitted to the Department of Urban Studies and Planning
On July 31, 1998 in Partial Fulfillment of
Master of Science in Real Estate Development
ABSTRACT
Real Estate Investment Trusts (REITs) were established in 1960 by Congress to open real estate
investing to the small investor, in the same way that mutual funds have allowed small investors
access to a diversified portfolio of stocks. As is the case with mutual funds, REITs enjoy a
conduit status, allowing them to avoid corporate level taxation as long as they meet certain
requirements. These requirements have been designed and legislated to ensure that REITs
remains passive owners of real estate.
As a passive owner of real estate, the traditional REIT vehicle is not ideally suited for an
operationally intensive business, even those with a large real estate component (notably hotels,
casinos, health care centers, and parking garages). Accordingly, variations of the REIT structure
have emerged over time in an effort to benefit from the active business income generated
through the operations of real estate holdings. One such variation is the Paired Share REIT.
Conceived in 1977, and later banned from further formation in 1984, the structure has once again
come under fire. Citing tax avoidance business practices that result in unfair competitive
advantage, the Clinton Administration proposes to curb the use of the Paired Share structure on
any new acquisitions by the five grandfathered Paired Share REITs that today still exist today.
This thesis examines the Paired Share REIT structure and its perceived tax advantage. It
concludes that while the Paired Share REIT structure can enjoy a tax advantage relative to a subchapter "C" corporation legislated REIT restrictions limit its financial flexibility. In addition,
there are financial tactics available to the "C" corporation that can do much to mitigate these
advantages. Two notable tactics are the use of the tax-shielding value of debt and the ability to
retain earnings to fund growth. Further, it is concluded that the combined tax expense of the
business entity and its shareholders does not differ significantly from the Paired Share REIT and
the "C" corporation.
Thesis Supervisor:
W. Tod McGrath
Title: Lecturer, Department of Urban Studies and Planning
Center for Real Estate
Table of Contents
..........
2
CHAPTER 1 Introduction......................................................
5
CHAPTER 2 REIT Legislature................................................
9
ABSTRACT.......................................................
10
The Emergence of the REIT......................................................
11
The Real Estate Investment Trust Act of 1960.............................
11
The Tax Reform Act of 1975..................................................
12
The Tax Reform Act of 1976.....................................................
13
The Revenue Act of 1978.........................................................
The Deficit Reduction Act of 1984.............................................. 14
The Tax Reform Act of 1986..................................................... 14
16
The Technical and Miscellaneous Act of 1988...............................
17
The Revenue Reconciliation Act of 1993.................. .....
17
The Real Estate Investment Simplification Act of 1997....................
....... 17
. ..........................
The 1999 Budget Proposal.........
CHAPTER 3 The Paired Share REIT......................................
20
Tax Shelter Advantages ..................................................
Shareholder Benefits.....................................
The H otel Industry...............................................................
Banning the Paired Share REIT...............................................
C urrent T rends...................................................................
22
23
24
25
26
CHAPTER 4 The Paper-Clip REIT..........................................
28
L eak ag e .............................................................................
Alignment of Interest.....................................
Tax Efficiencies...........................................
Legislative Risk........................................
CHAPTER 5 The Paired Share REIT Tax Advantage...................
31
31
32
33
36
Towards Modeling the Tax Advantage
....................
The Typical "C" Corporation..... .........
The Paired Share REIT.........................................................
C apital Structure.................................................................
Calculating Shareholder Value..................................................
Determining Risk Adjusted Returns on Equity..............................
Shareholder Value.................................................................
Total Tax Revenue..............................................................
37
37
38
39
41
53
56
APPENDIX A......................................................................
61
APPENDIX B......................................................................
98
APPENDIX C......................................................................
99
Acknowledgements
The author would like to thank Tod McGrath for his patience, advice and direction especially
during the final stages. I would also like to thank my husband, Jim, for understanding how
important this research was to me and for his knowledge of the principles of finance which he
graciously shared with me. Special thanks to the CREW. I do not know what I would have done
with out your support.
CHAPTER 1
Introduction
As the hotel sector rebounded in recent years from the overbuilding in the late 80's and the
economic downturn of the early 90's, the acquisitive activities of Real Estate Investment Trusts
(REITs) have allowed them to grow their asset base while taking full advantage of the public
capital market. In particular, the Paired Share REIT has generated the attention not only of
investors but competitors and legislators as well. The reason for this attention is twofold. This
structure, but for several notable exceptions, was legislated out of existence in 1984.
As it
happens, these several Paired Share REITs have acquired half of the total hotel assets sold in the
past three years.' This is due at least in part to the fact that this variation of the REIT vehicle is
well suited to owning and operating hotel property. The Paired Share format allows two entities,
one which owns the property (REIT) and one that operates the property, effectively to join
themselves as one. As such, this structural link enjoys unique tax advantages and operational
efficiencies by aligning the interest of ownership, operations, and shareholders.
While these
advantages have led to outstanding shareholder returns, outpacing most REIT indices through the
last quarter of 1997 (See Exhibit 1.1), they have also caused competitors to cry foul and to lobby
legislators to pare back this advantage. It has been alleged that the Paired Share REITs enjoy an
unfair tax advantage thus enabling them to create more value from acquisitions and therefore
outbid their non-Paired Share REIT competitors.
This work is intended to examine the Paired Share REIT structure and explore the tax avoidance
practices allegedly available to those who exploit this unique conduit status. Given the recent
proposals by the Clinton Administration to limit the use of the Paired Share format, the reader
will benefit from a heightened awareness of the structure's benefits and tax advantages.
Chapter 2 contains a retrospective of the history and legislative intent underlying the REIT
vehicle. It details the evolution of the REIT provisions with discussion of the lobbying efforts
and economic forces that impacted them. With an understanding of REIT legislation and the
intent behind it, the reader can better judge the alleged improprieties inherent in some of the
variations of the REIT structure. This chapter also highlights some of the motives behind the
1 Michelle Celarier, "The Trouble with REITs" CFO, Feb. 1998, pp. 22-24.
constraints the Internal Revenue Service places on the type of services a REIT can provide in
operating its properties. The chapter concludes by presenting the current REIT proposals
included in Clinton's 1999 Budget.
Chapter three presents a thorough examination of the Paired Share REIT. This chapter will
educate the reader as to the motivating force behind the creation of the Paired Share structure,
elimination of ownership and operational conflict, and discuss the need for such an alignment of
interests. This chapter also reports on the initial legislative ban on the Paired Share structure, in
the Deficit Reduction Act of 1984, and the current issues surrounding the Clinton
Administration's proposal to eliminate further expansion of the Paired Share REITs that remain
in existence today.
In light of the Administration's proposals, Chapter 4 explores a recent organizational phenomena
designed to mimic the benefits of the Paired Share REIT structure outside of the proposed
legislated boundaries. This form, the Paper-Clip REIT, has been employed by several prominent
REITs to date.
Should the proposed REIT legislation be enacted, the popularity and
implementation of the Paper-Clip REIT is certain to hasten, as Paired Share REITs seek to
maintain their ability to both own and operate real property. This chapter examines how well the
Paper-Clip structure meets the same objectives as the Paired Share and discusses where it is
shortcomings.
Lastly, Chapter 5 is intended to support or mitigate concerns over the tax advantage a Paired
Share REIT enjoys over its counterpart, the taxable "C" corporation.
At the root of these
concerns is the notion that a Paired Share REIT is able to manipulate operating revenue, nonqualifying REIT income, and avoid the corporate taxation it would be subject to as operating
income of a "C" corporation. With this tax avoidance mechanism at a REITs disposal, many
contend the Paired Share REIT is able to create more value from acquisitions than its
competitors, most notably the typical "C" corporation. This research contends that without a
proper examination of the capital structure and tax shielding benefits of corporate debt, in
conjunction with the restrictive dividend policy of a Paired Share REIT, an educated judgement
as to the size and importance of the Paired Share tax advantage can not be developed.
The
stylized model presented in this research was constructed in an effort to account for the effects of
leverage, dividend payout, and risk adjusted return on shareholder returns of a "C" corporation
and Paired Share REIT holding and operating an identical asset.
Paired Share REIT Returns
0
0
Through Last Quarter 1997
C'e)
0
0
-1 (N
-J
x
00
C
Z
0
0
0
-+- Patriot American Hospitality
+
Starwood Hotels & Resorts
-a-First Union Real Estate Equity +Morgan Stanley REIT Index
EXHIBIT 1.1
CHAPTER 2 REIT Legislature: Perfecting the REIT Vehicle
The emergence of REITs has arguably benefited the real estate sector by providing disciplined
access to capital. In recent years this access to capital along with the improving health of the
economy has allowed for the widespread establishment and growth of REITs. As the accretive
investments most REITs relied on to maintain growth and increased shareholder value begin to
become scare, REIT management faces a daunting task: how to sustain the growth expectations
within a structure more conducive to income investing?
Though legislative provisions, since the inception of the REIT, have evolved in an effort to perfect
the REIT vehicle, they struggle with addressing the benefits and abuses of this unique tax conduit
structure.
Historically, real estate investing has been predicated on a two-pronged investment strategy: tax
advantaged cash flows and capital appreciation. Typically, bound by the restrictions of the Internal
Revenue Code, real estate entity formation and capital structure choices have become a creative
process, generating well-devised allocations of cash flow and "paper" losses for income tax
reporting purposes.
It would seem only fitting that the REIT vehicle, conceptualized and legislated to allow the average
person to benefit from real estate investing, would also be granted certain tax breaks by Congress.
As a consequence, Congress has found itself mandating amendments to the REIT statutes in a
continuing effort to limit the abuse of this unique conduit structure while maintaining its intended
purpose: to serve as a passive investment vehicle. The industry, responding to market forces, has
countered with variations of the structure. Though careful to remain within the parameters allowed
by law, the boundaries occasionally cross into territory not intended for the REIT format. These
variations, in turn, force investigations into and reforms of the REIT structure. The focus of this
chapter is to explore the marketplace forces that have led to a number of lobbying efforts, to the
variations of the REIT structure, and ultimately to the basic legislative provisions that have evolved
and which now govern the qualifications for REIT eligibility.
The Emergence of the REIT
Prior to the Real Estate Investment Trust Act of 1960, legislation that dealt primarily with real estate
investment trusts (REITs) had not been enacted. In the absence of a legislated business structure, the
pooling of ownership in real estate generally took the form of a business trust. At that time, true
business trusts were granted "conduit" tax treatment and, therefore, avoided corporate tax at the
entity level. The challenge to this favorable tax treatment for real estate holding was then, and is
now, at the core of legislative provisions underlying the congressional intent of the REIT vehicle.
The uncertainty regarding the tax status of realty trusts began with the creation of the Corporate Tax
in the Tariff Act of 1909. The Tariff Act established "a special excise tax with respect to the
carrying on or doing business by such corporations, joint stock company or association or insurance
company." What followed was a number of Supreme Court rulings dealing specifically with the
applicability of the law to realty trusts, the last of which was Morrisssey v. Commissioner in 1935.
This ruling became the precedent for determining the "corporate" nature of a business trust as
defined by the following tests:
1) Title to property owned by the enterprise is held by trustees, as a continuing body, during the
existence of trust;
2) centralized management by trustees, as representatives of beneficial owners, whether selected
by or with the advise of beneficiaries or designated in the trust instrument with the power to
select successors;
3) continuity, uninterrupted by deaths among beneficial owners
4) means for transfer of beneficial interests and introducing new participants with out affecting
continuity;
5) limitation of personal liability of participants to property invested and contributed in the
undertaking;
These tests clearly defined realty trusts as corporations, thus subjecting them to double taxation.
Remarkably, the disallowance of the conduit tax treatment for realty trusts was not fought with an
organized lobbying effort until the early 1950s. It is believed that after many trusts were forced to
liquidate due to Morrisssey v. Commissioner, those that remained were not reeling from the new
income tax burden because they were generally operating at a loss. Once a concerted lobbying effort
was initiated, the goal became a legislative provision that would reinstate the conduit tax relief these
trusts had previously enjoyed. The proponents of this legislation fostered the notion that its passage
would increase property beckoning new buyers and attracting private capital to assist in the urban
renewal just beginning at the time. Understandably, Congressional opposition centered on the
applicability of the law. Even then, hotel chains were brought to the attention of lawmakers as
potential abusers of this structure. Lobbyists responded by insuring the intent of the law and
amended the bill each time nonrealty trust issues concerned Congress. These amendments led to the
passage of the bill (HR 4392) by both houses of Congress in 1956, but President Eisenhower still
doubted its intent and initially vetoed the bill.
"... It is by no means clear how far a new provision of this sort might by applied.
Though intended to be applicable only to a small number of trusts, it could, and might
well, become available to many real estate companies which were originally organized
and have always carried on their activities as fully taxable corporations."
The Real Estate Investment Trust Act of 1960
In 1960, the REIT bill (HR 10960) was reintroduced and passed again by both houses of the
Congress and subsequently signed by President Eisenhower. This legislation was the first to outline
the requirements an entity must meet to be considered a passive vehicle for real estate investments
(see appendix). Moreover, these requirements had to be met on an annual basis. Noncompliance
meant "sudden death", the permanent loss of REIT status and the imposition of corporate tax at the
entity level. One requirement that threatened the life of a REIT, due to its ambiguity, was the
income source test. "Qualified income" was defined as rents received for the "bare right to occupy
rental realty". This stricture did not cover much of what the industry felt should be considered real
estate income, such as commitment fees to lease or buy properties. Further, mitigating concern over
the reach of such a law, it also required REITs to organize as an unincorporated trust or association.
This was viewed as an attempt to curb the wide use of the REIT vehicle, as business trusts are a
creation of common law and therefore generally result in a greater degree of liability for the trustees.
The Tax Reform Act of 1975 -A Response to Economic Recession
In the late 1960's the REIT industry grew substantially with the creation of the mortgage REIT. The
economic environment at that time allowed banking institutions with mortgage lending operations to
set up REITs that would benefit from low interest rates and increased construction. By leveraging
their own equity capital, borrowing short term through commercial credit and bank loans (at 6%),
and funding development at a much higher lending rate (13% to 16%), mortgage REITs prospered.
Unfortunately, the economic recession in the early 1970's proved the flaws in this lending REIT
business model. The recession caused short-term interest rates to climb and the spreads between a
REITs cost of funds and earnings to become negative. More importantly, these REITs faced longstanding concerns regarding the treatment of property they acquired in foreclosure. The disposition,
acquisition and holding of such properties could trigger "sudden death." The statute at that time
disallowed any REIT from holding property primarily for sale to customers in the ordinary course of
its trade or business. In other words, the REIT structure prohibited some REITs from properly
managing their assets without infringing on the statute. Once again, a lobbying effort ensued. The
need for legislated relief with regard to foreclosed property was granted in 1975 with an amendment
to the REIT law. This amendment protected a REIT from disqualification due to noncompliance of
the income-source and asset tests on the activities connected with the foreclosed property. In
summary, a REIT could now actively manage, temporarily, or arrange to sell a foreclosed property.
The income from these activities that was not considered qualified income would not threaten a
REIT's status but rather be subjected to taxation at the corporate rate.
While this amendment granted REIT management the flexibility it needed to effectively handle
problem loans and leases, the ambiguity of the REIT restrictions still tied the hands of REIT
management with respect to their performing properties.
The Tax Reform Act of 1976 - A Response to Real Estate Business Realities
The TRA of 1975 provided the REIT limited flexibility in the management of their properties. It did
not, however, accomplish what many in the REIT industry had lobbied Congress for in the previous
four years. Their effort focused on elucidating the provisions, making them more sensitive to the
real estate marketplace and more effective with the business practices of the real estate industry.
Due largely to lobbying efforts, Congress included in The Tax Reform Act of 1976 legislation that
altered the inflexible REIT qualification requirements and granted relief from disqualification of
REIT status for failure to meet income, asset, and distribution requirements. The TRA of 1976
extended the same relief granted in the TRA of 1975 for income from foreclosed property to all
income a REIT generated that failed to meet the income-source and/or asset tests. More importantly,
the TRA of 1976 clarified the income source test immeasurably by including in rental income
amounts received for customary and ancillary services provided for the benefit of the tenant as well a
minimum allowance for rents from personal property in conjunction with the rents of real property.
This minimum allowance was set low enough to continue the exclusion of all hotel income from
qualifying as "good" income.
The Act included changes, which enable the REIT to correct a distribution deficiency and to carry
over net operating losses (NOLs) to subsequent tax years. Traditionally, the carry over of NOL was
a right reserved for corporations. As this act also granted REITs the right to incorporate, it was
fitting to allow NOL carry-forwards. The loosening of earlier restrictions did not come without a
cost. The TRA of 1976 also raised the income distribution requirements from 90 percent to 95
percent of their otherwise taxable income.
Although the TRA of 1976 did much to clarify REIT provisions allowing for additional flexibility in
REIT management, it was careful to ensure the REIT's role as a passive investor. No changes were
made to the requirement that all property owned by a REIT must be managed and operated by an
independent contractor or third party. REIT management was still forced to remain removed from
the operation of their properties.
The Revenue Act of 1978 - A Response to Investment Portfolio Management
As stated previously, the restrictions set forth in REIT legislation were imposed to ensure that REITs
remained a passive investment vehicle and did not engage in active business management. While
some of the restrictions were meant to prevent traditional real estate activities such as development
or brokerage, they also infringed upon a REIT's ability to modify its investment portfolio without
bearing the cost of the tax burden. In 1978, one such restriction was changed in an effort to correct
this shortcoming. The Revenue Act of 1978 created a "safe harbor" rule as an aid in determining
whether a sale by the REIT of one of its assets would be considered a prohibited transaction and thus
subjected to corporate taxation. If the asset sale met certain requirements, it would be considered a
sale for the benefit of the investment portfolio, and therefore the proceeds from the sale would
qualify as passive income. It would not be considered a result of the REITs participation in active
real estate sales activities.
With greater legislative latitude, REIT management took on more of a defining role. Some senior
management teams began looking at creative ways to add value to their entity while still remaining
in the confines of the REIT provisions. REIT management formulated alternatives or enhancements
to the REIT structure, which allowed them to invest in otherwise restricted assets. One area of
concentration became the value associated with service income generated from a real estate
operating company. Emerging from this strategy was the Paired-Share, or Stapled REIT entity.
Certain REITs sought and received permission from the IRS to staple an operating or management
company (run as a C-Corporation) to themselves and not lose their conduit tax status.
Deficit Reduction Act of 1984 - A Ban on the Stapled Entities
The Deficit Reduction Act of 1984 (DEFRA) was legislated to increase the efficiency of the tax
system in an effort to increase tax revenue. The bill proposed a small tax increase, and provisions
that would limit unwarranted tax benefits and curb tax shelter abuses. The latter motivated a
provision in the bill, which effectively banned any further formation of a stapled REIT entity. (For
further discussion of the Paired Share REIT, refer to chapter 3.)
