Until the early 2000’s the hotel model for generations had been hotel occupiers owning their own assets when suddenly we began to see a quantum shift away from hotel ownership and toward leasing – a model that was prevalent in other real estate classes.
This was caused by an ‘alignment of stars’ as hotel groups were not seeing the value of their real estate reflected in their share prices, and there was a demand from capital rich parties for diversification. The early 2000’s were, therefore, the era of the “sale-leaseback” agreement.
Having been at the coalface of large number of these deals, I recall, in the early days, the pain of trying to explain to these capital sources that a hotel was fundamentally no different from other real estate classes but with the added pluses of a revolving CapEx cycle that meant the asset was ‘fit for purpose’ at the end of its term… oh, and we never have voids in hotels. Indeed, as one industry doyen once said to me, “Hotels never stop being hotels!”
As we started to get competitive interest from the ‘new kids on the block’ owners, we were able to stretch the model away from fixed income leases to variable income and eventually to management contracts (to the leading brands). Fast-forward to where we have today – a whole spectrum from owner-operators to leading brand franchising with third-party management.
The sea change we have seen of late is really two-fold. The sharpest yields (I have ever seen in my 35 years) for quality covenanted fixed income, the ability for institutional investors to buy quality (but not necessarily AAA-rated covenant) tenanted hotels… and the ubiquitous ground leases.
So now to the thrust of my argument. Like many, I struggle to understand how the value of the hotel property (post a ground lease sale) is not severely impacted by this structure – and yet many argue the yield is, if anything, hardly altered (albeit naturally, we are capitalizing a lower number). How can this be the case?
The ground rent inflates across the model and as such has little regard to market adjustments and downturns which, with operationally leveraged businesses, can have material and dramatic impact to the bottom line, as well as the effect of the ground lease on the operator’s ability to think about wholesale repositioning, the ability to take on debt if rent coverage is ‘compromised,’ questions around alternative uses, the rental liability (who knows what tax regimes may or may not impose over time) as it impacts the ability for certain buyers to take this on, and the ‘emotional’ hotel buyer who simply cannot bring themselves to buy a lease, etcetera.
To be clear, I am not saying such leases are bad things. Indeed, there is a strong argument that with the cost of capital being so cheap that in many cases it allows the owner of the hotel(s) to de-lever materially.
My words of caution are for the long leasehold owner receiving variable income with an ever-inflating rent liability – and the ultimate fact this may have on the value of this tenanted position.
As an aside, I have yet to meet a ground lease owner whose financial model goes over 35 years (to be honest 25 years is the norm). As such, surely, we are missing a trick not having the ability to rebase the rent every 25 years as this arguably has little effect to the landlord but arguably huge effect to the tenant?
Contributed by Derek Gammage, non-executive chairman, EMEA, CBRE Hotels Ltd., London