Changes to hotel leases in select markets in Asia-Pacific and Europe during the times of COVID-19 (2/5)
Part 2: Hotel Leases in Asia-Pacific (Australia, PR China, Hong Kong SAR)
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).
Asia-Pacific is a region diverse by almost any dimension imaginable. This is reflected in the nature of the hotel lease environment across markets. In general, it is institutional investors who require a de-risking of hotel assets via a lease structure. Without the presence of these investors in a specific market, a strong hotel lease regime as market practice is less likely to take hold.
Hotel leases in Australia span a wide spectrum in terms of investors/ owners, lessees (operators or OpCos), rent structures and brand/product positioning. As a larger trend, leases have become less common over time, certainly for full-service hotels where only a few legacy leases remain in place. It would be highly unusual for a full-service hotel to bel eased in today’s environment or in the near future post COVID. Unlike management agreements, which can already have significant variations in their terms, leases are deal specific to ensure each party’s needs are sufficiently covered.
In Australia, non-traditional or say inexperienced owners seek out fixed leases, double net. It remains common to have fixed leases priced on a dollar per room per year basis (nowadays adjusted for inflation). Atone point operators started to understand their exposure to downside risk in leases and owners realized they are missing out on the upside during a stronger market.
One innovation in favour of the operator was to adjust the fixed rent based on a RevPAR index, rather than by inflation and/or have a built-in stop mechanism. Hybrid rents also became more prevalent. The fixed portion in a hybrid structure would either be based on a dollar-per-room basis or tied to debt coverage. The variable component is usually a percentage of revenues; however, some leases differentiate rates between rooms and food & beverage revenues. This appeals for hotels with larger food & beverage components where restaurants are not leased out to third party operators. Clearly, the trend is towards leases with a lower fixed component.
This development needs to be understood in the context of the investor base. Ultimately, it is for the owner to decide what terms to accept. In the current environment, assets with a lease attain a yield premium in non-core locations, whereas hotels under management agreements are priced at premium in CBDs, reflective of the capital requirements of the respective locations and potential buyers an asset could attract. Non-traditional investors still dominate the non-core markets, whereas more experienced investors target CBD locations.
At the same time, the number of operators willing to sign leases is dwindling. The need to capitalize leases on the balance sheet under IFRS 16 creates major challenges for asset-light operators. However, smaller players keen to fill the gap may not be able to offer sufficient guarantees to the owner. Finding a hotel operator to lease may thus become more challenging for the owner. Some mid-market properties are run under sandwich leases, and occasionally sub-leased, with a franchise agreement. In general, a sandwich structure would be more common for mid-market hotels, though meaningful guarantees may remain elusive. One large overseas developer uses sandwich leases to offload stabilised properties into their REIT and then leasing them to a ‘mom and pop’ OpCo with a franchise agreement (under a brand they control).
In the face of COVID, leasing activity in the market has further subdued. Sale-leaseback scenarios may provide some level of deal flow for upmarket hotels in the years ahead. As a fairly mature leasing market, both owners and operators understand the risks and benefits involved and over time have worked to advance the lease structure. The absence of strict financial regulations further allows the development of new lease structures, almost at will, to the point where a lender is involved. Operators will be more adamant about stop mechanisms, go-dark clauses and larger variable rent components. Archaic force majeure clauses may be phased out, while mandatory operating rights and properly addressing post-termination employee liabilities may become more common. Ultimately, the onus is on the operator, to define terms that can properly balance the risks and benefits. The main motivation for a hotel operator to enter a lease is to establish a presence in a key market.
The market for hotel leases in Mainland China is dominated by mid-market hotel brands, which have adopted a unique business model. Through their proprietary distribution systems, which can generate 75% of bookings or more, hotel operators seek to sign management contracts with owners. However, many of the State-Owned Enterprises (SOEs) that have a large stock of C-grade commercial properties are not keen to enter the hotel business. The SOEs thus lease out several floors to an OpCo which enters into a management or franchise agreement with the operator in the sandwich structure. The OpCo or tenant usually pays a fixed rent by square meter per day, which is periodically adjusted for inflation. The operator guarantees RevPAR and occupancy levels to the OpCo, who funds the renovation of the property. The tenure is typically ten years providing the OpCo with an attractive payback. However, as a triple net lease, the OpCo may need to inject equity for renovations every five years.