The Tax Reform Act of 1986 - The REIT Relief Act of 1986
No other piece of legislation, since The Real Estate Investment Trust Act of 1960, has contributed
more favorable to the growth and performance of REITs then The Tax Reform Act of 1986 (TRA
1986). The reason its impact was so broad is twofold. Firstly, TRA 1986 considerably diminished
the private real estate investment market by eliminating many of the tax shelter provisions associated
with investment in income producing properties. Secondly, it notably revised the REIT provisions
themselves.
The REIT provisions that where included in the TRA of 1986 were the culmination of a four year
lobbying effort by the National Association of Real Estate Investment Trusts (NAREIT). NAREIT,
once again, sought to update the REIT laws making them more attuned to the realities and practices
of the real estate industry. The aim of the REIT modernization bill, which ultimately was accepted
by the Conference Committee on Taxation and included as part of the TRA of 1976 tax reform
package, was best expressed by a supporter of the bill, Congressman Guy, .
"There is at the present time an urgent need for comprehensive revisions in order to
update the REIT tax rules to reconcile them with real estate taxation generally so that
REITS and their shareholders will be able to compete more effectively and to continue
their important function of enhancing the flow of capital to economically viable, incomeoriented real estate projects."
The TRA of 1986 was a major overhaul of the tax system; as such it included major changes to the
REIT tax provisions. Remarkably, The TRA of 1986 would result in a lower REIT tax burden on
non-qualifying income even though its intent was to offset the tax rate reduction it legislated to both
individuals and corporations2 by broadening the corporate tax base.
A number of the REIT provisions in the TRA of 1986 did provide substantial tax relief for REITs,
which in turn reduce d corporate tax revenue, but more notably, they impacted the effectiveness of
the REIT vehicle within the common practices of the real estate industry. One such provision was
the amendment to the independent contractor rule, which required REITs to contract out property
management and customary tenant services to a third party. The TRA of 1986 changed this by
allowing REITs to self manage and operate many types of income producing properties. The
investment community responded favorably to the additional control this legislation granted to the
REIT industry. Also as a consequence of this amendment, the management fees REITs previous had
paid out to independent contractors, most of which were C-Corps, could be internalized and thus
would not be subjected to corporate taxation. Unfortunately for the hotel industry, REITs were still
restricted from earning active business income even if the business had a strong connection to real
estate. Therefore services provided for the benefit of a single tenant still needed to be provided by
an independent contractor or operating company.
The TRA 1986 also included a new provision enabling REITs to operate through Qualified REIT
Subsidiaries (QRS). This provision, in keeping with the practices of the real estate industry, permits
a REIT to manage its properties through a QRS thus limiting its liability with respect to the
operations of the property. A QRS is a separate legal entity whose stock is 100% owned by the
2 The TRA of 1986 reduced the maximum corporate tax rate from 46 percent to 34 percent. It also reduced the
number of individual tax brackets to two- 15 percent and 28 percent.
REIT, but whose separate federal tax status is ignored. Therefore, the tax attributes of a QRS are
treated as those of a REIT. This provision comforted many in the investment industry because it
shielded a REIT's portfolio from the damage of a single under performing property while allowing a
REIT access to revenue from operations of their properties tax-free.
Modifications to the safe harbor rule regarding prohibited transactions were also legislated in the
TRA of 1986. A REIT is now allowed to make seven sales, instead of 5, in a taxable year with out a
corporate tax occurrence. Moreover, there was no limit on the number of sales as long as the total
adjustable basis of the properties sold did not exceed 10 percent of the REIT's assets at the
beginning of that year. Expenditures for improvements on property owned by and subsequently sold
by a REIT increased from 20 percent of its adjusted basis to 30 percent during the four years prior to
sale.
The Technical and Miscellaneous Act of 1988
Largely due to the increased role of management in a REIT, afforded to them by the TRA 1986,
many REITs contained integrated real estate service companies. REITs then sought to capitalize on
their in-house expertise in the fields of property management, development and other services by
offering them to third parties. Unfortunately, the income resulting from "active" third party business
is considered non-qualifying or "bad" income for a REIT and would be subjected to corporate level
taxation. In an effort to stay within the income and asset requirements of the REIT structure while
extracting value from third party fee income, some REITs formed separate corporations to house
their service operations. These corporations were not QRS; rather, they were organized with two
classes of stock: voting and non-voting stock. The non-voting stock was held by the REIT and paid
dividends allowing the REIT to retain most of the income generated by the impermissible business.
In 1988, the IRS allowed for the formation of these "preferred stock subsidiaries". The IRS
concluded that the dividends did represent qualified income for purposes of the income test, and the
holding of non-voting stock did not violate the asset test which states that a REIT can not own more
3
than 10% of the outstanding voting securities .
3 Richard T. Garrigan and John F. Parsins, Real Estate investment Trusts: Structure, Anaysis and Strategy (New
York: McGraw-Hill, 1998), p. 106
The Revenue Reconciliation Act of 1993 -Reconciling Domestic Pension Fund Investors
While the TRA 1986 encouraged and assisted the growth of REITs by making them a more
attractive real estate investment vehicle, the real estate market was still capital constrained in the late
80's and early 90's. Moreover, hindering the growth of many of the mid-sized and smaller REITs
were certain organizational requirements inherent in the REIT structure. The "5 or fewer rule" is an
organizational requirement in place to guard against concentration of ownership. It generally means
that no more than 50 percent of a REIT's stocks value can be owned by five or fewer individuals
during a taxable year. Prior to being amended in the Revenue Reconciliation Act of 1993 (RRA
1993), it limited some REIT's ability to attract the attention and capital of large institutional
investors, most notably domestic pension funds. The rule was amended with a "look through"
provision that deemed the beneficiaries of the pension fund as individual investors rather than
considering the pension fund as a sole investor for purposes of this ownership concentration
calculation. This amendment served to mitigate investor's fears of violating the ownership
requirements of a REIT, increased the liquidity of REITs, encouraging institutional investment, and
increased access to growth-generating capital.
The Real Estate Investment Simplification Act of 1997 - A REIT Friendly Act
Among the many benefits of the Real Estate Investment Simplification Act of 1997 (REITSA 1997),
it allowed REITs to perform nontraditional services for a fee as long as they do not exceed 1%of the
property's gross income. While this was beneficial to the REIT industry as a whole, the hotel REITs
didn't gain much ground from this reform. Hotels generate a substantial amount of their revenue
from nontraditional services (i.e., maid, food, beverage and telephone), upwards of 40%4.
The 1999 Budget Proposal - Closing Certain REIT Loopholes
The 1999 Budget Proposal, introduced by the Clinton Administration in early 1998, contains three
proposals that impact the REIT industry. The aim of the proposals is to "eliminate unwarranted
benefits and adopt other revenue measures". The Administration contends that some REITs conduct
business or execute transactions that deviate from the intention of the REIT provisions. These
"borderline" transactions are typically tax avoidance measures that have been allowed by, or granted
reprieve from, existing REIT laws by interpretation thereof They include restrictions on: the
4 PKF Consulting, Hotel Development, (Urban Land Institute, Washington, DC) 1996 p 40.
formation of preferred stock subsidiaries and closely held REITs, and further acquisitions under the
Paired-share REIT structure.
As discussed above, a 1988 IRS interpretation of the REIT laws has allowed many REITs to form
taxable "preferred stock" subsidiaries to conduct third-party business. The REIT is allowed to own
90% or more of the economic benefits of non-REIT corporation (subsidiary) through the retention of
non-voting stock. The subsidiary pays dividends on non-voting stock out of the "active" business
revenue it generates. These dividends represent qualified income to the REIT. This arrangement
has invoked concern from the Administration. They contend that the subsidiary is typically levered
with debt from the REIT and that much of the REITs general and administrative costs are covered by
the subsidiary. This would allow the subsidiary to shield most of its income from corporate level
taxation thus passing on the majority of its income to the REIT in the form of dividends and above
mentioned "excess" interest and administrative expenses. The Clinton Administration's 1999
Budget proposes to limit a REIT from holding no more than 10% of the vote or value of non-REIT
securities.
Similar to their concern with "preferred stock subsidiaries" is the belief held by the Administration
that the intent of the "closely held" limitation on REITs is being side stepped by interpretations of
the current test. To ensure that REITs are widely held entities as intended for the benefit of small
real estate investors. Along with the "five or fewer rule discussed above, ownership must be held be
100 persons including individuals, corporations and trusts.
The Administration contends that corporations and other non-individual entities (i.e., REITs) are
using closely held REIT subsidiaries to take advantage of their tax-free status. The current "closely
held" tests are satisfied as follows: the corporation holds common stock with 100% voting rights and
a majority of the total REIT value. The REIT issues non-voting stock worth a fraction of the total
REIT value to 99 shareholders. Thus there are 100 owners, and the majority owner is not an
individual.
This perceived abuse would be eliminated by the Administration's proposal to add an additional
"closely held" test. This proposed test would prohibit any person (including corporations, trusts, or
partnerships) from owning greater than50% of the voting stock or 50% of the total value of a REIT.
And lastly, the Administration proposes to prohibit the remaining paired share REITs from further
acquisitions under their unique grandfathered structure. Currently, REIT legislation requires only
the REIT side of the stapled entity to meet the REIT qualification tests. As such, the "active" net
operating income that "C" corporation earns, and would otherwise be subjected to corporate level
taxation, can be passed to the REIT in the form of rent or qualified REIT income. The proposal
would treat the REIT and stapled "C" corporation as one entity for the purpose of the REIT
qualification tests, and therefore effectively remove the ability to shelter taxable operating income
through this structure on further acquired properties.
CHAPTER 3: The Paired Share REIT: Aligning Ownership and Operations
As discussed in Chapter 2, the REIT provisions of the Internal Revenue Code have evolved in an
effort to perfect the REIT structure as a real estate investment vehicle attuned to the requirements
of the public markets and the practices of the real estate industry. The IRS has remained
consistent, though, in its restrictions on a REIT to earn active business income. The requirement
that REITs be largely passive owner-entities is one of the concessions a REIT must make in
order to be allowed the benefit of no corporate level taxation. It also serves to discourage a
REIT from holding properties (restricted assets) that may have a strong real estate component but
which primarily generate income from the services provided in connection with those property
types. These restricted assets are, most notably, hotels, racetracks, casinos, parking garages, golf
course and health care facilities. To remain compliant with the REIT provisions, a REIT is
entitled to revenue derived from owning title to these properties, typically in the form of rent or
lease payments. A REIT cannot earn active business income from the operations housed in these
properties.
In an effort to derive revenue from the operations of their properties without earning "active"
business income, some REITs petitioned and eventually received permission from the IRS to
form stapled entities.5 The formation of a stapled entity requires creation of two companies, a
REIT and an operating company. As a stapled entity, a share of stock in the REIT is stapled or
paired with a share of stock in the operating company. Each paired share stock is required to
trade as a single unit and, therefore, both companies are owned by the same shareholders (see
Exhibit 3.1). Though the shares trade as one, the two companies are separate entities with regard
to the IRS. Accordingly, the strictures of the REIT provisions due not apply to the operating
company typically organized as a "C" corporation. As a "C" corporation, the operating company
has no restrictions on the type of business it can operate and, therefore, can collect revenue that
5 Section 269B of the IRS Code, refers to stapled entities as "any group of two or more entities if more than 50
percent of value of the beneficial ownership in each of such entities consist of stapled interest." Section 269B
defines stapled interests as "by reason of form of ownership, restrictions on transfer, or other terms or conditions, in
connection with the transfer of 1 of such interest the other such interest are also transferred or required to be
transferred."
Paired-Share REIT Structure
EXHIBIT 3.1
"--
-
- I
tloaw-
results from services provided in conjunction with restricted assets, i.e. non-qualifying or "bad"
REIT income. The REIT, functioning as a lessor, receives a rent or lease payment from the
operating company who has operational control of the property. This rent payment now
represents qualifying or "good" REIT income. The original intent behind pairing these
companies was to allow the shareholders of the paired share REIT to enjoy the full economical
benefit from both the ownership and operations of the asset.
The ability to adopt the paired share REIT format was available to all existing and newly formed
REITs from the time of its inception, 1977, until it was outlawed by Congress in the DEFRA
1984. Surprisingly, it was only employed by six REITs during that period. Many have
speculated that management of the conventional REIT at that time may not have considered
thoroughly the advantages of the Paired Share structure. This was primarily because most REITs
were not holding restricted assets and/or generating enough service revenue ("bad" REIT
income) that could largely benefit from the avoidance of corporate level taxation. Also, the
conventional REIT had been granted some lenience by the passage of the TRA 1976 in regard to
the services they could provided for the benefit of the tenant without having the service income
be considered non-qualifying (see Chapter 2). Many also speculated at the time that there would
be further liberalization of the IRS's rule, thus granting more service income conduit status.
Though the tax advantages of the Paired Share REIT have been the most poignant argument for
the benefits and productiveness of the structure, it is important to explore the other advantages
associated with this REIT structure as they relate to the public ownership of real estate.
Tax Shelter Advantages
The tax advantage of the Paired Share REIT is predicated on a shared management team and its
ability to avoid, or materially reduce, corporate level taxation on active business income. This is
accomplished by management's careful allocation of revenue and expenses. The operating
company, required as a C corporation to pay corporate level tax on its taxable income, stands to
benefit from management's decision to allocate a disproportionate amount of tax deductible
expenses, effectively reducing its taxable income and tax burden. The "disproportionate"
expenses incurred by the operating company are commonly a portion of the REIT's overhead
and above market lease payments made to the REIT.
The operating company's lease payments serve as income to the REIT and, therefore, to comply
with REIT statutes must be based on revenue generated from property operations not net
income.6 Management of the Paired Share REIT can structure the lease to result in an above
market lease payment to the REIT which escapes taxation at the REIT level, thus affording the
combined entity an effective tax shield on its otherwise taxable operating profits.
Shareholder Benefits
As managers of a publicly held entity, the shared management of a Paired Share REIT is able to
utilize the advantages of its structure to increase shareholder value. Senior management of a
Paired Share REIT can effectively invest in operationally intensive business while maintain
tighter control over their assets and provide its shareholders with full economic benefit of the
ownership and operation of their assets.
In the absence of a structural link between ownership (REIT) and operations (operating
company), a typical REIT must remain a passive real estate owner and rely on third party
management to profitably operate the asset. This structure does not provide adequate alignment
of the interests between ownership and operations. As noted above, the lessee of a REIT owned
property pays rent based on revenue not operating profits. While this type of leasehold interest
creates an incentive for the lessee to maximize profits, the REIT shareholders are not
compensated fully on property level performance if, for instance, revenue is jeopardized because
management's focus is on profits. As an example, a hotel operator may decide not to drop room
rates to increase occupancy, and hence revenue, if doing so does not increase profits as well.
With the Paired Share structure, the property is managed to maximize cash flow to its
shareholders. With identical interests in both the ownership and operations of the property,
shareholder are less concerned with operational conflicts or which entity is deriving the most
benefit from property level operations.
6 "Rents from real property" are defined in IRC Section 856(d).
Another area for operational conflict between the lessee and lessor arises from decisions
involving the disbursement of capital reserves and maintenance obligations. Depending on how
the lease is structured, capital reserves may be funded by the lessor but spent at the discretion of
the lessee. If a capital improvement funded out of reserves would favor decreasing operating
expenses over increasing revenue, the lessee may be receiving the entire benefit of that
expenditure since it in would result in increased operating profits. The lessor (REIT) can also be
penalized if the lessee under-funds it maintenance obligations in an effort to increase its profits.
The short-term benefits derived from this type of management can have long-standing
detrimental effects on the ownership of the property. Once again, the Paired Share REIT
structure mitigates these conflicts because a shared management team aligns the interest of both
the operations (lessee) and ownership (lessor) of the property.
The shareholders of traditional (non-Paired Share) REITs which invest in restricted assets are at
a distinct disadvantage to shareholders of a Paired Share REIT. Inherent in the Paired Share
structure is the elimination of conflict of interest between ownership and
operations/management. With cohesive business strategies, management of a Paired Share REIT
will implement policy that maximizes after -tax cash flow to its collective shareholders.
A Paired Share REIT's ability to avoid corporate level income taxation is clearly an advantage to
the valuation of an operationally intensive business. One would estimate that the value derived
from this structure would accrue to its shareholders, leading to an increased stock valuation and
ultimately, a distinct competitive advantage. While this view is widely shared, it neglects to
consider the strict requirements of the REIT provisions that are still embedded in the Paired
Share REIT as well as the effect of capital structure on the perceived tax benefits of a Paired
Share REIT versus a typical "C" Corporation. These issues are further explored and quantified
in Chapter 5.
The Hotel Industry and the Paired Share REIT
Though one of the earliest ventures to form under the Paired Share REIT structure was a
racetrack, Santa Anita Racetrack; the structure quickly gained the interest of hotel real estate
companies. Though hotels are largely income producing real estate, their operations entail the
performance of many personal services and accordingly, much of their revenue and profits are
derived from furnishing these services. Unfortunately, the REIT provisions state that the net
operating income from these investments, due to the significance of the services provided to the
tenant does not qualify as rent from real property. As such, a REIT is forbidden from owning a
hotel and performing these services. The hotel REIT must, therefore, rely on third party
management to operate the hotel. As discussed earlier, this creates operational conflicts and does
not allow the shareholders of the REIT proper compensation from operating profits. The Paired
Share REIT was a solution to this dilemma. It allowed a REIT to recapture lost operating profits
(known as leakage) and through a shared management team align the interest of ownership and
operations.
Banning the Paired Share Structure
As stated earlier, the Paired Share REIT format was legitimized by an IRS ruling (Section 269B),
and amended in 1984 to effectively prevented new Paired Share REITs from forming. Congress
determined at that time that:
"stapling of corporate stock is a simple means of attempting to avoid tax rules intended to
limit the abuse of the U.S. tax system or to limit the use of special tax benefits granted by
Congress. Stapling of a tax entity with a nontaxable entity is particularly serious
problem. In such cases, the shareholders (who are the same for both corporations)
generally prefer profits to be realized in the nontaxable entity rather than in the taxable
entity. The committee believes that not to do something to preclude the use of such a
7
transparent device would lead to disrespect for the tax system."
It is unclear what provoked the congressional ban on stapled REIT entities. The six Paired Share
REITs existing in 1983 were not then engaging in activities contrary to the spirit of the REIT
provisions. Congress may have feared that allowing the Paired Share REIT structure to continue
might invite the interest of corporations primarily conducting non-real estate business activities.
It may have been speculated that such corporations would be attracted by the inherent tax
7 H.R, Rep. No. 432(11), 98th Cong., 2d Sess. 1984
advantages and resulting savings in dividend cost. Lerner described the benefits of this
arrangement' as follows:
"By Pairing its stock with the stock of a REIT holding the real estate assets of such nonqualifying corporation, such a corporation was able to essentially substitute pretax
dividend payments for the after-tax dividend payments typically made by operating
corporations."
