Changes to hotel leases in select markets in Asia-Pacific and Europe during the times of COVID-19 (1/5)
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.
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.
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.
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.
In part 2 of the series, we will review key characteristics of leases in Australia, mainland China and Hong Kong SAR.