This model has proven to be very successful and given China’s resilience during COVID-19, no adverse impact can be observed that would call for major changes. The main risk is posed by operators introducing new brands to circumvent area of protection provisions, potentially cannibalizing existing properties in their system.
One scenario for leasing of full-service hotels is at airport locations, where the airport authority leases out hotel premises directly to an operator. Here, the owner pays for “immovables” (including building, fixtures and equipment) at a fixed budget, which the operator can top up to their brand standards. The operator is also responsible to fund CapEX during the term and pays for “movables” (furniture and operating supplies and equipment, etc). The operator pays a lump sum in Year 0 and variable rent off of revenues for a relatively long term.
Given the small number of airport hotels, this model will likely stay in place though the operator may need to exercise caution to have sufficient funding for renovations, which can be costly for full-service, upmarket hotels.
Hong Kong SAR
Home to one of the first hotel management agreements in the world at the Hong Kong Hilton in 1963, hotel leases are not a common form of hotel ownership in Hong Kong. Although management agreements were quasi leases in those days, the industry in Hong Kong has come a long way and hotels are nowadays either owner-operated or under management agreements. After all, the strong performance during peak periods had often handsomely rewarded those hotels not redeveloped to offices during market slumps.
The most prominent example of hotel leasing today is one single REIT, which maintains a sandwich structure similar to the Singapore REITs. According to the REIT’s annual report 2020, the leases for the hotels owned by the REIT have both fixed and variable rent components. In the initial years, the fixed component is typically based on annual yield targets in the range of5.0% to 5.5%. In later years, the fixed component is subject to annual market rental reviews by a jointly appointed independent, professional property valuer. During the most recent rental review in November 2020, the fixed components for most of the hotels in the portfolio for 2021 were reduced by 35to 40% compared to 2020. The variable component equates to 50% of excess net property income (which was negligible during 2020).
The annual rent review mechanism for the fixed rent gives the REIT some flexibility to reflect market conditions. While this structure is favourable to the lessee, in this case an entity controlled by the sponsor of the REIT, it is less favourable to REIT shareholders. Without further transparency on the review process, the level of de-risking of the asset remains unclear.
Another example is a fixed single investment trust, which operates in a complex quasi sandwich structure as owner to a fully controlled master lessee/OpCo, who leases three properties from the group sponsor and the trust’s major shareholder of stapled shares. The three leased hotels are under a management agreement with an operator controlled by the group sponsor who also acts as guarantor to the management company. According to trust documents, the master leases are on a 14-year term and have two rent reviews for years seven and eleven by an independent property valuer. The fixed rent component is set at a specific amount and the variable component equates to 70% of gross operating profit before deduction of the marketing fees. The ratio of fixed to variable rent component was 32%/68% in 2018 and 41%/59% in 2019. Notably, the leases terminate if the independent property valuer, upon review, determines that the variable rent payable should be lower than 70% of gross operating profit before deduction of the marketing fees.
This structure is very specific to this group sponsor yet does show some flexibility towards upside changes in market performance, does however not provide any downside protection other than a potential termination. The annual report states that “there can be no guarantee that we could enter into alternative leasing arrangements on similar terms as the Master Lease Agreements or at all, or that the actual revenue derived from the Hotels would be equivalent to the Base Rent and the Variable Rent payable under the Master Lease Agreements. It may also be difficult to enter into alternative leasing arrangement on similar terms to the Master Lease Agreements if the master lessee is not also the Hotel Manager.”
Outside of REITs, it is unlikely that owners will be able to lease out properties post-COVID.
In part 3 of the series, we will review key characteristics of leases in South Korea, Singapore, Thailand & Malaysia.