The amendment (to IRS section 269B) requires that both corporations under the Paired Share
REIT umbrella be treated as a single entity for the purpose of determining REIT status.
Congress's intend was to end any tax avoidance by active business that through a paired stock
arrangement could effectively and legally place active business profits on the tax conduit side of
the arrangement.
More notably, the amendment grandfathered (applied prior law to) the six existing Paired Share
REITs. They were (current names): Starwood Lodging (Starwood Hotels & Resorts), Santa
Anita Realty (MediTrust), California Jockey Club (Patriot American Hospitality), First Union
Real Estate, Corporate Property Investors, and Hollywood Park.
Current Trends
In the years following the ban on the formation of stapled entities, the grandfathered Paired
Share REITs have all been witness to not only a rebounding real estate market with REITs at the
helm, but a considerable gain in notoriety and interest. With the opportunity to form new Paired
Share REITs eliminated, the once obscure and under-utilized conduit structure has become
highly sought after. It has been speculated that the structure alone is worth $200 million,
specifically, in the acquisition of Santa Anita Realty (a grandfathered Paired Share REIT),
9
MediTrust was said to have paid close to $200 million net of other tangible assets.
The interest and notoriety of the Paired Share REIT has emerged primarily from the hotel sector.
As of late, hotel REITs seemed to have benefited most from the improving health of the
8 Lerner, "REITs:Use of "Stock Pairing" Arrangements to Increase After-Tax Corporate Distributions, " 1980 Tax
Adviser 468 (1980)
8 9
9 Green Street Advisors, Inc. "Paired Share REITs and the Paper Clip Alternative" August 12, 1997 pp. -
economy. While most real estate entities were still dealing with staggering financial problems
lingering from the late 80's, hotel REITs, most created after 1992, were able to access public
capital and take advantage of tremendous buying opportunities in the mid 90's. This led to
enormous growth of the hotel REIT, providing investors with strong returns and causing their
non-REIT competitors to cry foul. At the root of the conflict is the aggressive buying techniques
of the Paired Share REIT, notably Starwood Lodging and Trust (HOT). In a 1997 battle to
acquire ITT Corporation, a portfolio worth $10 billion, Starwood Lodging and Trust outbid
Hilton Hotels Corporation (HLT). As a result, Hilton's president and chief executive cites
Starwood's paired share structure that he contends helps it avoid taxes as an unfair competitive
advantage. He argues:
"I don't think it's right that we have to compete against companies that get a tax break
that we don't. We shouldn't have a market economy where a chosen few get advantages0
it's not good economics, it's not good politics, it's not good business."'
Representatives from Marriott International have also voiced their concerns over the alleged
unfair tax advantages that puts other companies at a disadvantage when bidding for acquisitions
against the Paired Share REIT.
Whether responding to critics or drafting sound policy, the federal government proposed
legislation, introduced in the House and Senate on March 2, 1998, would put an end to option to
using the Paired Share REIT as a structure used to hold REIT "restricted assets". The proposal
would block the Paired Share REIT from applying their unique grandfathered structure to any
future acquisitions.
10 Kevin L. McQuaid, "Industry Calls REIT Plan a Wrong Move," The Baltimore Sun, 8 February 1998, p. ID
CHAPTER 4 The Paper-Clip REIT: Replicating the Advantages of the
Paired Share REIT
As the popularity and intense scrutiny of the Paired Share REIT has continued to rise, the rush to
discover an alternate REIT structure has intensified. One innovative structure that shows much
promise is the Paper-Clip REIT.
The Paper-Clip REIT was designed to parallel the Paired Shared REIT in its ability to own and
operate "restricted assets". As in the Paired Share REIT structure, a Paper-Clip REIT combines
a REIT (property owner) and "C" corporation (business operator). While these entities work in
tandem, their shares are not required to trade together and therefore they are not considered
paired stocks. For a shareholder to derive true "Paired Share REIT" benefits, it is necessary for
them to hold stock in both entities.
With all its similarities to the Paired Share REIT, one would think that it would be embraced by
hotel REITs as a solution to their most notable problem; leakage. As it happens, the Paper-Clip
REIT structure was formulated by Crescent Real Estate Equities (CEI), known in the industry as
a diversified REIT."
Diversified REITs typically do not hold any single property type but rather
a diversified portfolio of properties. Crescent's objective was to create shareholder value though
service oriented businesses that began in the REIT and then were spun off to its REIT
shareholders. The formation of a "paper-clipped" entity involves a taxable distribution to the
existing REIT shareholders of shares in the new operating company, typically organized as a
taxable "C" corporation. Initially, the original shareholders of both entities are the same, only
now besides their ownership of the REIT, they have an interest in a company that will grow
outside (and trade independent from) the REIT but which enjoys an ongoing relationship with
the REIT.
In the Paper-Clip REIT structure, the ongoing affiliation the two entities have with each other is
viewed by some as a mechanism to create value, growth and opportunity, though to others it may
be viewed as troublesome. While via this "paper-clipped" relationship the REIT has the ability
11 Crescent's holdings as of 6/98 consist of 96% office, 1%industrial, 2% retail and 1%hotel.
to push expenses to the "C" corporation on the premise of overall tax minimization, the "C"
corporation is potentially left absorbing a disproportionate amount of costs and is technically
worse off than its counterpart. This imbalance is dealt with through inter-company agreements.
The inter-company agreements are critical to the success of a Paper-Clip REIT and help define
real economic value to both entities and their shareholders. They encourage long term
cooperation between the two entities and ensure that inter-company transactions stay within the
REIT strictures. Inter-company agreements typically contain rights of first refusal on
acquisitions and development opportunities. They may also, for example, contain financing
arrangements in which the REIT provides the "C" corporation with financing or assistance in
raising capital by providing various guarantees to the "C" corporation. The "C" corporation, in
turn, can provide investment opportunities to the REIT, a necessity for any growth-oriented
REIT.
Though the premise of the Paired Share and Paper-Clip REITs are quite similar, the "paperclipped" entities typically have identical management teams but may have shared, but not
identical, boards of directors and shareholders (see Exhibit 4.1). Because the two entities trade
independent of one another, shareholders of the different entities may have divergent interests.
This may lead to shareholder law suits if it is thought that management is not performing their
fiduciary duties. Also, differing ownership (shareholders) and management may cause the
business strategies of the two sides of the structure to diverge, despite inter-company agreements
to the contrary. In this instance, the two entities whose interests are not "stapled" together are no
longer functioning as one, and the structure loses its effectiveness.
Since the Paper-Clip structure was established to serve as an alternate business structure to the
Paired Share REIT or to the "C" corporation to own and operate otherwise REIT "restricted
assets", it is prudent to explore the advantages and shortcomings of this structure versus the
alternatives.
Paper Clip REIT Structure
REIT-Restricted
Business Activities
L
L
Operating
E
Lease Payments/
E
Pr(
S
0
Company
s
S
(C Corp.)
E
0
E
R
RentS
EXHIBIT 4.1
(F
Leakage
As discussed previously, due to the restrictions on REITs forcing them to base lease payments on
operating revenue and not operating profits, the shareholders of a traditional hotel REIT do not
capture all of the financial benefits from increased property performance. A Paired Share REIT
does much to mitigate these concerns over "leakage" (see Chapter 3); therefore, their
shareholders participate fully in the economic benefits of both owning and operating their assets.
The Paper-Clip REIT works much in the same way as the Paired Share REIT, though, it is at the
discretion of the shareholder to hold stock in both entities and thus participate in both ownership
and operations. They, unlike the Paired Share REIT stockholders, are afforded this additional
flexibility and liquidity.
Leakage issues typically do not arise when the asset is held by a "C" corporation. A "C"
corporation has an advantage over the Paper-Clip REIT, as it does over the Paired Share REIT,
as it can directly own and operate REIT "restricted assets". It can also, as economics dictate,
outsource hotel operations and structure leases around hotel profits.
Alignment of Interest
The Paired Share REIT, it seems, has an advantage over the Paper-Clip REIT with respect to
alignment of interest because both entities in the Paired Share have common shareholders and
management team. The management team is then bound by only one set of shareholder
objectives and one goal: maximize cash flow to their single set of shareholders. As such,
allocations of revenue and expenses are largely left to their discretion. Unfortunately, the
shareholders of the paper-clip entities are not always identical, and will likely care about
management's allocation decisions. However, shareholders of Paper-Clip REIT can find solace
in their investment decisions by recognizing that management is looking to simply minimize the
combine entities tax burden. To mitigate any remaining concerns, shareholders need only to
hold positions in both paper-clipped entities. Shareholder's of Paper-Clip REITs have the luxury
of determining which side of the structure management is "favoring", if any, and investing only
in that entity. If the interests of both entities are fully aligned, management themselves should be
investing equaling in both, and shareholders should want to hold both.
Once again, due to a "C" corporation's unrestricted ability to own real estate and earn active
business income, it is not necessary to hire an outside operator. Moreover, if a "C" corporation
chooses to outsource hotel operations, a lease agreement could be drafted without the concerns
for REIT imposed restrictions, to mitigate any foreseen operational conflicts.
Tax Efficiencies
REITs have been legislated to act as a tax efficient way to hold real estate assets. At the root of
this discussion is whether they are tax efficient vehicles to own and operate real estate assets,
more notably those assets that are operationally intensive.
Avoidance of corporate level taxation is the primary reason to operate under a REIT umbrella.
Accordingly, for the Paired Share and Paper-Clip REIT to fully capitalize on this privilege,
management must operate the underlying assets such that the "C" corporation bears the brunt of
the costs incurred in running the business. While this type of business strategy may effectively
reduce the valuation of the "C" corporation, which will continually show low income and
dividend payouts, the "C" corporation is left to derive most of its value from its relationship with
the REIT. In a Paired Share structure this relationship is more solid as the two entities are bound
together by common shareholders. As stated earlier, this is not the case in a Paper-Clip REIT,
whose management team may feel the pressure from Board members who have fiduciary
responsibilities to different shareholders who may have diverging interests. In such as case,
management must consider not only the tax consequences of their cost allocations but of the
economic motivation of the shareholders as well. Ultimately, this may result in the Paired Share
REITs ability to take stronger action to avoid corporate taxation and push the envelope with
regard to their cost allocations decisions.
Obviously, the "C" corporation does not enjoy the same tax advantages that a REIT does. Their
net operating income is subjected to double taxation, it is taxed on the corporate and shareholder
level. While this may seem that the REIT holds a distinct competitive advantage over the "C"
corporation, this distinction can be mitigated when the effects of leverage and dividend policy
are examined (see Chapter 5).
Legislative Risk
In light of the recent congressional action aimed at eliminating the ability of the five
grandfathered Paired Share REITs to apply their unique status to future acquisition, it is wise to
examine the threat that legislation may disallow each of these structures. Since it is highly
unlikely that the "C" corporation structure would come under congressional attack, therefore, the
"C" corporation faces no legislative risk.
The current legislative proposals center around perceived tax sheltering abuses stemming from
disproportionate expense and revenue transfers between the "C" corporation and the REIT of the
Paired Share REIT structure. Many in Congress believe that the common shareholders of a
Paired Share REITs make this structure a "transparent device" and the structure is "simple a
means of attempting to avoid tax rules". It is unfortunate that a structure which was yielding
strong returns to its shareholders would come under such attack. The effects of legislative risk to
shareholder value is substantial as evidenced by the performance of Paired Share REIT stocks
after the news of Clinton's Administration's proposals in the first quarter of 1998. Exhibit 4.2 is
an extension of Exhibit 1.1, including the stock performance for the first and second quarter of
1998.
As it stands many in the industry predict that the Paired Share REIT may became the "sacrificial
lamb" and lobby harder for the other amendments to the REIT provisions that the administration
is also proposing (see Chapter 2). In a broader sense it is also viewed as an effort to appease the
administration and protect REIT law in general.
The Paper-Clip REITs face a considerable lower legislative risk then that of the Paired Share
because the two "paper-clipped" entities have different shareholders, resulting in an appropriate
level of the policing of management and their cost allocations which will serve to limit outright
abuse. Conversely, since the "C" corporation depends on the inter-company agreements for
enhanced shareholder valuation, the arm's length nature of these agreements are likely to come
under scrutiny.
Paired Share REIT Returns
Through 2nd Quarter 1998
0
0
c'.)
0
0
0N
z
0
0)
lb
-0- Starwood Hotels & Resorts
-*-First Union Real Estate Equity -- Morgan Stanley REIT Index
-+-
Patriot Am erican
Hospitality
EXHIBIT 4.2
Conclusion
Though the going price of $200 million for the tax advantaged Paired Share REIT may be
justified', its costs, limited availability, and impending legislative battle, make it less of an
attractive structure for pursuing investment opportunities in REIT "restricted assets". The PaperClip REIT duplicates many of the benefits of the Paired Share REIT and is currently returning
strong returns to its shareholders (see Exhibit 4.3) without the risk of legislative action banning
its use. Though much of the legislative risks associated with holding the untested Paper-Clip
REIT structure can be controlled by management's diligence in using appropriate tax
minimization strategies, investors will ultimately pay the consequence if the IRS believes
management's strategies are pushing the envelope too far. The REIT could then be subject to
penalties and interest for avoided taxes and possible lost of their REIT status. Shareholders
should weigh the tax savings potential generated through the use of this structure against the
risks they undertake when investing in it.
12 Green Street Advisors, "Paired Share REITs and the Paper Clip Alternative", 12 August 1997
Chapter 5
The Paired Share REIT Tax Advantage: Fact or Fiction
The issues surrounding the impending legislative proposals to restrict the Paired Share REIT
structure from further acquisitions revolves around the perceived tax advantage these companies
have over a traditional "C" corporation. Proponents of the legislation assert that, "Congress
eliminated the tax benefits of the stapled REIT structure (DRA 1984) out of concern that it could
effectively result in one level of tax on active corporate business income that would otherwise be
subject to two levels of tax."1 3 As stated earlier, the DRA 1984 allowed the five existing Paired
Share REITs to continue to conduct business as stapled entities. Opponents of the legislation
argue that the Paired Share REIT structure does not enjoy a tax advantage over other real estate
companies. Many contend that the legislation was drafted in part due to the intense lobbying
efforts of the Hilton Hotels Corporation after their highly publicized defeat by Starwood Hotels
and Resort Trust for the ITT hotel empire. A statement from the Treasury Department on
Clinton's 1999 Budget does seem to support the concerns of the proponents.
"While the market largely ignored the grandfathered entities for a significant period of
time after 1984, recent promoters have begun exploiting these stapled REITs to
accumulate large holding of properties that could not be operated directly by a REIT.
These entities have used their tax-favored grandfathered status to obtain a competitive
advantage over others and to expand their operations greatly beyond the levels and types
of businesses conducted in 1984." "
Opponents of the legislation to restrict the growth of the existing Paired Share REIT firmly
believe that the REIT vehicle has been refined through previous legislation (see Chapter 2), and
currently performs as it was intended to when initially formulated. They point to the
requirements for a REIT to distribute 95% of its otherwise taxable income as dividends to its
shareholders who, at a higher personal tax rate, contribute to tax revenue. Moreover, due to this
dividend distribution deduction, there is less incentive for a REIT to use tax-shielding debt. It
therefore operates with a much less risky capital structure, generating less risky returns to its
13 Statement of the Honorable Bill Archer, March 26, 1998
14 M&C Taxation - Congressional Tax Alert: The President's Budget, February 2, 1998
shareholders. The Paired Share REIT, they argue, is more in keeping with the intent of the initial
legislation: "to allow the small investor to pool their capital in a mechanism to own commercial
real estate on terms comparable to larger, wealthier investors."
5
With the alignment of property
ownership and management under the Paired Share structure, shareholders, they contend, realize
benefits more closely matching those of corporate real estate and larger private owners receive.
Some Capital Hill lawmakers agree:
"Paired Share REITs have been particularly beneficial to their shareholders because they
align the interest of property owners and managers while taking advantage of the tax
6
efficiencies, access to capital markets and public accountability available to all REITs."1
Evaluating the Tax Advantage
After scrutinizing much of was has been written on the tax advantages of a Paired Share REIT
versus a "C" corporation, it is instructive to compare the income tax and related cash-basis
implications of revenue generated from conducting business through both entities.
The Typical "C" Corporation
In the stylized model, a subchapter "C" corporation (C-Corp) owns a hotel and incurs all the
operating and fixed charges of hotel operations. The C-Corp has a subsidiary management
company which runs the hotel for a management fee based on the hotel's revenue. The C-Corp.
is a publicly traded corporation capitalized with a mixture of debt (LEV) and equity. It is subject
to corporate level income taxation based on its net taxable income. Dividend policy (DIV) is
based on a percentage of net income after taxes. The subsidiary management company pays out
no dividends, its income is subject to tax at the corporate level, and its cash on hand and retained
earnings are consolidated in the balance sheet of the parent hotel C-Corp. The C-Corp earns
interest income in any given year on the opening cash balance for that year.
The Paired Share REIT
In the stylized model, the Paired Share REIT owns the hotel. The REIT leases the hotel to the
Operating Company, which pays "rent" out of the net revenue of the hotel in the form of a lease
15 President and CEO of NAREIT Steven A. Wechsler
16" Treasury Tax Correspondance", Tax Notes Today (34-48), Feb. 20, 1998
payment and is entitled to run the hotel and retain as profits the balance of net revenue minus the
lease payment. The REIT, as owner of the hotel, qualifies for a deduction from otherwise
taxable income for dividends paid, and can avoid paying a federal income taxes if the dividend
payout (DIV) is greater than or equal to its otherwise taxable income.' 7 The Operating
Company, organized as a "C" corporation, incurs all operating expenses (including the lease
payment to the REIT) and is subjected to corporate level taxation. The ownership of the hotel is
financed with a mixture of debt (LEV) and equity. Due to the stapled nature of the REIT and the
Operating Company, the balance sheet is a consolidation of the assets and liabilities of both
entities. For simplification, it is assumed that a shareholder of stock in the REIT is entitled to lay
claim to assets of both entities. The Paired Share REIT earns interest income in the same manner
as the C-Corp does (see above).
Capital Structure
The capital structure of both entities (C-Corp and Paired Share REIT) will serve as variables in
the model (LEV). The single property, the beginning asset of both entities, will be financed with
varying amounts of debt and equity. The opening debt level is specified, and this establishes
both the interest rate (which is a function of the level of debt, discussed below), and equity
amount. The interest rate equation embedded in the model was arrived at using current market
interest rates and an application of modern finance theory.' 8 A simple regression analysis was
employed to determine equations for specifying interest rates as a function of the debt level. To
better compensate for the non-linear increase in interest rates as debt levels increase substantially
and become more risky, interest rate equations were formulated for two distinct ranges of debt
levels, 0%-69% leverage and 70% - 100% leverage. They are as follows:
DEBT LEVEL RANGE
0% - 65%
66%
-
100%
Interest Rate = 0.0579 + 0.02044 * (Debt Level)
LN (Interest Rate) = - 4.00632 + 2.03 5807* (Debt Level)
17 The REIT must pay out a minimum of 95% of its otherwise taxable net income to qualify for the dividends paid
resuction.
