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The leased of your problems
As hotel investors have grown more sophisticated, and as more institutional investors have entered the sector, so the tenure of agreements between owners and operators have grown more complicated but also, to some degree more owner-friendly. Instead of having to choose between a classic “three and ten” management contract or a fixed lease, hotel property owners now have a range of intermediate solutions such as a turnover lease with or without a minimum guarantee.
Many commentators have decided that these represent an optimal structure for the owners, combining safety with upside. But in the new world of sexier leases, there are still pitfalls to watch out for.
HOFTEL outlines some of them here:
Split of capital expenditure between owner and operator. The most owner-friendly structures are those which could be called “full maintaining and repairing” in which the operator undertakes to repair and replace all the hotel’s fixtures, fittings and equipment as well as the fabric of the building. The most extreme of these that I’ve seen actually insists that the operator returns the hotel in exactly the same state it was handed over, with the implication that upon its return to the owners it needs brand new MM&E. But other leases are far less stringent, calling (for example) only for the operator to keep the hotel at a certain star grading. In some cases, owners have to pay for the upkeep of walls and roofs (the classic German ‘dach und fach’) and in others, the owner also replaces MM&E and even FF&E. Clearly, the degree to which the owner is shielded from wear and tear is a major determinant of the yield on which the hotel should trade.
Transparency of underlying results. Another significant factor is whether the hotel is over-rented. In the normal sense, this means that the rent paid by the operator is above that which the market would currently command. But a more subtle and more important issue is whether the hotel is over-rented based on its own performance i.e. whether the operator is making profits out of it, or having to subsidise a shortfall in which NOP is lower than the rent. This is obviously a sensitive topic in that an operator making strong profits from a lease doesn’t really want to share that information – the obvious danger being that the owner will seek a big rent increase. However, the flip side is that it’s extremely hard for any owner to sell a rented hotel if the potential buyer has no clue whether, once the lease ends (or if the lessee goes bust), a new tenant will be able to afford the rent.
Split turnover leases. An increasingly common feature of turnover leases, especially in Scandinavia, is that the percentage of revenue paid as rent varies between room revenue and F&B revenue. In some ways, this seems quite logical as it means operators pay a much higher percentage on the very profitable rooms departmental income and much less on F&B, thereby giving them an incentive to drive new F&B income. Alas, it’s never so simple once the dreaded concept of allocations comes into play. If the operator pays a much lower percentage of revenue for F&B revenue, there’s clearly a temptation to allocate as much of any package to F&B as possible. I remember booking a bed and breakfast package at a conference hotel for €175 and was a little surprised when the rather modest breakfast was €25. I later asked the owner and learnt that he got 8% of F&B income and 25% of room income. We worked out that if the breakfast had been allocated at €17 instead, the hotel would have been worth about €500,000 more!
When does it close? Another complexity for turnover leases is how far the operator is obliged to maximize revenues. Can they, for example, just close a hotel in low season, as one exasperated operator complained to me recently. It depends of course on what discretion the contract gives them.
Security of lease. Just how safe is the lease? At one end of the spectrum, it may be signed or guaranteed by the parent company of the lessee, or even by a bank. But how firm is the parent guarantee? And what about cases where the lease is only guaranteed by the local arm of the management group? In one case I saw, the lessee’s guarantee was only from the national subsidiary of the group. The lessor owned almost all of this management company’s hotels in the relevant country, making the guarantee pretty insecure – if the lessee’s hotels underperformed, then the lessee might, in theory, be unable to meet its obligations. In some cases, of course, parent guarantees are anyway limited to certain amounts or periods of time. Indeed, it’s not uncommon to see any form of parent obligation replaced by a “cash pool” which the lessor can use to cover shortfalls until its used up. For owners, being completely sure of what level of security they can access and for how long is a vital consideration.
Security of lessee. Then assuming that you do have recourse to the lessor or its parent, just how much comfort can that give. Many institutions with leases to Meridien and Dorint faced a rude shock a few years ago as those groups succumbed to a period of financial difficulty. Institutions buying leased hotels need to do solid research into their tenants – even if it means asking questions that tenants would prefer not to answer! And if the owner doesn’t ask them, he can be sure his lenders will…
Sharing the revenue. The logical assumption behind a turnover lease is that the operator is always going to try to maximize revenue. But that may not always be true. What if the operator has opened a better hotel just up the road – especially if they own it themselves. Or if they merge with a group that happens to have your hotel’s main competitor? At that point, even lease-owners may find that having a radius restriction in the contract is a useful addition to their rights.
Consultation. Some operators take the view that they will run the hotel and the owner should, as long as the rent is paid, otherwise largely mind their own business. Other – more enlightened – lessees recognise that the owner can be a useful ally in producing ideas to boost turnover, maximizing space utilization and thinking through potential improvements and upgrades. Any potential lessor should thoroughly test their manager’s attitude to co-operation before signing on the dotted line.
Compensation for improvements. Operators often push their lessors for upgrades to the property – new restaurant concepts, soft room renovation, conversion of some dead space into meeting rooms, creation of a spa etc. Those owners who contractually have the responsibility to pay for these changes have the ability – but don’t always make use of it – to insist on some linking of the rental formula to the amount spent, ensuring that operators think carefully before spending the owner’s money, but also making the overall proposal into a win-win for both sides.