Part 1: Overview of Key Aspects in Hotel Leases: Hotel operating or master leases, referred henceforth as hotel leases, are among the most conservative approaches to hotel ownership.
A lease is a contractual arrangement calling for the lessee to pay the lessor for use of an asset. A lease can be structured in many ways and can further be subject to externalities including regulations from various authorities and market practices.
With few exceptions, hotel operators are reluctant to enter into lease agreements and need to carefully evaluate the risks and benefits.
Considering COVID-19, many assumptions driving the rationale in structuring a lease for an operator have been called into question.
A scenario where an event would cause a market slump over a prolonged period of months or even years was simply not factored pre-COVID, when new supply was the biggest concern.
This series of articles discusses key characteristics by illustrating the most salient points of hotel leases (part 1) in Australia, Mainland China, Hong Kong SAR (part 2), Malaysia and Thailand, Singapore, South Korea in Asia-Pacific (part 3) and Austria, Germany, Switzerland (jointly as DACH) and the UK & Ireland in Europe (part 4) along with our conclusion (part 5).
Japan, as a major leasing market in Asia-Pacific, deserves its own article (or book) and is not discussed in this series.
Overview of Common Lease Structures
Leases can be structured indifferent ways. One key aspect is how rent payments are calculated. There are three common rent types for hotel leases as shown in the table below.
Common rent types
A fixed rent is the most traditional rent type and commonly accepted in other types of real estate, such as residential and offices. Under IFRS16, income from fixed rents must be capitalized on the balance sheet of the lessee. For ‘asset light’ hotel operators these greater liabilities would increase the cost of capital, which is undesirable. To ensure the lessee can meet its obligations towards the fixed rent, an owner may ask for a form of guarantee. Guarantees can either be a form of deposit, like in the residential sector, or came in the form of corporate and bank guarantees.
On the other hand, the owner will register the fixed rent receivable as an asset and can use it as collateral, hence the term ‘bankable’. For example, to get better credit terms from its lenders. These two aspects create two opposing forces that need to be carefully balanced.
For income producing real estate such as retail, restaurants, and hotels, the owner may want to get a share of that income stream. The concept is common in retail malls where the owner is largely responsible for driving footfall into property. As a two-way benefit, the owner would want to earn higher rent when driving more traffic to the store, whereas a tenant would not want to pay a high fixed rent should the owner fail to generate such traffic. Fully variable rents are less common as they are not bankable and do not shield the owner from any operating risk.
Many leases nowadays thus have a hybrid rent. They are a combination of different types of fixed and variable rents to find an agreeable balance between the parties to the lease. There is rarely a perfect rent structure, even using hybrid rents. Ultimately, events such as the fallout from the COVID-19 pandemic put the lease structure to the test and, as we will see in the later discussion here, fail more often than not for at least one of the two parties.
There are commonly two parties to a lease, a lessor (owner) and lessee (tenant). In the case of hotels and prior to the advent of management agreements in the 1960s, it was hotel brands aka operators that entered into a lease agreement (as lessee or Operating Company/OpCo) with an owner (Property Company/PropCo). Interestingly, early hotel management agreements read much like a lease and some still do to this day. Given the challenges of guarantees, liabilities and hotel brands increasing focus on management and franchising, a third party was introduced as a go-between. The following image illustrates the concept:
There are three parties to a ‘sandwich’ lease: the owner/lessor/PropCo on the bottom, the lessee/OpCo in the middle (being sandwiched), and the hotel operator under a management agreement on the top. In some cases, the OpCo may manage the property themselves and enter into a franchise agreement with a hotel brand (a club sandwich?). The precarious nature of a sandwich lease is that the OpCo has to pay rent to the PropCo and fees to the hotel manager or franchisor, reducing its cash flow. In some jurisdiction, a sandwich lease can be more tax efficient.
In some (rare) instances, a lessee may decide to sub-lease the property to an OpCo who then enters into a franchise agreement. This is rarely advisable given the volatile nature of the hotel business and having more parties involved means less income to distribute to each party.
Lastly, an owner has one more dimension to control risk exposure from a lease, depending on who pays for renovations, maintenance, and other ownership costs. In the traditional sense, commercial leases can be differentiated into single, double and triple net leases or a gross lease. The chart below gives an overview of the four types.
Principle types of leases
Notably, for hotel leases, it is less common for the lessee to pay ownership costs such as taxes and insurance. An owner can either lease a fully-fitted out (aka fully furnished) building or a bare shell (with or without mechanical plant and equipment) for the lessee to fit out. It is uncommon for the lessee to be responsible for and install mechanical plant and equipment. In some cases, a lessee maybe be better positioned to execute a fit out themselves, though the associated capital costs may be too high.
Should the owner fit out the premises (turn-key), a reserve can be allocated for capital expenditures during the lease term. For a fitted-out property, there is a risk to the owner that a lessee will not return the premises in the same condition at the end of the term, which is one strong argument for triple net leases. The terminology for hotel leases can be confusing with the lease traditional definitions in mind shown above.
Hotel lease types
The two most common types of hotel leases are referred to as double and triple net. Notably, there are variations across countries and regions. Ultimately, determining who is responsible for what can be a lengthy part of the negotiation process.
A metric often used in the analysis and structing of leases is the lease coverage ratio. Similar to debt coverage, the ratio expresses the margin in income versus certain recurring payment obligations. The numerator is the NOI or EBITDAR, while the denominator is the rent payable (and in some cases debt payments).
Leases can be priced by their coverage ratios, a more expensive leases having a lower coverage ratio and vice versa. If the ratios increase, it is easier for an operator to make a profit, while the risk of a making a loss increases as the ratio approaches 1.0.
Dan Voellm, MRICS is the CEO & Founder of AP Hospitality Advisors, responsible for all aspects of the firm. Based in Hong Kong he covers the entire APAC region.
With more than 15 years of consulting experience, Dan Voellm has provided advice in 24 territories across Asia Pacific. Prior to rebranding the firm to AP Hospitality Advisors in 2021, Dan Voellm was Managing Partner of HVS Asia Pacific responsible for five offices in Greater China and Thailand. He started his career to become Vice President at HVS’ global headquarters in New York (2005-2008) conducting a wide range of appraisals, market studies and underwriting due diligence services in 22 states as well as Canada. Dan Voellm brings a strong understanding of the hospitality industry to AP. His experience in hotel and food and beverage operations in Germany, Switzerland, England and the United States is complemented by an Honours Bachelor of Science Degree from Ecole hôtelière de Lausanne in Switzerland.
Dan works closely with key institutional and private owners of hotel properties, financiers, developers and investors, and has gained a strong understanding of their investment requirement and approaches to assessing market values of investment properties. Dan further advises on property and concept development and strategy as well as expert witness testimony.
Dan is vice-chair of the Urban Land Institute’s (ULI) Hospitality Development Council in Asia Pacific and became a Professional Member of the Royal Institute of Chartered Surveyors in 2016.