18 Richard A. Brealey and Stewart C. Myers, Pricliples of Corporate Finance (New York: McGraw-Hill, 1981), pp.
447-462
Thus, the interest rate varies between 5.79% (the coefficient of the regression constant at a zero
percent debt level) and 13.7% with a debt level of 100%.
With a given debt level defined, the required equity capitalization was determined and the
number of shares outstanding was calculated based upon an assumed share price of $20 for both
the C-Corp and Paired Share REIT.
Calculating Shareholder Value
The primary objective of any publicly-held entity is to maximize shareholder value. For the
purpose of our model, we gauge the relative advantage of the Paired Share REIT based on the
incremental shareholder value it creates. Our analysis of shareholder value is predicated on a
three year investment horizon for both entities. Each entity's opening period balance sheet will
be the same. At the end of year three, the share price for each entity will be calculated for the
purpose of selling each stock.
The share price at the end of year three will be equal to the sum of (i) cash-on hand, plus (ii) the
market value of the assets, minus (iii) the outstanding debt balance, all divided by the number of
shares outstanding.
The calculation of the net present value of owning a share of stock requires the development of a
cash flow profile which includes the initial cost of the share, the pre & after-tax dividends paid to
the shareholder, and the pre & after-tax proceeds from the sale of the share at the end of period
three. At this point it is instructive to recognize a unique tax deferral benefit available to a
shareholder of a REIT. When a REIT pays a dividend that is greater than its otherwise taxable
income, the portion of the dividend in excess of the otherwise taxable income is considered a
non-taxable return of capital for the purpose of federal income taxation. The shareholder's tax
basis in the stock, however, is reduced by the amount of the dividend considered to be return of
capital. Accordingly, no tax is paid on that portion of the dividend deemed to be return of capital
until the stock is sold; i.e., the tax liability is deferred. Furthermore, the tax liability is then
calculated at the typically lower capital gains tax rate. To account for the deferred tax liability of
the Paired Share REIT shareholder, care was taken to apply the appropriate tax rate to the pre-tax
dividends received during each period, and to recognize, only upon sale of the stock, the capital
gains based upon the resulting shareholder's basis in the stock.
The C-Corp's shareholder also can enjoy a deferred tax liability. Though not common in
practice, a C-Corp can make a dividend payment in excess of its net income (which, by
definition, is after-taxes). In this circumstance, when the dividend payment is greater than
GAAP net income, the portion of the dividend that is in excess of GAAP net income is
considered return of capital. (This typically only occurs when a company is liquidating, and the
return of capital is usually reflected as a decrease in Paid in Capital on the balance sheet.) This
dynamic was also embedded in the stylized model.
Developing the Base Case
To establish the relative value of the Paired Share structure, it was necessary to develop a Base
Case scenario. The Base Case scenario will serve as a benchmark for determining an appropriate
shareholder's return on equity. With respect to the appropriate return on equity, the Base Case
extends the theory applied to determine appropriate interest rates. It presupposes that when the
capital structure is all equity, the return on equity (pre-tax) is equal to the return on assets.
Accordingly, our Base Case scenario involves setting the debt level of both entities to zero and
then determining the pre-tax and after tax return (IRR) for the C Corp. based on an assumed
shareholder investment horizon of 3 years. Prior to identifying such pre-tax and after-tax returns,
the dividend policy for the C Corp had to be determined. For purposes of illustration, the
dividend payment was established such that both entities would have equal amounts of cash
retained at the end of the three year investment horizon. Recalling, that the C-Corp and the
Paired Share REIT are assumed to own the same asset, this dividend policy will result in the
same sale price for the stock.
The resulting pre-tax and after tax IRRs for the shareholder of the C Corp were then determined.
Once the after-tax IRR was determined, it was used as the discount rate to establish the net
present value (NPV) of the Paired Share REIT structure. The resulting NPV represents the
incremental change in the after-tax cash flows to shareholder of Paired Share REIT structure.
Determining Risk Adjusted Returns on Equity
Finance theory maintains that as a firm's debt-equity ratio increases, so too does a shareholder's
expected rate of return on equity. Therefore, it is important to embed this dynamic in our
stylized model. It has been done so, as follows:
" First, the expected pre-tax return on assets was determined for the shareholder of the
C-Corp based on the profile of expected pre-tax cash flows shown in exhibit 5.1;
"
Second, the expected pre-tax return on equity for the shareholders of both the C-Corp
and Paired Share REIT was determined for varying levels of debt in the entity level
capitalization structure through application of the following formula;
RE = RA - RD*LEV
(1-LEV)
Where:
RE=
Pre-Tax Return on Shareholder's Equity
RA=
Return on Asset
LEV= Debt / Value
"
Third, estimates of the federal tax income liabilities for the shareholders of both the
C-Corp and Paired Shared REIT structure were prepared as shown in the top portion
of Exhibit 5.2;
e
Fourth, expected after-tax cash flows were identified by integrated Exhibits 5.1 & the
top portion of Exhibit 5.2; these results are shown in the bottom portion of Exhibit
5.2,
*
Fifth, having established a pre-tax and after-tax IRR for each of the shareholders in
the Base Case, the tax rate used to establish an appropriate after-tax return on
shareholder's equity across varying levels of debt in the entity level capital structure
was estimated by:
ATREC = PTREC * (1-TRC)
ATRER
=
PTRER * (1- TRR)
Where:
ATREC = After-Tax Return (IRR) on the C-Corps Shareholder's Equity
ATRER = After-Tax Return (IRR) on the Paired Share REITs Shareholder's
Equity
PTREC = Pre-Tax Return (IRR) on the C-Corps Shareholder's Equity
PTRER = Pre-Tax Return (IRR) on the Paired Share REITs Shareholder's
Equity
TRC = Blended Tax Rate (ordinary income and capital gains) for
Shareholders of C-Corp
TRR = Blended Tax Rate (ordinary income and capital gains) for
Shareholders of Paired Share REIT
.
Lastly, steps 3, 4 and 5 were then repeated for varying levels of debt.
BASE CASE
Analysis of Pre-Tax Shareholder Returns
Common Leverage
C-Corp. & Management Co.
Paired Share REIT
BEFORE TAX
(000)
0
YEAR
Pre-Tax Investment
2
1
$ 10,000,000
Pre-Tax Dividends 1
319,755
327,405
$
3
477,279
$
491,584
$ 505,150
0.98
1.01
(20.00)
(20.00)
0.64
0.62
0.65
0.95
28.26
28.26
Sale of Stock
Pre-Tax IRR=
2
1
$ 10,000,000
309,686
Pre-Tax Invesment Per Share
Pre-Tax Dividends Per Share
Before Tax Cash Flow
0
3
$
(20.00) $
0.62
$
0.64
$
28.91
15.07%
$
(20.00) $
16.61%
Notes:' Dividend Payments by C-Corp are lower due to (i) corporate-level federal income taxes and (ii) a dividend policy which is designed to
equalize year-end cash-on-hand for both the C-Corp and Paired-Share REIT
EXHIBIT 5.1
0.95
$
0.98
$
29.27
BASE CASE
Analysis of After-Tax Shareholder Returns
AFTER TAX
(000)
YEAR
Before Tax Cash Flow
Less Taxes
On Dividends
On Sale
$
ATCF
$
After Tax IRR=
0
(20.00) $
0.62
$
0.37
0.64
$
$
0.39
28.91
$
0
(20.00) $
$
27.00
$
(20.00) $
12.69%
11.74%
EXHIBIT 5.2
2
1
0.95
$
0.58
0.98
$
$
0.59
3
29.27
(0.40)
(1.65)
(0.39)
(0.38)
(0.26)
(1.65)
(0.25)
(0.24)
(20.00) $
3
2
1
$
27.22
Model Output-Shareholder Value
The model was run through a number of iterations in an attempt to illustrate the perceived tax
advantage of the Paired Share structure over a traditional C-Corp. The Base Case scenario was
developed to return a value that would represent the difference in the net present value of an
investment in a share of stock in the REIT versus the C-Corp, with asset value and cash on hand
being held constant at the entity level. A positive value would represent an increase in
shareholder value from the Paired Share REIT structure while a negative value would signify a
loss in shareholder value from the Paired Share REIT structure. This relative advantage was
examined over a range of common debt levels for the C-Corp and Paired Share REIT. Exhibit
5.3 displays these results.
Some practical differences across certain operating variables were then introduced. First, the
debt level (LEV) and the dividend payout percentage (DIV) were established for the REIT based
on contemporary organizational requirements and industry estimates of leverage and
dividend policy. Secondly, data sensitivity tables were constructed to identify the relative impact
on the model output of a range of debt levels and payout ratios for the C-Corp. The tables
present the results in two ways: exhibits labeled A display the relative shareholder advantage in
dollars; exhibits labeled B display the relative shareholder advantage as a percentage of the
initial $20.00 share price.
The following table outlines the revised (more contemporary) model inputs:
REIT
REIT
Relative
Debt Level
Dividend Payout'
Shareholder Value
LEV
DIV
CASE 1
35%
100%
Exhibit 5.4A & B
CASE 2
35%
115%
Exhibit 5.5A & B
CASE 3
30%
95%
Exhibit 5.6A & B
As a percentage of otherwise taxable income.
BASE CASE
Estimating Shareholder Value
Relative Per Share
Advantage of
Paired Share REIT
Structure
Common Debt Levels
(C-Corp and Paired
Share REIT)
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
90%
95%
0.50
0.49
0.49
0.48
0.47
0.45
0.42
0.39
0.33
0.26
0.19
0.13
0.07
0.00
0.00
0.00
0.00
0.00
0.00
EXHIBIT 5.3
Relative Per Share
Advantage of
Paired Share REIT
Structure
(as a % of initial
share price)
2.5%
2.5%
2.5%
2.5%
2.4%
2.4%
2.3%
2.2%
2.1%
1.9%
1.7%
1.3%
0.9%
0.6%
0.3%
0.0%
0.0%
0.0%
0.0%
0.0%
CASE I
Estimating Relative Shareholder Value
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT'=
35%
100%
45%
C-Corp LEVERAGE=
C-Corp DIVIDEND PAYOUT2=
30%
C-Corp - Dividend Payout
C-Corp -
Leverage
IS 0.451
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
10%
20%
0.84
0.80
0.76
0.73
0.69
0.65
0.62
0.58
0.55
0.53
0.51
0.51
0.54
0.61
0.68
0.81
1.00
1.29
0.78
0.75
0.71
0.68
0.64
0.61
0.57
0.54
0.51
0.49
0.47
0.48
0.50
0.57
0.64
0.78
0.98
1.29
30%
0.72
0.69
0.66
0.63
0.59
0.56
0.53
0.50
0.47
0.45
0.44
0.44
0.46
0.53
0.60
0.74
0.96
1.29
Notes: 1 Based on percentage of Otherwise Taxable Income
2 Based on percentage of Net Income After Taxes
EXHIBIT 5.4A
40%
50%
0.7
60%
0.69510
0.70
0.66
0.63
0.59
0.55
0.52
0.49
0.46
0.43
0.41
0.40
0.40
0.42
0.48
0.55
0.71
0.93
1.29
0.70
0.66
0.62
0.59
0.55
0.51
0.47
0.43
0.40
0.37
0.36
0.36
0.38
0.44
0.51
0.67
0.91
1.29
0.69
0.66
0.62
0.58
0.55
0.51
0.47
0.43
0.39
0.36
0.34
0.32
0.34
0.40
0.47
0.64
0.89
1.29
CASE 1
Estimating Relative Shareholder Value
(as a % of Initial Share Price)
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT'=
35%
110%
C-Corp LEVERAGE=
2
C-Corp DIVIDEND PAYOUT =
45%
30%
C-Corp - Dividend Payout
10%
20%
20%
30%
40%
50%
60%
4.3%
3.7%
3.5%
3.3%
3.5%
3.5%
4.1%
4.0%
3.8%
3.3%
3.3%
3.9%
3.7%
3.6%
3.5%
3.4%
3.1%
3.1%
3.2%
3.1%
3.0%
2.9%
3.5%
3.3%
3.2%
3.3%
3.1%
2.9%
2.8%
2.7%
2.9%
2.7%
2.5%
2.7%
40%
3.0%
2.8%
2.9%
2.8%
2.6%
2.6%
2.4%
2.5%
2.4%
2.2%
2.5%
2.4%
2.2%
2.0%
2.2%
2.0%
45%
2.7%
2.5%
2.3%
2.1%
1.9%
1.8%
2.3%
2.1%
1.9%
1.9%
1.7%
1.7%
23%|
0%
23%
5%
10%
C-Corp -
Leverage
15%
20%
25%
30%
35%
50%
55%
60%
65%
70%
75%
80%
2.6%
85%
3.1%
2.5%
3.5%
2.7%
2.3%
2.7%
2.5%
2.3%
2.1%
2.8%
2.6%
2.4%
2.2%
2.5%
2.0%
1.8%
2.3%
2.1%
2.9%
3.6%
2.6%
2.4%
3.4%
3.3%
4.8%
6.6%
4.7%
4.6%
6.6%
6.6%
3.2%
3.5%
2.9%
2.7%
3.1%
4.2%
3.3%
4.0%
5.1%
5.0%
4.9%
6.6%
6.6%
6.6%
3.8%
Notes: 1 Based on percentage of Otherwise Taxable Income
2 Based on percentage of Net Income After Taxes
EXHIBIT 5.4B
CASE 2
Estimating Relative Shareholder Value
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT'=
35%
115%
50%
C-Corp LEVERAGE=
C-Corp DIVIDEND PAYOUT2=
20%
C-Corp - Dividend Payout
$s
I$
0%
5%
o.50
0.50
10%
15%
20%
25%
C-Corp -
30%
Leverage
40%
35%
45%
50%
55%
60%
65%
70%
75%
80%
85%
10%
20%
30%
40%
50%
60%
0.86
0.83
0.79
0.75
0.81
0.77
0.74
0.70
0.67
0.63
0.60
0.57
0.54
0.51
0.50
0.50
0.53
0.60
0.67
0.80
1.01
1.32
0.75
0.72
0.70
0.66
0.63
0.60
0.70
0.66
0.62
0.59
0.55
0.51
0.47
0.69
0.71
0.68
0.64
0.61
0.58
0.55
0.54
0.54
0.57
0.64
0.71
0.84
1.03
1.32
0.68
0.65
0.62
0.59
0.55
0.52
0.50
0.48
0.46
0.46
0.49
0.55
0.62
0.77
0.98
1.32
Notes: 1 Based on percentage of Otherwise Taxable Income
2 Based on percentage of Net Income After Taxes
EXHIBIT 5.5A
0.57
0.54
0.51
0.48
0.46
0.44
0.42
0.42
0.45
0.51
0.58
0.73
0.96
1.32
0.44
0.42
0.40
0.39
0.39
0.41
0.47
0.54
0.70
0.94
1.32
0.66
0.62
0.58
0.55
0.51
0.47
0.43
0.39
0.36
0.35
0.35
0.37
0.42
0.49
0.66
0.92
1.32
CASE 2
Estimating Relative Shareholder Value
(as a % of Initial Share Price)
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT'=
35%
115%
C-Corp LEVERAGE=
2
C-Corp DIVIDEND PAYOUT =
50%
20%
C-Corp - Dividend Payout
1
2.5%I
0%
5%
10%
2.5%
15%
C-Corp -
Leverage
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
10%
20%
4.1%
4.0%
3.9%
3.9%
3.8%
3.7%
3.5%
3.6%
3.3%
3.2%
4.3%
3.4%
3.2%
3.0%
30%
3.7%
3.6%
3.4%
3.3%
40%
3.5%
3.3%
3.2%
3.0%
50%
60%
3.5%
3.3%
3.5%
3.3%
3.1%
2.9%
2.7%
3.1%
2.9%
2.7%
3.1%
2.9%
2.9%
2.8%
2.7%
2.5%
2.4%
2.5%
2.6%
2.4%
2.2%
2.2%
2.1%
2.0%
2.0%
1.8%
2.3%
3.0%
2.9%
2.8%
2.8%
2.6%
2.7%
2.6%
2.5%
2.4%
2.3%
2.2%
2.7%
2.7%
2.5%
2.3%
2.1%
1.9%
1.7%
2.5%
2.3%
2.1%
1.9%
1.7%
2.8%
2.6%
2.4%
2.2%
2.0%
1.8%
3.2%
3.0%
2.8%
2.5%
2.3%
2.1%
3.5%
3.3%
3.1%
2.9%
2.7%
2.5%
4.2%
4.0%
3.8%
3.7%
3.5%
3.3%
5.1%
5.0%
4.9%
4.8%
4.7%
4.6%
6.6%
6.6%
6.6%
6.6%
6.6%
6.6%
Notes: 1 Based on percentage of Otherwise Taxable Income
2 Based on percentage of Net Income After Taxes
EXHIBIT 5.5B
CASE 3
Estimating Relative Shareholder Value
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT'=
30%
95%
C-Corp LEVERAGE=
C-Corp DIVIDEND PAYOUT2=
55%
10%
C-Corp - Dividend Payout
$
C-Corp
-
Leverage
0.49
0%
5%
10%
15%
20%
25%
10%
0.79
0.76
0.72
0.69
0.65
0.61
20%
0.74
0.71
0.67
0.64
0.61
0.57
30%
0.69
0.66
0.63
0.60
0.56
0.53
40%
0.70
0.65
0.59
0.55
0.52
0.49
50%
0.82
0.77
0.71
0.65
0.59
0.52
30%
35%
40%
0.58
0.55
0.52
0.54
0.51
0.48
0.50
0.47
0.45
45%
50%
55%
60%
65%
70%
75%
80%
85%
0.50
0.49
0.49
0.52
0.60
0.67
0.80
1.00
1.30
0.46
0.45
0.45
0.48
0.55
0.63
0.77
0.98
1.30
0.43
0.42
0.42
0.45
0.51
0.59
0.74
0.96
1.30
0.46
0.44
0.41
0.39
0.38
0.38
0.41
0.47
0.54
0.70
0.94
1.30
0.46
0.41
0.38
0.36
0.35
0.35
0.37
0.43
0.50
0.67
0.92
1.30
Notes: 1 Based on percentage of Otherwise Taxable Income
2 Based on percentage of Net Income After Taxes
EXHIBIT 5.6A
60%
0.95
0.89
0.82
0.76
0.69
0.63
0.56
0.49
0.43
0.36
0.32
0.31
0.33
0.39
0.46
0.64
0.90
1.30
CASE 3
Estimating Relative Shareholder Value
(as a % of Initial Share Price)
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT'=
30%
95%
C-Corp LEVERAGE=
2
C-Corp DIVIDEND PAYOUT =
55%
10%
C-Corp - Dividend Payout
C-Corp -
Leverage
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
10%
4.0%
20%
3.8%
3.6%
3.5%
3.4%
3.4%
3.2%
3.2%
3.1%
2.9%
2.7%
2.6%
2.5%
2.4%
2.5%
2.6%
3.0%
3.3%
4.0%
5.0%
6.5%
3.7%
3.0%
2.9%
2.7%
2.6%
2.4%
2.3%
2.3%
2.3%
2.4%
2.8%
3.1%
3.8%
4.9%
6.5%
30%
3.4%
3.3%
3.1%
3.0%
2.8%
2.7%
2.5%
2.4%
2.2%
2.1%
2.1%
2.1%
2.2%
2.6%
2.9%
3.7%
4.8%
6.5%
Notes: 1 Based on percentage of Otherwise Taxable Income
2 Based on percentage of Net Income After Taxes
EXHIBIT 5.6B
40%
3.5%
3.2%
3.0%
2.8%
2.6%
2.5%
2.3%
2.2%
2.1%
2.0%
1.9%
1.9%
2.0%
2.4%
2.7%
3.5%
4.7%
6.5%
50%
60%
4.1%
3.8%
3.5%
4.7%
3.2%
3.8%
2.9%
2.6%
2.3%
2.0%
1.9%
1.8%
1.7%
1.7%
3.5%
1.9%
2.2%
2.5%
3.3%
4.6%
6.5%
4.4%
4.1%
3.1%
2.8%
2.5%
2.1%
1.8%
1.6%
1.6%
1.7%
2.0%
2.3%
3.2%
4.5%
6.5%
Results -Shareholder Value
The results of our base case scenario indicate a clear creation of value for the Paired Share REIT
shareholders relative to the C-Corp shareholders. The dividend payout of the C-Corp was
estimated and set at 40.6% of its cash flow after taxes. This resulted in both entities having Net
Assets with a market value of approximately $14.1 million at the end of the three-year period
modeled, or a stock price at the time of sale of $28.26. The relative value created from holding
and operating properties through a Paired Share structure was due to its reduced tax burden
versus that of the C Corp. This allowed the Paired Share REIT to distribute higher dividends
payments. The after-tax IRRs of the C Corp and Paired Share REIT are 11.74% and 14.69%
respectively. The Paired Share stock returns $0.50 (or 2.5%) more over the three year holding
period on a net present value basis. These results can be found in Appendix A.
Examining Exhibit 5.3, the results of the stylized model seem to indicate that the relative
shareholder value of the Paired Share REIT can be mitigated through the use of tax shielding
debt. As both entities increase the use of financial leverage, the C-Corp realizes the tax shielding
benefits of debt and achieves the tax free characteristics inherent in the REIT structure. In this
comparison it its important to note that debt levels are identical and therefore the interest burden
on both entities is equal. Given this, the only variable in the cost structure of the two entities is
the tax expense. At the highest levels of leverage, the C-Corp's tax liability is completely
shielded, and therefore the cost structures are equivalent, resulting in equal returns to
shareholders (or relative shareholder advantage of zero for the Paired Share REIT.)
A possible shortcoming of this base case scenario lies in the capital structure of the two entities.
While REITs typically maintain relatively low levels of debt, there is a tax shelter advantage
(interest tax shield) to the more moderate (higher) levels of debt often found in the capital
structure of a C-Corp, as shown in the previous exhibit. For example, a 35 percent debt level
approximates the industry average for REITs. Recall that because REITs are required to
distribute 95 percent of their income and are allowed a deduction for dividends paid, they
effectively pay no federal income taxes at the entity level, and therefore benefit from increased
levels of debt.
The data tables in exhibit 5.4, 5.5 and 5.6 were designed to explore whether changes to a CCorp's capital structure and dividend policy could effectively mitigate the relative financial
advantage of the Paired Share REIT structure, as constrained by industry average debt levels and
dividend payout ratios. The resulting tables do much to support the notion that certain income
requirements and strictures of the REIT vehicle curtail the tax advantages many believe to be
ever-present. The data tables seem to all indicate that the tax advantages of the Paired Share
structure are somewhat mitigated by the dividend payout requirement (95%) and the debt level
(35%) currently employed by many REITs. The tables suggest that when a C-Corp. is using
moderate levels of debt (in the 45% to 55% range), it can mitigate the Paired Share tax
advantage, by raising the dividend payout percentage. The Payout policy of both entities is a
management decision, although a C-Corp has the luxury of not paying a dividend at all. REITs
are required to pay dividends and are further restricted by a minimum dividend payment that is
equal to 95% of its otherwise taxable income.
Importantly, the tables seem to support the theory that the tax-shielding advantage of debt has
limitations. Though "C" corporations typically utilize debt to reduce tax liability and positively
affect shareholder value, high levels of debt can actually reverse any gain to its shareholders.
This is evidenced by the higher relative financial advantage of the Paired Share REIT structure
when the C-Corp has 60% - 80% debt in its capital structure. As leverage rises and debt gets
riskier, the cost of debt increases and the return the equity holders demand also rises and
overwhelms the tax shielding advantage of debt. (This dynamic is displayed graphically in
Appendix C.) In addition, as exhibits 5.4 - 5.6 demonstrate, the C-Corp is not capable of
replicating the tax-advantaged structure of the REIT through the use of financial leverage.
Increasing debt brings with it increased cash tax burden. The savings in cash taxes are offset by
this increased use of cash to service the interest expense on the debt. Even when the C-Corp's
income is shielded entirely from taxes and it, like the Paired Share REIT, will pay no federal
income tax, its cost structure is much larger then that of the Paired Share REIT (with a debt level
of 35%) because of its higher interest expense. As the exhibits indicate, the C-Corp's
shareholders are never at a relative advantage over the Paired Share REIT's shareholders.
To fully explore our results, we took a small sample of publicly traded hotel "C" corporations
and estimated their current debt to market value ratio (see Appendix B) and dividend policy.
Unfortunately, all the "C" corporations in our sample did not currently pay regular dividends,
and most had not paid out dividends in the past 4 years. Our sampling did yield an average debt
to market value ratio of 48.4%. Notably, our data tables indicate that in the leverage ratio
ranging between 45% and 55% the relative advantage of the shareholders in the C-Corp relative
to the Paired Share REIT is at its lowest.
It is important to note that this model was designed to examine the scenario in which both
entities own and operate a single asset. It is not designed to measure the benefits to shareholder
value of these structures in their ability to grow their asset base. To fund new investments, the
C-Corp has infinite flexibility to establish dividend policy and retain earnings. Investments with
returns higher than those required by shareholders could be funded with retained earnings. This
use of cash may ultimately increase shareholder value more than returning those earnings in the
form of dividends. The restricted dividend policy required of a REIT doesn't provide this source
of capital. Instead, REITs are forced to raise equity capital for most new investments externally.
Relative to capital raised internally, external capital carries with it two drawbacks for current
shareholders. Firstly, there is a cost to raising external capital (approximately 5% to 7%).
Secondly, raising large amounts of equity can have dilutive effects on returns realized by current
shareholders for new investments.
Given the preceding arguments, it is conceivable that a C-Corp. has the ability beyond that
represented in this stylized model to further mitigate the relative advantage of the Paired Share
structure as measured by shareholder returns.
Calculating Total Tax Revenue
The stylized model was also constructed to investigate the conception that operating a business
through a REIT's tax conduit structure will mean less tax revenue for the government. To
examine the total tax revenue generated by the hotel's operation in our model, we employ a
methodology similar to the one used above. We built a cash flow diagram drawing from the tax
liability at the corporate level for each structure and the tax burden of its shareholders. In an
effort to capture the benefits granted to REIT shareholders who are able to defer their taxable
capital gains, we assumed 25% of the shareholders would sell their stock at the end of period
three. The tax liabilities of the shareholders for each entity were then calculated by applying the
ordinary income tax rate to any dividends they received and, where applicable, applying the
capital gains tax to the difference between the sales price and their basis in the stock. Once
again, the present value of these tax payments at the entity and shareholder level for both the CCorp and the Paired Share REIT. The difference between these two present value sums is
labeled Additional Tax Revenue Associated with the Paired Share REIT structure in Appendix
A, page 69.
REIT
REIT
Data Table
Debt Level
Dividend Payout'
Total Tax Revenue
LEV
DIV
CASE 1
35%
100%
Table 5.7
CASE 2
35%
115%
Table 5.8
CASE 3
30%
95%
Table 5.9
As a percentage of otherwise taxable income.
Results-Total Tax Revenue
The resulting data tables parallel the outcome of the shareholder value iterations. When the Base
Case was input, the tax liability of the C-Corp was greater than that of the Paired Share REIT.
More importantly, the data tables generated from our model indicate that with debt levels
(50% - 60%) and dividend payout ranges (10% - 30%) more in keeping with industry standards
for "C" corporations, the Paired Share REIT structure actually generates a large present value
contribution to total tax revenue than does the C-Corp.
CASE 1
Estimating Total Tax Revenue
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
25.00%
5.5% Three Year Treasury
35%
100%
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT1=
45%
30%
C-Corp LEVERAGE=
C-Corp DIVIDEND PAYOUT2=
C-Corp - Dividend Payout
C-Corp Leverage
(522,955)
(474,423)
(424,207)
(372,305)
(318,718)
(263,444)
(206,481)
$
$
$
$
$
$
$
(441,904)
(403,888)
(364,709)
(324,365)
(282,855)
(240,176)
(196,326)
$
$
$
$
$
$
$
(475,532)
(441,901)
(409,639)
(377,680)
(341,318)
(298,799)
(248,839)
$
$
$
$
$
$
$
(522,204)
(474,391)
(424,176)
(372,276)
(323,327)
(274,568)
(227,651)
$
$
$
$
$
$
$
$
(44,412) $ (98,060) $
$
(151,305)
(105,110)
(57,739)
(5,925)
50,459
112,104
179,920
268,464
302,698
317,572
334,750
$
(4,184)
37,138
79,554
123,066
167,673
213,377
272,658
302,479
317,466
334,750
(196,851)
(140,421)
(81,405)
(18,226)
46,638
113,188
181,424
269,719
302,806
317,625
334,750
$
$
(183,161)
(135,797)
(79,362)
(16,315)
48,414
114,827
182,925
270,970
302,915
317,678
334,750
$ (149,697)
$ (95,475
0%
5%
10%
15%
20%
25%
30%
$
$
$
$
$
$
$
35%
40%
45%
50%
55%
60%
65%
70%
75%
80%
85%
60%
50%
40%
30%
20%
10%
($57,739)
$
$
$
$
$
$
$
$
$
(295,470)
(262,871)
(229,184)
(194,409)
(158,546)
(121,592)
(83,548)
$
$
$
$
$
$
$
(368,963)
(333,645)
(297,202)
(259,632)
(220,934)
(181,107)
(140,150)
$ (54,837) $
$
$
$
$
$
$
$
$
$
(10,479)
35,015
81,646
130,391
186,075
267,207
302,589
317,519
334,750
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
$
(45,708)
853
52,465
116,462
184,421
272,218
303,023
317,731
334,750
Notes: A positive value indicates the Paired Share REIT and its shareholders have a higher federal tax burden
than does the C-Corp and its shareholders. A negative value means the Paired Share REIT and
its shareholders have a lower combined tax burden than does the C-Corp and its shareholders
EXHIBIT 5.7
CASE 2
Estimating Total Tax Revenue
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
25.00%
5.5% Three Year Treasury
35%
115%
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUTI=
50%
20%
C-Corp LEVERAGE=
C-Corp DIVIDEND PAYOUT2=
C-Corp - Dividend Payout
$72,361
0%
5%
10%
-
20%
(331,617)
(296,299)
(259,856)
(222,286)
(183,588)
(143,761)
(102,804)
$
$
$
$
$
$
$
30%
(404,558)
(366,542)
(327,363)
(287,019)
(245,509)
(202,830)
(158,980)
$
$
$
$
$
$
$
$
$
$
$
$
$
$
50%
(522,204)
(474,391)
(424,176)
(372,276)
(323,327)
(273,526)
(220,207)
(159,506) $
(103,075) $
(44,059) $
19,120 $
(163,062)
(103,380)
(42,016)
21,031
$
$
$
$
$
$
$
$
$
$
$
40%
(473,904)
(435,401)
(394,361)
(351,264)
(306,963)
(261,453)
(211,493)
60%
(522,955)
(474,423)
(424,207)
(372,305)
(318,718)
(263,444)
(206,481)
20%
25%
30%
35%
40%
45%
50%
$
$
$
$
$
$
$
$
$
$
$
(7,066) $
33,162 $
74,484 $
116,900 $
55%
$
160,412
118,992
$
$
83,984
$
85,760
$
87,531
60%
$
205,019 $ 167,737
$
149,450 $
150,534
$
152,173
$
153,808
65%
$
250,723
$
223,421
$
217,266
$
218,770
$
220,271
$
221,767
70%
$
310,004
$
304,553
$
305,810
$
307,064
$
308,316
$
309,564
75%
$
339,825 $ 339,934
$
340,043
$
340,152
$
340,261
$
340,369
80%
$
354,812
$ 354,865
$
354,918
$
354,971
$
355,024
355,077
85%
$
372,096
$ 372,096
$
372,096
$
372,096
$
372,096
$
$
15%
C-Corp
10%
(258,124)
(225,525)
(191,838)
(157,063)
(121,200)
(84,246)
(46,202)
$
$
$
$
$
$
$
$
(60,714) $
(17,491)
$
26,867 $
72,361 $
(113,959) $
(67,764) $
(20,393) $
31,421 $
87,805
(149,697)
(95,475)
(39,129)
22,936
372,096
Notes: A positive value indicates the Paired Share REIT and its shareholders have a higher federal tax burden
than does the C-Corp and its shareholders. A negative value means the Paired Share REIT and
its shareholders have a lower combined tax burden than does the C-Corp and its shareholders
EXHIBIT 5.8
CASE 3
Estimating Total Tax Revenue
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
Paired Share REIT LEVERAGE=
Paired Share REIT DIVIDEND PAYOUT1
30%
95%
C-Corp LEVERAGE=
C-Corp DIVIDEND PAYOUT2=
55%
10%
25.00%
5.5%
Three Year Treasury
C-Corp - Dividend Payout
$1i~668
$
5%
10%
50%
$
$
$
$
$
$
$
$
$
$
55%
60%
65%
70%
75%
80%
85%
15%
20%
25%
30%
C-Corp -
Leverage
10%
-,
0%
35%
40%
45%
20%
(256,868) $ (330,360)
(224,268) $ (295,042)
(190,581) $ (258,599)
(155,807) $ (221,029)
(119,943)
(82,990)
(44,946)
(5,810)
34,419
75,741
118,157
$
$
$
$
$
$
$
(182,332)
$
161,668 $
120,248
$
$
$
$
$
$
206,276
251,980
311,260
341,082
356,068
373,352
30%
(403,301)
(365,285)
(326,106)
(285,763)
(244,252)
(142,505)
(101,547)
(59,457)
(201,573)
(16,234)
(66,507)
(19,136)
32,678
89,062
28,124
73,618
$ 168,993
$ 224,678
$ 305,809
$ 341,191
$ 356,122
$ 373,352
(157,724)
(112,702)
150,707
218,523
307,067
341,300
356,175
373,352
40%
(477,866)
(436,238)
(393,526)
(350,008)
(305,706)
(260,196)
(210,236)
(158,249)
(101,818)
(42,803)
20,377
50%
(546,231)
(495,000)
(441,319)
(388,566)
(334,389)
(278,516)
(220,947)
(161,994)
(102,123)
(40,759)
22,287
60%
(587,666)
(528,269)
(467,036)
(406,461)
(345,051)
(284,676)
(223,321)
(163,872)
(102,786)
(39,999)
24,048
88,788
85,241
87,017
151,791
220,027
153,430
221,527
155,065
308,321
309,572
310,820
341,409
356,228
373,352
341,517
356,281
373,352
341,625
356,334
373,352
223,024
Notes: Apositive value indicates the Paired Share REIT and its shareholders have a higher federal tax burden
than does the C-Corp and its shareholders. A negative value means the Paired Share REIT and
its shareholders have a lower combined tax burden than does the C-Corp and its shareholders
EXHIBIT 5.9
Conclusion
With the forces of public market accountability and strict REIT requirements, the results of our
stylized model seem to indicate the perceived tax advantage of the Paired Share structure, which
many have said leads to an unfair competitive advantage, can be disputed. We conclude that, on
balance, higher debt to equity ratios utilized by "C" corporations coupled with their ability to
retain earnings do much to offset the tax conduit benefits afforded the Paired Share REIT.
With regard to the notion that allowing Paired Share REITs to operate as a tax conduit structure
will mean a loss of total tax revenue to the government, our model seems to indicate otherwise.
To remain competitive as a real estate investment to smaller investors, REITs do not use taxsheltering debt to the extent of "C" corporations. As such, the dividends they distribute to
shareholders, along with the income profits from operations, generate a tax liability that our
model suggests, in most cases, is at least equal to than that of a corresponding "C" corporation.
Appendix A
Stylized Model Parameters and Outputs
Exhibit No.
Title
Pa
A. 1
A.2
62
63
A.4
Base Case Model Assumptions
Base Case - Year 1 Income and Cash Statements
Base Case - Year 1 Balance Sheet
Base Case - Year 2 Income and Cash Statements
A.5
Base Case - Year 2 Balance Sheet
66
A.6
Base Case - Year 3 Income and Cash Statements
67
A.7
Base Case - Year 3 Balance Sheet
68
A.8
A.9
A.10
A. 11
Base
Base
Case
Case
A. 12
Case
A. 13
A. 14
A. 15
Case
Case
Case
A. 16
Case
A. 17
A. 18
Case
Case
A. 19
Case 2 - Model Assumptions
80
A.20
Case 2 - Year 1 Income and Cash Statements
Case 2 - Year 1 Balance Sheet
Case 2 - Year 2 Income and Cash Statements
Case 2- Year 2 Balance Sheet
Case 2 - Year 3 Income and Cash Statements
81
A.25
Case 2 - Year 3 Balance Sheet
86
A.26
A.27
Case 2 - Estimating Relative Shareholder Value
Case 2 - Estimating Total Tax Revenue
87
88
A.28
Case 3 - Model Assumptions
89
A.29
90
A.31
A.32
A.33
Case 3 - Year 1 Income and Cash Statements
Case 3 - Year 1 Balance Sheet
Case 3 - Year 2 Income and Cash Statements
Case 3- Year 2 Balance Sheet
Case 3 - Year 3 Income and Cash Statements
A.34
Case 3 - Year 3 Balance Sheet
95
A.35
A.36
Case 3 - Estimating Relative Shareholder Value
Case 3 - Estimating Total Tax Revenue
96
97
A.3
A.21
A.22
A.23
A.24
A.30
Case - Estimating Relative Shareholder Value
Case - Estimating Total Tax Revenue
1 Model Assumptions
1 - Year 1 Income and Cash Statements
1 - Year 1 Balance Sheet
1 - Year 2 Income and Cash Statements
1- Year 2 Balance Sheet
1 - Year 3 Income and Cash Statements
1 - Year 3 Balance Sheet
1 - Estimating Relative Shareholder Value
1 - Estimating Total Tax Revenue
64
65
69
70
71
72
73
74
75
76
77
78
79
82
83
84
85
91
92
93
94
BASE CASE
Model Assumptions
C-Corp
REIT
$ 10,000,000
$ 1,000,000
$ 10,000,000
$ 1,000,000
OWNERSHIP
Asset Value
Stabilized NO[
Leverage:
LI
Debt Level:
Interest Rate:
Amortization Term: (years)
Loan Amount:
Yearly PMT:
$
0%
5.79%
25
$-
-
$0
$0
Equity:
Share Price:
No. of Shares:
Risk Adjusted Return on Equity:
$
100%
20.00
500,000
15.07%
$
100%
20.00
500,000
15.07%
REIT
C-Corp
Dividend Payout:
% of Net Income-after taxes
% of Otherwise Taxable Income
0%
5.79%
25
D
41%
100%
4%
4%
Interest Income (after tax return)
Tax Rate:
0%
39.5%
20%
35%
39.5%
20%
Corporate:
Personal:
Capital Gains:
OPERATIONS
Hotel Operations
Revenue Growth
1.5% peryear
Year 1
$ 3,000,000
Revenue
Year 3
3,090,675
Year 2
3,045,000
67% of Revenue
Operating Expense
REIT
C-Corp
Lease Structure:
$
Base:
% of Revenue
Management Fee:
% of Net Income
Depreciation:
3,000,000
over
6.0%
452,381
452,381
452,381
452,381
(TAX)
(GAAP)
TAX
10,000,000
(1,500,000)
(2,000,000)
6,500,000
Buy Price
Land
FF&E
Building Depreciable Basis
(39yrs)
(7yrs)
166,667
285,714
452,381
EXIHI BIT A.1
REIT
GAAP
10,000,000
(1,500,000)
(2,000,000)
6,500,000
C-Corp.
GAAP
10,000,000
(1,500,000)
(2,000,000)
6,500,000
Depreciations Calculations:
Building Depreciation
FF&E Depreciation
Total Depreciation
940,000
30%
(39)
(7)
166,667
285,714
452,381
(39)
(7)
166,667
285,714
452,381
BASE CASE
IncoBW5Ln@)sh Statements
Year 1
Balance Sheet
Year 1
C-Corp. Ownership
YEAR 1
Paired Share REIT Ownership
(000)
C-Corp.& Management Co(000)
I
N
caA
Lease Payment
PPE
NOI
LT
ASSETS
(000)
Revenue
YEAR1
Operatir(00)ErlodA
YYEAR1
O
N/A
10,000
$
(452
em$
ASES0,0
(000)
Beginning Perod
Interest
Deorciation
(000)
$
-
$
" Raxable Income
5
CApitalEklWtimdUrolDividends Paid
9,995
Cqital iN%9BI KYik me
Liability0
a
Taxin
10,00A
SLiabilit
Net Income-after taxes
Sh-oIZ
q A,
_lIABILITY
$
$
0
0
0
~452)
478
N/A
N/A
5
478
40
310
:0
N/A
-
(1)
452
10,401
(2,000)
940
60
N/A
60
LIABILITIES and d
0
(000)
$
(
-
60
477
5
5
60
(21)
9,995
492
940 10,000
10e0ee
60
930
LIABILITIES and O/E
EBITDA
YEAR1
Ending Peiod
10,000
492
1,040
1000
o0
ASSW
10,3Q000
g ement Fee
Tot~As.1A
E
Del#
$
Co
-rating
SIT
IPaired
$
_4
0
0
0
$
10,0 $
1.
JU188
60
(21)
39,e
0______
40
N/A
0
0
60
4121
YEAR 1
owner
(000)
Year I
C
A
S
H
E
F
F
E
C
T
EBITDA
Interest Income
Interest Expense
Principal
Tax Liability
Cash Flow After Taxes
$
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
C-Corp. Ownership
EXIHIBBIT A.3 Management Co.
(000)
$
930
0
0
0
(167)
763
$
60
0
0
0
(21)
39
$
930
0
0
0
0
930
60
0
0
0
(21)
39
Dividend Payout
Cash Retained for Operations
310
453
0
39
477
452
0
39
CASH RETAINED
453
39
452
39
TOTAL DIVIDENDS PAID
310
477
TOTAL CASH RETAINED
492
492
YEAR 1
Year 1
GAAP BASIS
I
N
C
0
M
E
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
E
F
F
T
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
3,000
$
0
(2,000)
N/A
1,000
(60)
(10)
(21)9)_(21)
930
0
(452)
478
(167)
310
60
0
0
60
21_0
39
350
EXIHIBIT A.2
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
3,000
$
0
(2,000)
(940)
60
940
N/A
N/A
60
0
3 0452
60
931
0
478
21)
39
478
517
BASE CASE
Balance Sheet
Year I
nml
YEAR 1
Beginning Period
Cash
PP&E
Less:Acc. Depr.
Total Assets
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & O/E
Dividend Payout =
Return of Capital=
$
C-Corp.& Management Co.
ASSETS
YEAR 1
(000)
Ending Period
492
10,000
$
10,000
9,548
(452)
10,040
10,000
$
LIABILITIES and OiE
(000)
$
$
9,995
0
10,000
YEAR 1
Beginning Period
10,000
$
10,000
LIABILITIES and OlE
(000)
$
-0
0
$
$
$
REIT & Operating Co.
ASSETS
(000)
9,995
40
10,040
$
5
9,995
0
10,000
-
EXIHIBIT A.3
-
0
$
$
310
YEAR 1
Ending Period
492
$
10,000
9,548
(452)
$
10,040
477
5
9,995
40
10,040
BASE CASE
Income and Cash Statements
Year 2
YEAR 2
TAX BASIS
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
954
N/A
N/A
(10)
61
944
0
0
0
(452)
61
492
N/A
(492)
61
0
(21)
0
40
0
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
(2,030)
N/A
1,015
(61)
(10)
61
944
0
0
0
(452)
61
491
N/A
N/A
61
491
(21)
(172)
40
319
21
193
TOTAL TAX LIABILITY
YEAR 2
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
EBITDA
Interest Income
Interest
Principal
Tax Liability
Cash Flow After Taxes
$
$
944
20
0
0
(172)
792
$
61
0
0
0
(21)
40
$
944
20
0
0
0
964
61
0
0
0
(21)
40
Dividend Payout
Cash Retained for Operations
320
472
0
40
492
472
0
40
CASH ON HAND
472
40
472
40
TOTAL DIVIDENDS PAID
320
492
TOTAL CASH RETAINED
512
512
YEAR 2
GAAP BASIS
I
N
C
O
M
E
E
F
C
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Co rp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
20
(2,030)
N/A
1,035
(61)
(10)
61
963
0
0
0
(452)
61
511
(21)
(172)
40
339
379
EXIHIBIT A.4
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
N/A
(10)
964
0
(452)
511
0
511
61
0
0
61
(21)
40
551
BASE CASE
Balance Sheet
Year 2
REIT~
Cash
PP&E
Less:Acc. Depr.
Total Assets
C-Corp.& Management Co.
ASSETS
YEAR 2
(000)
YEAR 2
Ei nding Period
Begining Period
1,004
$
492
9,5 48
9,095
(452)
9,548
$
10,099
10,040
$
$
Dividend Payout=f C% it-I=
Rt4.
eumC
p
o
9,995
40
10,040
$
$
$
$
YEAR 2
BeginningPeriod
$
492
YEAR 2
Ending Period
1,004
9,548
(452)
9,548
10,040
$
9,096
10,100
$
5
9,995
100
10,100
LIABILITIES and OlE
(000)
LIABILITIES and OlE
(000)
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
PN i d Sh
a re
are
REIT & Operating Co.
ASSETS
(000)
5
9,995
99
10,099
$
-$
5
9,995
40
10,040
$
320
EXIHIBIT A.5
492
BASE CASE
Income and Cash Statements
Year 3
YEAR 3
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,091
$
(2,061)
(967)
63
N/A
N/A
C-Corp. Ownership
Management Co.
Owner
TAX BASIS
(000)
(000)
Revenue
$ 3,091
(2,061)
Operating Expense
N/A
Lease Payment
1,030
NOI
(62)
Management Fee
G&A
(10)
62
958
EBITDA
0
0
Interest
0
(452)
Depreciation
62
506
Otherwise Taxable Income
N/A
N/A
Deductions for Dividends Pa
62
506
Net Taxable Income
(21)
(177)
Income Tax Liability
40
329
Net Income - after taxes
(10)
N/A
63
(22)
41
22
198
TOTAL TAX LIABILITY
63
0
0
63
958
0
(452)
505
(505)
0
0
0
YEAR 3
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$
EBITDA
Interest Income
Interest Expense
Principal
Tax Liability
Cash Flow After Taxes
$
958
40
0
0
(177)
821
0
0
(21)
40
958
40
0
0
0
998
$
62
$
63
0
0
(22)
41
Dividend Payout
Cash Retained for Operatio
327
494
0
40
505
493
0
41
CASH ON HAND
494
40
493
41
TOTAL DIVIDENDS PAID
327
505
TOTAL CASH RETAINED
534
534
YEAR 3
GAAP BASIS
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,091
40
(2,061)
N/A
1,070(62)
(11)
62
0
0
62
(22)
40
998
0
(452)
545
(177)
368
409
EXIHIBIT A.6
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,091
$
40
(2,061)
(967)
63
967
N/A
N/A
(10)
63
998
0
0
0
(452)
63
545
0
(22)
41
545
586
BASE CASE
Balance Sheet
Year 3
Paired Share REIT'
C-Corp.& Management Co.
ASSETS
YEAR 3
(000)
YEAR 3
Ending Period
Beginning Period
1,538
1,004
$
9,095
8,643
(452)
9,095
$ 10,181
$ 10,099
Cash
PP&E
Less:Acc. Depr.
Total Assets
REIT & Operating C o.
ASSETS
YEAR 3
(000)
YEAR 3
Ending Period
Beginning Peri 1d
1,538
$
1,004
9,095
8,643
(452)
9,096
$ 10,181
$
10,100
LIABILITIES and O/E
(000)
LIABILITIES and OlE
(000)
Debt
Less:Principal Repayment
Shareholder's Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & O/E
Dividend Payout=Return of Capital=
Return of Canital=
$
9,995
99
10,099
$
$
327
$
-
5
9,995
180
10,180
$
5
9,995
181
$ 10,181
5
9,995
100
10,100
$
EXIHIBIT A.7
505
BASE CASE
Estimating Relative Shareholder Value
C-Corp
2
1
Sale of Stock
Assets
CASH
Market Value of Property
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
REIT
1,537,870
$
12,591,489
$ 14,129,358
C-Corp.
$ 1,538,047
12,591,489
$ 14,129,535
0.65
0.00
0.64
0.00
0.62
0.00
20.00
20.00
Current Basis in Stock
Liabilities
3
20.00
Debt
Paired Share REIT
Share Price
28.26
28.26
Sale of Stock
Tax Basis in Stock
Capital Gain
Tax Liability @ 20%
After Tax Proceeds
28.26
20.00
8.26
(1.65)
26.61
28.26
20.00
8.26
(1.65)
26.61
3
2
$ 14,129,358
14,129,535
Net Assets at Market Value
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
- Current Basis in Stock
0.95
0.00
0.98
0.00
1.01
0.00
20.00
20.00
20.00
Shareholder's Cash Flow Statement
Paired Share REIT
C-Corp. & Management Co.
BEFORE TAX
(000)
$ 10,000,000
$ 10,000,000
Pre-Tax Investment
Pre-Tax Dividends
$
327,405
319,755
309,686
477,279
$
491,584
$
1.01
0.98
0.95
0.65
0.64
0.62
28.26
28.26
Sale of Stock
$
Before Tax Cash Flow
0.62
(20.00) $
0.64
$
$
28.91
$
0.95
(20.00) $
AFTER TAX
(000)
Before Tax Cash Flow
Less Taxes
On Dividends
On Sale
$
ATCF
$
(20.00) $
0.62 $
0.37
$
0.39
After Tax IRR=
11.74%
Blended Tax Rate=
22.1%
28.91
$
(20.00) $
$
27.00
$
$
(20.00) $
0.58
Present Value=
Net Present Value-
$
Paired Share Advantage
$
Paired Share Advantage
(20.00) $
0.00
$
$
0.31
$
0.59
29.27
(0.40)
(1.65)
$
27.22
$
1951
12.69%
11.74%
11.74%
0.34
0.98
(0.39)
PRESENT VALUE ANALYSIS
Discount Rate = After Tax Return on Equity =
29.27
3
2
0.95
(0.38)
(0.26)
(1.65)
(0.25)
(0.24)
(20.00) $
$
1
0
3
0.64
$
16.61%
2
1
0
0.98
$
15.07%
Pre-Tax IRR=
YEAR
505,150
(20.00)
(20.00)
Pre-Tax Invesment Per Share
Pre-Tax Dividends Per Share
3
2
1
0
3
2
1
0
YEAR
$
19.35
$
$
(20.00) $
0.50
0.52
$
0.48
0.50
Represents the difference in shareholder value of a Paired Share REIT vs. a C-Corp.
2.5%
Represents the difference in shareholder value as a percentage of the initial stock price ($20.00)
EXHIBIT A.8
BASE CASE
Estimating Total Tax Revenue
Generated Tax Revenue
C-Corp & Management Co.
3
2
1
Corporate Liability
Per Shareholder: $
0.38
Shareholders Liability
Dividend Income:
Capital Gains Income:
0.24
Shareholders $
Selling Shareholders $
0.62
0.62
0.39
$
$
0.25
0.64 $
0.64 $
$
$
1
0.26
1.65
$
$
0.04 $
0.04 $
0.04
0.38
0.39
0.40
0.42
0.42
$756,265
EXHIBIT A.9
$
$
0.43
0.43
25.00%
5.5% Three Year Treasury
$1,035,979
Additional Tax Revenue Paid by the Paired Share REIT structure =
3
1.65
0.66
2.31
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
Present Value =
$
0.40
Paired Share REIT
2
($279,714)
$
$
0.44
2.09
CASE 1
Model Assumptions
C-Corp
REIT
$ 10,000,000
$ 1,000,000
$ 10,000,000
$ 1,000,000
OWNERSHIP
Asset Value
Stabilized NOI
Leverage:
LEV
Debt Level:
Interest Rate:
Amortization Term: (years)
Loan Amount:
Yearly PMT:
$
45%
6.71%
25
4,500,000
$376,107
55%
20.00
275,000
21.90%
Equity:
Share Price:
No. of Shares:
Risk Adjusted Return on Equity:
$
$
$
65%
20.00
325,000
19.68%
REIT
C-Corp
Dividend Payout:
% of Net Income-after taxes
% of Otherwise Taxable Income
35%
6.51%
25
3,500,000
$287,079
30%
100%
4%
4%
35%
39.5%
20%
0%
39.5%
20%
Interest Income (after tax return)
Tax Rate:
Corporate:
Personal:
Capital Gains:
OPERATIONS
Hotel Operations
Revenue Growth
1.5% per year
Year 1
$ 3,000,000
Revenue
Year 3
3,090,675
Year 2
3,045,000
67% of Revenue
Operating Expense
REIT
C-Corp
Lease Structure:
Management Fee:
% of Net Income
Depreciation:
$
N/A
N/A
Base:
% of Revenue
3,000,000
over
6.0%
452,381
452,381
452,381
452,381
(TAX)
(GAAP)
TAX
10,000,000
(1,500,000)
(2,000,000)
6,500,000
Buy Price
Land
FF&E
Building Depreciable Basis
(39yrs)
(7yrs)
166,667
285,714
452,381
EXIHIBIT A.10
REIT
GAAP
10,000,000
(1,500,000)
(2,000,000)
6,500,000
C-Corp.
GAAP
10,000,000
(1,500,000)
(2,000,000)
6,500,000
Depreciations Calculations:
Building Depreciation
FF&E Depreciation
Total Depreciation
940,000
30%
(39)
(7)
166,667
285,714
452,381
(39)
(7)
166,667
285,714
452,381
CASE 1
Income and Cash Statements
Year 1
YEAR 1
TAX BASIS
I
N
C
0
M
E
E
F
F
E
C
T
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income -after taxes
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
3,000
$
(2,000)
(940)
60
940
N/A
N/A
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
3,000
$
(2,000)
N/A
1,000
(60)
(10)
60
930
0
(302)
0
(452)
60
176
N/A
N/A
60
176
(21)
(61)
39
114
(0)
N/A
60
(21)
39
21
82
TOTAL TAX LIABILITY
60
0
0
60
930
(228)
(452)
250
(250)
0
0
0
YEAR 1
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
Year 1
C EBITDA
A Interest Income
S Interest Expense
H Principal
Tax Liability
E Cash Flow After Taxes
F
F Dividend Payout
E Cash Retained for Operations
C
T CASH RETAINED
$
492
39
930
0
(228)
(59)
0
643
148
345
0
39
250
393
$
930
0
(302)
(74)
$
60
0
0
0
(21)
(61)
$
60
0
0
0
(21)
39
0
39
250
TOTAL CASH RETAINED
ITOTAL
DIVIDENDS PAID
148
432
384
YEAR I
Year I
GAAP BASIS
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
3,000
$
0
(2,000)
N/A
1,000
(60)
(10)
60
930
0
(302)
0
(452)
60
176
(61)
(21)
39
114
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
3,000
$
0
(2,000)
(940)
60
940
N/A
N/A
(9)
60
0
0
60
(21)
39
931
(228)
(452)
251
0
251
290
153
EXIHIBIT A.11
72
CASE 1
Balance Sheet
Year I
YEAR 1
Beginning Period
Cash
PP&E
Less:Acc. Depr.
Total Assets
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
Dividend Payout =
Return of Caoital=
tl
C peuno
$
$
$
C-Corp.& Management Co.
ASSETS
YEAR
(000)
Ending
10,000
10,000
(452)
10,000
LIABILITIES and OlE
(000)
$
4,500
3
5,497
0
10,000
1
Period
$
$
4,500
(74)
YEAR 1
Beginning Period
10,000
384
9,548
9,931
$
10,000
$
3,500
$
3
6,497
0
10,000
$
148
S
-
LIABILITIES and OlE
(000)
$
4,426
5,497
6
$
Share REIT
PaIred
[red Share REIT
Pa
REI T & Operating Co.
ASSETS
(000)
9,931
3,500
(59)
3,441
$
$
EXIHIBIT A.12
YEAR 1
Ending Period
433
$
10,000
9,548
(452)
9,980
$
250
3
6,497
40
9,981
CASE I
Income and Cash Statements
Year 2
YEAR 2
TAX BASIS
I
N
C
O
M
E
E
F
F
E
C
T
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
N/A
N/A
(10)
61
944
0
(224)
0
(452)
61
268
N/A
(268)
61
0
(21)
0
40
0
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
(2,030)
N/A
1,015
(61)
(10)
61
944
0
(297)
0
(452)
61
195
N/A
N/A
61
195
(21)
(68)
40
126
21
89
TOTAL TAX LIABILITY
YEAR 2
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
EBITDA
Interest Income
Interest
Principal
Tax Liability
Cash Flow After Taxes
$
$
944
15
(297)
(79)
(68)
515
$
61
0
0
0
(21)
40
$
944
17
(224)
(63)
0
674
61
0
0
0
(21)
40
Dividend Payout
Cash Retained for Operations
154
361
0
40
268
406
0
40
CASH ON HAND
361
40
406
40
TOTAL DIVIDENDS PAID
154
268
TOTAL CASH RETAINED
401
447
YEAR 2
GAAP BASIS
I
N
C
O
M
E
E
F
C
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
15
(2,030)
N/A
1,030
(61)
(10)
61
0
0
61
(21)
40
959
(297)
(452)
210
(68)
142
181
EXIHIBIT A.13
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
N/A
954
N/A
(10)
961
(224)
(452)
285
0
285
61
0
0
61
(21)
40
325
CASE I
Balance Sheet
Year 2
Cash
PP&E
Less:Acc. Depr.
Total Assets
C-Corp.& Management Co.
ASSETS
YEAR 2
(000)
YEAR 2
En ding Period
Begining Period
785
$
384
9,5448
9,095
(452)
9,548
9,880
$
9,931
$
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
$
$
Dividenc Payout=Return o.f Caital=
p'
LIABILITIES and OlE
(000)
$ 4,426
4,426
(79)
4,347
3
5,497
6
9,931
3
5,497
33
9,880
$
$
154
$
-
Paired Share REIT
REIT & Operating Co.
ASSETS
(000)
YEAR 2
Beginning Period
$
433
879
9,548
(452)
$
9,548
9,980
$
LIABILITIES and OlE
(000)
3,441
$
$
3
6,497
40
9,981
$
3,441
(63)
268
9,096
9,975
3,377
$
$
EXIHIBITA.14
YEAR 2
Ending Period
3
6,497
98
9,975
CASE I
Income and Cash Statements
Year 3
YEAR 3
TAX BASIS
I
N
C
O
M
E
E
F
F
E
C
T
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,091
$
(2,061)
(967)
63
967
N/A
N/A
(10)
63
958
0
(220)
0
(452)
63
285
N/A
(285)
63
0
0
(22)
41
0
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,091
(2,061)
N/A
1,030
(62)
(10)
62
958
0
(292)
0
(452)
62
214
N/A
N/A
62
214
(21)
(75)
40
139
22
96
TOTAL TAX LIABILITY
YEAR 3
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$
63
538
0
0
(21)
40
958
35
(220)
(67)
0
706
Dividend Payout
Cash Retained for Operations
159
380
0
40
285
420
0
41
CASH ON HAND
380
40
420
41
EBITDA
Interest Income
Interest Expense
Principal
Tax Liability
Cash Flow After Taxes
$
ITOTAL
$
958
31
(292)
(84)
$
62
0
0
(22)
41
DIVIDENDS PAID
159
285
TOTAL CASH RETAINED
420
461
YEAR 3
GAAP BASIS
I
N
C
O
M
E
E
F
F
E
C
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,091
31
(2,061)
N/A
1,062
(62)
(11)
989
62
(292)
0
(452)
0
245
62
(22)
(75)
170
40
210
EXIHIBIT A.15
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
$
3,091
(2,061)
(967)
63
N/A
N/A
(10)
993
(220)
(452)
321
0
321
63
0
0
63
(22)
41
362
CASE I
Balance Sheet
Year 3
C-Corp.& Managernen t Co.
ASSETS
YEAR 3
YEAR 3
(000)
Beginning Period
Ending Period
785
1,205
$
9,095
(452)
8,643
9,095
$
9,880
$
9,848
Cash
PP&E
Less:Acc. Depr.
Total Assets
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & O/E
Dividend Payout=
Return of Capital=
$
$
LIABILITIES and O/E
(000)
4,347
$ 4,347
(84)
3
5,497
33
9,880
4,262
LIABILITIES and O/E
(000)
3,377
$ 3,377
(67)
3,310
3
5,497
85
9,847
3
6,497
98
9,975
3
6,497
174
9,984
$
$
$
$
Paired Share REIT
REIT & Operating C0.
ASSETS
(000)
YEAR 3
YEAR 3
Ending Period
Beginning Pero d
879
1,340
$
9,095
9,096
(452)
8,643
$ 9,983
$
9,975
159
$
$
$
-
EXIHIBIT A.16
285
CASE I
Estimating Relative Shareholder Value
C-Corp
CASH
Market Value of Property
C-Corp.
$
1,205,118
12,488,462
$ 13,693,580
REIT
$ 1,340,418
12,488,462
$ 13,828,880
4,262,240
3,309,989
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
Debt
0.58
0.00
0.56
0.00
0.54
0.00
Current Basis in Stock
Liabilities
3
2
1
Sale of Stock
Assets
20.00
20.00
20.00
Paired Share REIT
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
Share Price
34.30
32.37
Sale of Stock
Tax Basis in Stock
Capital Gain
Tax Liability @ 20%
After Tax Proceeds
34.30
20.00
14.30
(2.86)
31.44
32.37
20.00 -Current
12.37
(2.47)
29.89
Basis in Stock
3
2
1
$ 10,518,891
9,431,340
Net Assets at Market Value
0.77
0.00
0.82
0.00
0.88
0.00
20.00
20.00
20.00
Shareholder's Cash Flow Statement
Paired Share REIT
C-Corp. & ianagement Co.
BEFORE TAX
(000)
$
Pre-Tax Investment
Pre-Tax Dividends
$ 6,500,000
5,500,000
$
158,616
153,735
147,704
249,590
$
267,759
$ 285,439
(20.00)
(20.00)
Pre-Tax Invesment Per Share
Pre-Tax Dividends Per Share
3
2
1
0
3
2
1
0
YEAR
0.88
0.82
0.77
0.58
0.56
0.54
32.37
34.30
Sale of Stock
$
Before Tax Cash Flow
0.54
(20.00) $
0.56
$
$
34.87
$
0.77
(20.00) $
$
33.24
$
3
33.24
20.92%
22.04%
Pre-Tax IRR=
0.82
$
AFTER TAX
(000)
Before Tax Cash Flow
Less Taxes
On Dividends
On Sale
$
ATCF
$
0.54 $
(20.00) $
$
0.32 $
After Tax IRR=
Blended Tax Rate=
0.34
34.87
$
(20.00) $
$
31.79
2
0.77
$
$
(20.00) $
0.46
0.82
(0.35)
(2.47)
(0.33)
(0.30)
(0.23)
(2.86)
(0.22)
(0.21)
(20.00) $
0.56
1
0
3
2
1
0
YEAR
$
0.50
17.73%
16.51%
19.6%
21.1%
17.62%
15.53%
$
30.42
$
19.73
PRESENT VALUE ANALYSIS
Discount Rate = After Tax Return on Equity =
Present Value=
Net Present Value-
$
Paired Share Advantage
$
Paired Share Advantage
(20.00) $
0.06
0.28
$
0.24
$
19.54
$
$
(20.00) $
0.51
0.40
$
0.37
0.45
Represents the difference in shareholder value of a Paired Share REIT vs. a C-Corp.
2.2%
Represents the difference in shareholder value as a percentage of the initial stock price ($20.00)
EXHIBIT A.17
CASE 1
Estimating Total Tax Revenue
Generated Tax Revenue
C-Corp & Management Co.
Corporate Liability
Per Shareholder: $
0.30
0.32
$
Shareholders Liability
0.21
Dividend Income:
$
Shareholders
$
0.51
0.51
$
$
$
0.35
0.22
0.23
2.86
0.55
0.55
0.58
3.44
Capital Gains Income:
Selling Shareholders $
1
3
2
1
Paired Share REIT
2
0.06
$
0.30
$
$
0.37
0.37
$
$
0.07
Present Value =
0.35
2.47
0.39 $
0.39 $
0.41
2.89
25.00%
5.5% Three Year Treasury
$512,972
$570,711
Additional Tax Revenue Paid by the Paired Share REIT structure =
EXHIBIT A.18
($57,739)
0.07
0.33
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
$
3
CASE 2
Model Assumptions
C-Corp
REIT
$ 10,000,000
$ 1,000,000
$ 10,000,000
OWNERSHIP
Asset Value
Stabilized NOI
$
1,000,000
$
6.51%
25
3,500,000
Leverage:
LEV
Debt Level:
Interest Rate:
Amortization Term: (years)
Loan Amount:
Yearly PMT:
$
Equity:
Share Price:
No. of Shares:
Risk Adjusted Return on Equity:
$
35%
50%
6.81%
25
5,000,000
$421,811
$287,079
50%
20.00
250,000
23.32%
$
65%
20.00
325,000
19.68%
REIT
C-Corp
Dividend Payout:
% of Net Income-after taxes
% of Otherwise Taxable Income
20%
Interest Income (after tax return)
4%
4%
35%
39.5%
20%
0%
39.5%
20%
115%
Tax Rate:
Corporate:
Personal:
Capital Gains:
OPERATIONS
Hotel Operations
Revenue Growth
1.5% per year
Year 1
$ 3,000,000
Revenue
Year 3
3,090,675
Year 2
3,045,000
67% of Revenue
Operating Expense
REIT
C-Corp
Lease Structure:
Base:
% of Revenue
$
Management Fee:
% of Net Income
Depreciation:
3,000,000
over
6.0%
452,381
452,381
452,381
452,381
(TAX)
(GAAP)
TAX
Buy Price
Land
FF&E
Building Depreciable Basis
10,000,000
(1,500,000)
(2,000,000)
6,500,000
(39yrs)
(7yrs)
166,667
285,714
452,381
EXIHIBIT A.19
REIT
GAAP
C-Corp.
GAAP
10,000,000
(1,500,000)
Depreciations Calculations:
Building Depreciation
FF&E Depreciation
Total Depreciation
940,000
30%
10,000,000
(1,500,000)
(2,000,000)
6,500,000
(2,000,000)
6,500,000
(39)
(7)
166,667
285,714
452,381
(39)
(7)
166,667
285,714
452,381
CASE 2
Income and Cash Statements
Year 1
YEAR I
TAX BASIS
I
N
C
0
M
E
E
F
F
E
C
T
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
REIT
Operating Co
(000)
(000)
3,000
$
(2,000)
(940)
940
60
N/A
N/A
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
3,000
$
(2,000)
N/A
1,000
(60)
(10)
(10)
930
(341)
(452)
137
930
(228)
(452)
250
(287)
(37)
0
(37)
60
0
0
60
N/A
N/A
137
(48)
89
60
(21)
39
N/A
60
(21)
39
21
69
TOTAL TAX LIABILIT
60
0
0
60
YEAR 1
Paired Share REIT Ownership
REIT
Operating Co
(000)
(000)
C-Corp. Ownership
Owner
Management Co.
(000)
(000)
Year 1
C EBITDA
A Interest Income
S Interest Expense
H Principal
Tax Liability
E Cash Flow After Taxes
F
F Dividend Payout
E Cash Retained for Operations
C
T CASH RETAINED
$
$
930
0
(341)
(81)
(48)
460
92
368
$
60
0
0
0
(21)
39
930
0
(228)
(59)
0
643
$
287
356
0
39
60
0
0
0
(21)
39
0
39
TOTAL DIVIDENDS PAID
92
287
TOTAL CASH RETAINED
407
395
YEAR 1
Year I
GAAP BASIS
I
N
C
0
M
E
E
F
F
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Owner
Management Co.
(000)
(000)
3,000
$
0
(2,000)
N/A
1,000
(60)
(10)
930
(341)
(452)
137
(48)
89
60
0
0
60
(21)
39
128
Paired Share REIT Ownership
REIT
Operating Co
(000)
(000)
$
3,000
0
(2,000)
(940)
940
60
N/A
N/A
(9)
931
60
(228)
0
0
(452)
251
60
0
(21)
251
39
290
EXIHIBIT A.20
81
CASE 2
Balance Sheet
Year 1
P
YEAR 1
Beginning Period
Cash
PP&E
Less:Acc. Depr.
Total Assets
Debt
Less:Principal Repayment
Shareholder's Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
$
$
$
C-Corp.& Management Co.
ASSETS
YEAR 1
(000)
Ending Period
$
10,000
10,000
(452)
$
10,000
LIABILITIES and O/E
(000)
$
5,500
2
4,498
0
10,000
9,548
9,929
$
10,000
LIABILITIES and OlE
(000)
$
3,500
5,412
$
4,498
17
9,929
$
3
6,497
0
10,000
w
-
EXIHIBIT A.21
YEAR 1
Ending Period
$
395
10,000
9,548
(452)
9,943
$
3,500
(59)
3,441
$
$
Dividend Payout =
Return of Caitl=
are. REIT
Shk
YEAR 1
Beginning Period
10,000
$
5,500
(88)
a1re d
REIT & Operating Co.
ASSETS
(000)
287
6,497
3
9,943
CASE 2
Income and Cash Statements
Year 2
YEAR 2
TAX BASIS
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
954
N/A
N/A
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
(2,030)
N/A
1,015
(61)
(10)
61
944
0
(335)
0
(452)
61
156
N/A
N/A
61
156
(21)
(55)
40
102
(10)
N/A
61
(21)
40
21
76
TOTAL TAX LIABILITY
61
0
0
61
944
(224)
(452)
268
(308)
(40)
0
(40)
YEAR 2
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
EBITDA
Interest Income
Interest
Principal
Tax Liability
Cash Flow After Taxes
$
$
944
16
(335)
(87)
(55)
484
$
61
0
0
0
(21)
40
$
944
16
(224)
(63)
0
673
61
0
0
0
(21)
40
Dividend Payout
Cash Retained for Operations
96
387
0
40
308
365
0
40
CASH ON HAND
387
40
365
40
TOTAL DIVIDENDS PAID
96
308
TOTAL CASH RETAINED
427
405
YEAR 2
GAAP BASIS
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
16
(2,030)
N/A
1,031
(10)
61
0
0
61
(21)
40
960
(335)
(452)
173
(55)
118
158
EXIHIBIT A.22
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
16
(2,030)
(954)
61
954
N/A
N/A
(10)
61
960
0
(224)
0
(452)
61
284
(21)
0
40
284
324
CASE 2
Balance Sheet
Year 2
Cash
PP&E
Less:Acc. Depr.
Total Assets
C-Corp.& Management Co.
ASSETS
YEAR 2
(000)
YEAR 2
En ding Period
Begining Period
834
$
407
9,548
9,095
(45-2)
9,548
9,930
$
9,955
$
Debt
Less:Principal Repayment
Shareholder's Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
$
$
Dividend Payout=Reunof
Capnital=
Return of Canital=
LIABILITIES and OlE
(000)
$ 4,919
4,919
(87)
4,832
3
4,998
36
9,955
3
4,998
98
9,930
$
$
YEAR 2
Beginning Period
$
395
800
$
9,548
9,943
$
LIABILITIES and OlE
(000)
3,441
$
$
-
EXIHIBIT A.23
YEAR 2
Ending Period
9,548
(452)
3
6,497
3
9,943
$
3,441
(63)
268
40
9,096
9,896
3,377
$
$
96
$
Paired Share REIT
Paired Share REIT
REIT & Operating Co.
ASSETS
(000)
3
6,497
18
9,896
CASE 2
Income and Cash Statements
Year 3
YEAR 3
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
TAX BASIS
Revenue
Operating Expense
Lease Payment
NOl
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
$
$ 3,091
(2,061)
N/A
1,030
(62)
(10)
958
(329)
(452)
176
N/A
176
(62)
115
N/A
(10)
958
(220)
(452)
285
(328)
(43)
0(43)
62
0
0
62
N/A
62
(21)
40
63
0
0
63
N/A
63
(22)
41
22
83
TOTAL TAX LIABILITY
3,091
(2,061)
(967)
63
N/A
YEAR 3
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
EBITDA
Interest Income
Interest Expense
Principal
Tax Liability
Cash Flow After Taxes
$
$
958
33
(329)
(93)
(62)
508
0
0
(21)
40
958
32
(220)
(67)
0
702
$
62
$
63
0
0
(22)
41
Dividend Payout
Cash Retained for Operations
100
408
0
40
328
374
0
41
CASH ON HAND
408
40
374
41
TOTAL DIVIDENDS PAID
100
328
TOTAL CASH RETAINED
448
415
YEAR 3
GAAP BASIS
I
N
C
Revenue
Interest Income
Operating Expense
0
M
Lease Payment
NOI
E
E
Management Fee
G&A
EBITDA
F
Interest
F
E
C
T
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,091
33
(2,061)
N/A
1,064
(62)
(11)
62
991
0
(329)
0
(452)
62
210
(22)
(62)
40
148
188
EXIHIBIT A.24
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,091
$
32
(2,061)
(967)
63
967
N/A
N/A
(10)
63
990
0
(220)
0
(452)
63
317
0
(22)
41
317
359
CASE 2
Balance Sheet
Year 3
rairea
raireu ~nare
Qnare ri1cI
REIT & Operating Co.
ASSETS
YEAR 3
(000)
YEAR 3
Ending Period
Beginning Period
1,215
8
$
9,095
8,643
(452)
9,096
.~i
C-Corp.& Managemen t Co.
ASSETS
YEAR 3
(000)
YEAR 3
Ending Period
Beginning Period
1,283
834
$
9,095
8,643
(452)
9,095
Cash
PP&E
Less:Acc. Depr.
$
Total Assets
$
9,930
9,926
$
LIABILITIES and O/E
(000)
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & O/E
Dividend Payout=0ae.+- -fu9 iemi.
$
4,832
$
$ 4,832
(93)
4,739
3
4,998
98
$
$
9,930
$
100
It
.
LIABILITIES and O/E
(000)
$ 3,377
3,377
(67)
3
3
6,497
18
$
$
9,896
4,998
186
9,925
9,858
3,310
3
6,497
49
$
9,896
$
EXHIBIT A.25
I
285
43
9,859
CASE 2
Estimating Relative Shareholder Value
C-Corp
CASH
Market Value of Property
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
REIT
$
1,215,298
12,511,787
$ 13,727,085
C-Corp.
$ 1,282,970
12,511,787
$ 13,794,756
Debt
4,739,392
3,309,989
9,055,364
$ 10,417,096
0.38
0.00
0.40
0.00
20.00
20.00
0.37
0.00
Current Basis in Stock
Liabilities
3
2
1
Sale of Stock
Assets
20.00
Paired Share REIT
Net Assets at Market Value
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
Share Price
36.22
32.05
Sale of Stock
Tax Basis in Stock
Capital Gain
Tax Liability @ 20%
After Tax Proceeds
36.22
20.00
16.22
(3.24)
32.98
32.05
19.63 -Current
12.42
(2.48)
29.57
Basis in Stock
3
2
1
0.77
0.12
0.82
0.12
0.88
0.13
19.88
19.76
19.63
Shareholder's Cash Flow Statement
Paired Share REIT
C-Corp. & Management Co.
BEFORE TAX
(000)
$
Pre-Tax Investment
Pre-Tax Dividends
$
5,000,000
6,500,000
$
99,735
96,236
92,034
287,029
$
307,922
$
1.01
0.95
0.88
0.40
0.38
0.37
32.05
36.22
Sale of Stock
$
Before Tax Cash Flow
328,255
(20.00)
(20.00)
Pre-Tax Invesment Per Share
Pre-Tax Dividends Per Share
3
2
1
0
3
2
1
0
YEAR
0.37
(20.00) $
0.38
$
Pre-Tax IRR=
(20.00) $
$
36.62
$
0.88
$
0.95
$
33.06
$
3
33.06
21.08%
23.48%
AFTER TAX
(000)
$
ATCF
$
2
1
0
YEAR
Before Tax Cash Flow
Less Taxes
On Dividends
On Sale
(20.00) $
0.37
$
(0.15)
(0.15)
(20.00) $
0.22
$
$
After Tax IRR=
Blended Tax Rate=
0.23
1
0
3
0.38
36.62
$
(20.00) $
33.22
$
$
(20.00) $
0.58
0.95
(0.33)
(0.30)
(0.16)
(3.24)
$
2
0.88
$
0.62
19.13%
16.65%
18.5%
21.0%
19.00%
15.54%
(0.35)
(2.48)
$
30.23
$
19.60
PRESENT VALUE ANALYSIS
Discount Rate = After Tax Return on Equity =
Present Value=
Net Present Value=
$
Paired Share Advantage
$
Paired Share Advantage
(20.00) $
0.07
0.19 $
0.16
$
19.71
$
$
(20.00) $
0.57
0.50
$
0.47
0.50
Represents the difference in shareholder value of a Paired Share REIT vs. a C-Corp.
2.5%
Represents the difference in shareholder value as a percentage of the initial stock price ($20.00)
EXHIBIT A.26
CASE 2
Estimating Total Tax Revenue
Generated Tax Revenue
C-Corp & Management Co.
3
2
1
Corporate Liability
Per Shareholder: $
Shareholders Liability
Dividend Income:
Capital Gains Income:
Shareholders $
Selling Shareholders $
0.27
0.30
$
0.46
0.46
$
$
$
0.33
$
$
Paired Share REIT
2
0.06
$
$
$
0.49
3.73
0.37
0.37
0.07
$
$
0.39
0.39
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
Present Value =
25.( 00%
5.5% Three Year Treasury
$513,765
$478,950
Additional Tax Revenue Paid by the Paired Share REIT structure =$34,
EXHIBIT A.27
315
$
3
0.07
0.35
2.48
0.33
0.30
0.16
3.24
0.15
0.15
0.42
0.42
$
1
$
$
0.41
2.90
CASE 3
Model Assumptions
C-Corp
REIT
$ 10,000,000
$ 1,000,000
$ 10,000,000
$ 1,000,000
OWNERSHIP
Asset Value
Stabilized NOI
Leverage:
LEV
Debt Level:
Interest Rate:
Amortization Term: (years)
Loan Amount:
Yearly PMT:
$
Equity:
Share Price:
No. of Shares:
Risk Adjusted Return on Equity:
$
55%
6.91%
25
5,500,000
$468,316
$
45%
20.00
225,000
25.03%
$
70%
20.00
350,000
18.78%
REIT
C-Corp
Dividend Payout:
% of Net Income-after taxes
% of Otherwise Taxable Income
30%
6.40%
25
3,000,000
$243,746
10%
95%
4%
4%
35%
39.5%
20%
0%
39.5%
20%
Interest Income (after tax return)
Tax Rate:
Corporate:
Personal:
Capital Gains:
OPERATIONS
Hotel Operations
Revenue Growth
1.5% per year
Year 1
$ 3,000,000
Revenue
Year 3
3,090,675
Year 2
3,045,000
67% of Revenue
Operating Expense
REIT
C-Corp
Lease Structure:
$
Base:
% of Revenue
Management Fee:
% of Net Income
Depreciation:
3,000,000
over
6.0%
452,381
452,381
452,381
452,381
(TAX)
(GAAP)
TAX
10,000,000
(1,500,000)
(2,000,000)
6,500,000
Buy Price
Land
FF&E
Building Depreciable Basis
(39yrs)
(7yrs)
166,667
285,714
452,381
EXIHI BIT A.28
REIT
GAAP
10,000,000
(1,500,000)
(2,000,000)
6,500,000
C-Corp.
GAAP
10,000,000
(1,500,000)
(2,000,000)
6,500,000
Depreciations Calculations:
Building Depreciation
FF&E Depreciation
Total Depreciation
940,000
30%
(39)
(7)
166,667
285,714
452,381
(39)
(7)
166,667
285,714
452,381
CASE 3
Income and Cash Statements
Year 1
YEAR I
TAX BASIS
I
N
C
0
M
E
E
F
F
E
C
T
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
3,000
$
(2,000)
(940)
60
940
N/A
N/A
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
3,000
$
(2,000)
N/A
1,000
(60)
(10)
60
930
0
(380)
0
(452)
60
97
N/A
N/A
60
97
(21)
(34)
39
63
0
(452)
60
285
(271)
14
(5)
9
N/A
60
(21)
39
26
55
TOTAL TAX LIABILITY
60
0
930
(192)
YEAR I
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
Year I
C EBITDA
A Interest Income
S Interest Expense
H Principal
Tax Liability
E Cash Flow After Taxes
F
F Dividend Payout
E Cash Retained for Operations
C
T CASH RETAINED
$
0
(380)
(88)
60
0
0
0
(34)
(21)
28
39
681
60
0
0
0
(21)
39
43
385
0
39
271
410
0
39
385
39
930
TOTAL DIVIDENDS PAID
TOTAL CASH RETAINED
$
$
$
930
0
(192)
(52)
(5)
39
43
271
424
449
YEAR 1
Year 1
GAAP BASIS
I
N
C
O
M
E
E
F
F
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
3,000
$
0
(2,000)
N/A
1,000
(10)
930
(380)
(452)
97
(34)
63
60
0
0
60
(21)
39
102
EXIHIBIT A.29
Paired Share REIT Ownership
Operating Co
REIT
(000)
(000)
$
3,000
0
(2,000)
(940)
60
940
N/A
N/A
(9)
931
(192)
(452)
286
(5)
281
60
0
0
60
(21)
39
320
CASE 3
Balance Sheet
Year I
YEAR 1
Beginning Period
Cash
PP&E
Less:Acc. Depr.
Total Assets
Debt
Less:Principal Repayment
Shareholder's Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
Dividend Payout =
Retaurn of Capt
$
$
$
C-Corp.& Management Co.
ASSETS
YEAR 1
(000)
Ending Period
$
10,000
10,000
(452)
3
10,000
LIABILITIES and OiE
(000)
$
5,500
2
4,498
0
10,000
5,500
(88)
43
C
-
REIT & Operating Co.
ASSETS
(000)
10,000
9,548
9,972
$
10,000
$
3,000
$
4
6,997
0
10,000
LIABILITIES and OlE
(000)
$
5,412
$
$
YEAR 1
Beginning Period
4,498
60
9,972
3,000
(52)
2,948
$
$
EXIHIBIT A.30
YEAR 1
Ending Period
450
$
10,000
9,548
(452)
9,997
$
271
4
6,997
49
9,998
CASE 3
Income and Cash Statements
Year 2
YEAR 2
TAX BASIS
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
954
N/A
N/A
(10)
61
944
0
(189)
0
(452)
61
303
N/A
(288)
61
15
(21)
(1)
40
10
C-Corp. Ownership
Management Co.
Ow ner
(000)
(000)
$ 3,045
(2,030)
N/A
1,015
(61)
(10)
61
944
0
(374)
0
(452)
61
117
N/A
N/A
61
117
(21)
(41)
40
76
27
62
TOTAL TAX LIABILITY
YEAR 2
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
EBITDA
Interest Income
Interest
Principal
Tax Liability
Cash Flow After Taxes
$
$
944
17
(374)
(94)
(41)
451
$
61
0
0
0
(21)
40
$
944
18
(189)
(55)
(5)
713
61
0
0
0
(21)
40
Dividend Payout
Cash Retained for Operations
45
407
0
40
288
425
0
40
CASH ON HAND
407
40
425
40
TOTAL DIVIDENDS PAID
45
288
TOTAL CASH RETAINED
446
465
YEAR 2
GAAP BASIS
I
N
C
0
M
E
E
F
F
E
C
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,045
17
(2,030)
N/A
1,032
(61)
(10)
61
961
0
(374)
0
(452)
61
134
(41)
(21)
93
40
133
EXIHIBIT A.31
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,045
$
(2,030)
(954)
61
N/A
954
N/A
(10)
962
(189)
(452)
321
(5)
315
61
0
0
61
(21)
40
356
CASE 3
Balance Sheet
Year 2
Cash
PP&E
Less:Acc. Depr.
Total Assets
C-Corp.& Management Co.
ASSETS
(000)
YEAR 2
YEAR 2
Ending Period
Begining Period
870
424
$
9,548
9,095
(452)
9,548
9,966
$
9,972
$
Debt
Less:Principal Repayment
Shareholders Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & OlE
$
$
LIABILITIES and OlE
(000)
$ 5,412
5,412
(94)
5,318
2
4,498
60
9,972
2
4,498
148
9,965
$
Dividend Payout=-
$
Retuim of(Ca ital=
$
fC peu
tl
Share REIT
Paired
Paired Share REIT
REIT & Operating Co.
ASSETS
(000)
YEAR 2
Beginning Period
$
450
915
9,548
(452)
$
9,548
9,997
$
LIABILITIES and OlE
(000)
$
2,948
$
$
4
6,997
49
9,998
EXIHIBIT A.32
2,948
(55)
288
9,096
10,011
2,893
$
$
45
-
YEAR 2
Ending Period
4
6,997
117
10,011
CASE 3
Income and Cash Statements
Year 3
YEAR 3
TAX BASIS
Revenue
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation
Otherwise Taxable Income
Deductions for Dividends Paid
Net Taxable Income
Income Tax Liability
Net Income - after taxes
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,091
$
(2,061)
(967)
63
N/A
N/A
(10)
63
958
0
(185)
0
(452)
63
320
N/A
(304)
63
16
(22)
(6)
41
10
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,091
(2,061)
N/A
1,030
(62)
(10)
62
958
0
(368)
0
(452)
62
138
N/A
N/A
62
138
(21)
(48)
40
90
27
70
TOTAL TAX LIABILITY
YEAR 3
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
EBITDA
Interest Income
Interest Expense
Principal
Tax Liability
Cash Flow After Taxes
$
$
958
35
(368)
(101)
(48)
476
0
0
(21)
40
958
37
(185)
(58)
(6)
745
$
62
$
63
0
0
(22)
41
Dividend Payout
Cash Retained for Operations
47
429
0
40
304
441
0
41
CASH ON HAND
429
40
441
41
TOTAL DIVIDENDS PAID
47
304
TOTAL CASH RETAINED
470
482
YEAR 3
GAAP BASIS
I
N
C
D
M
E
E
F
F
E
C
T
Revenue
Interest Income
Operating Expense
Lease Payment
NOI
Management Fee
G&A
EBITDA
Interest
Depreciation (GAAP)
EBT
Provisions for Taxes
Net Income
TOTAL GAAP NET INCOME
C-Corp. Ownership
Management Co.
Owner
(000)
(000)
$ 3,091
35
(2,061)
N/A
1,065
(62)
(11)
62
992
0
(368)
0(452)
172
62
(22)
(48)
124
40
164
EXIHI BIT A.33
Paired Share REIT Ownership
Operating Co.
REIT
(000)
(000)
3,091
$
37
(2,061)
(967)
63
N/A
N/A
(10)
63
995
0
(185)
0
(452)
63
357
(22)
(6)
41
351
392
CASE 3
Balance Sheet
Year 3
P
C-Corp.& Managemen t Co.
ASSETS
YEAR 3
(000)
YEAR 3
Ending Period
Beginning Period
1,340
870
$
9,095
8,643
(452)
9,095
$
9,983
$
9,966
Cash
PP&E
Less:Acc. Depr.
Total Assets
Debt
Less:Principal Repayment
Shareholder's Equity
Capital Stock, par value $.01
Capital in excess of par value
Retained Earnings
Total Liabilities & O/E
Dividend Payout=
Return of Capital=
Return of Canital=
$
$
LIABILITIES and O/E
(000)
$ 5,318
5,318
(101)
5,217
2
4,498
148
9,965
2
4,498
265
9,982
$
$
$
$
.
$
LIABILITIES and O/E
(000)
$ 2,893
2,893
(58)
EXHIBIT A.34
2,835
4
6,997
205
$ 10,040
4
6,997
117
10,011
$
47
-
EIT
dh
REIT & Operating C0.
ASSETS
YEAR 3
(000)
YEAR 3
Ending Period
BeginningPeric d9
$
1,397
915
9,095
8,643
(452)
9,096
$ 10,040
$
10,011
304
CASE 3
Estimating Relative Shareholder Value
C-Corp
CASH
Market Value of Property
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
REIT
1,396,983
$
12,528,650
$ 13,925,633
C-Corp.
$
1,340,188
12,528,650
$ 13,868,838
Debt
20.00
20.00
Paired Share REIT
2
1
$ 11,090,717
8,651,624
Pre-Tax Dividends
Taxable Portions
Untaxed Return of Capital
Share Price
38.45
31.69
Sale of Stock
Tax Basis in Stock
Capital Gain
Tax Liability @ 20%
After Tax Proceeds
38.45
20.00
18.45
(3.69)
34.76
31.69
20.00 -11.69
(2.34)
29.35
*Current Basis in Stock
0.82
0.00
0.87
0.00
20.00
20 00
20.00
Paired Share REIT
C-Corp. & Management Co.
BEFORE TAX
(000)
$
Pre-Tax Investment
Pre-Tax Dividends
$
4,500,000
7,000,000
$
46,766
44,919
42,756
270,924
$
287,656
$
0.87
0.82
0.77
0.21
0.20
0.19
31.69
38.45
Sale of Stock
$
Before Tax Cash Flow
303,886
(20.00)
(20.00)
Pre-Tax Inv esment Per Share
Pre-Tax Dividends Per Share
3
2
1
0
3
2
1
0
0.19
(20.00) $
0.20
$
$
38.66
$
0.77
(20.00) $
0.82
$
$
32.56
20.12%
25.15%
Pre-Tax IRR=
AFTER TAX
(000)
$
ATCF
$
0.19
(20.00) $
$
0.11
0.20 $
$
After Tax IRR=
Blended Tax Rate=
38.66
$
0
(20.00) $
0.12 $
34.89
2
1
0.77
$
$
(20.00) $
0.47
$
Present Value=
Net Present Value=
$
20.74%
17.6%
21.3%
Paired Share Advantage
$
Paired Share Advantage
0.10
$
0.08
$
3
32.56
(0.34)
(2.34)
$
29.88
$
19.76
14.78%
20.63%
(20.00) $
0.05
0.50
15.83%
PRESENT VALUE ANALYSIS
Discount Rate = After Tax Return on Equity =
0.82
(0.32)
(0.31)
(0.08)
(3.69)
(0.08)
(0.08)
(20.00) $
3
2
1
0
YEAR
Before Tax Cash Flow
Less Taxes
On Dividends
On Sale
$
19.87
$
$
(20.00) $
0.54
0.41
$
0.38
0.49
Represents the difference in shareholder value of a Paired Share REIT vs. a C-Corp.
2.5%
Represents the difference in shareholder value as a percentage of the initial stock price ($20.00)
EXHIBIT A.35
3
0.77
0.00
Shareholder's Cash Flow Statement
YEAR
20.00
2,834,917
5,217,214
Net Assets at Market Value
0.21
0.00
0.20
0.00
0.19
0.00
Current Basis in Stock
Liabilities
3
2
1
Sale of Stock
Assets
CASE 3
Estimating Total Tax Revenue
Generated Tax Revenue
C-Corp & Management Co.
2
3
1
1
Paired Share REIT
2
3
Corporate Liability
Per Shareholder: $
Shareholders Liability
Dividend Income:
Capital Gains Income:
Shareholders $
Selling Shareholders $
0.24
$
0.28
0.08
0.32
0.32
$
$
$
$
0.31
0.08
0.08
3.69
0.36 $
0.36 $
0.39
4.08
0.07
$
0.38
0.38
$
$
0.40
0.40
Total Tax Revenue
Basis for Analysis:
Percent of outstanding shares sold after 3 years=
Discount Rate:
Present Value =
25.00%
5.5% Three Year Treasury
$551,543
$391,618
Additional Tax Revenue Paid by the Paired Share REIT structure
=
EXHIBIT A.36
$159,926
$
0.08
0.34
2.34
0.32
0.31
$
$
0.08
$
$
0.42
2.76
APPENDIX B
CURRENT C-CORP HOTEL'S CAPITAL STRUCTURES
Company Name
Ticker
Symbol
Market
Cap.
(Mil. $)
(A)
Prime Hospitality Corporation
ShoLodge Inc.
Suburban Lodge of America, Inc.
Bristol Hotel Company
Hilton Hotels
John Q. Hammons Hotels, Inc.
Amerihost Properties, Inc.
Host Marriott Corporation
Promus Hotel Corporation
Servico Hotels & Resorts
Red Roof Inns
Average
Note: (D) = (A/B)*(C)
PDQ
LODG
SLAM
BH
HLT
JQH
HOST
HMT
PRH
SER
RRI
724.7
77.4
223.7
1,018.0
6,340.0
41.9
28.6
3,562.0
3,499.0
304.1
472.0
1,481.0
Price/
Book
Ratio
(B)
1.36
0.81
1.06
1.54
1.89
2.39
1.40
2.74
3.00
1.25
1.39
Debt/
Book Equity
Ratio
(C)
1.08
1.61
0.12
1.07
0.9
37
2.96
2.92
0.59
1.55
1.62
Debt
(Mil. $)
(D)
Leverage
D/(D+A)
575.5
153.8
25.3
707.3
3,019.0
648.7
60.5
3,796.0
688.1
377.1
550.1
44.3%
66.5%
10.2%
41.0%
32.3%
93.9%
67.9%
51.6%
16.4%
55.4%
53.8%
963.8
48.5%
APPENDIX C
The Risk-Return Tradeoff
50%45% 40% -
35% 30% *a
Return on Equity - Pre Tax
25% -
20%15%10%-
Return on Assets
Return on Debt
0% 40%
20%
40%
60%
Leverage
80%
100%