Changes to hotel leases in select markets in Asia-Pacific and Europe during the times of COVID-19 (3/5)
Part 3: Hotel Leases in Asia-Pacific (South Korea, Singapore, Thailand & Malaysia)
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, is not discussed in this series.
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.
South Korea is no stranger to market disruptions from the Middle East respiratory syndrome (MERS) in 2015, the fallout from political tensions with China (a key source market in Seoul) after 2017, and now COVID-19. In a market that was already facing oversupply issues pre-COVID, more and more properties are being converted to offices or residential use. In short, hotels are out of favour among local real estate investors and funds, condo hotels aside.
Regardless, hotel leases have been common in the market for some full-service hotels in a sandwich structure with a strong OpCo from a local conglomerate or cheabol. These chaebols have a very strong balance sheet, usually act on ulterior motives and enter into management agreements with large international hotel operators. Given the chaebols’ standing, the operators are comfortable with this structure. While only few such cases exist, there is currently no adverse reason that similar leases will not be created again in the future.
More common are leases for mid-market hotels, mostly in the Seoul metropolitan area. Predominantly domestic but also some foreign (mostly Japanese, some Chinese) hotel operators would enter directly into a lease with the owner. Usually, these overseas operators seek to enter an important market with a strong location where leasing is the only option available. The owners are inmost cases local investment funds or asset management companies representing institutional money that are passive and have stringent yield targets for their investments (in the range of 4.0% to 5.0% of development cost). These yield targets formed the basis for a fixed or a minimum guaranteed rent, along with a variable rent, effectively providing a floor to the owner in the hybrid rent. The hotel operators were often sub-divisions of cheabols or had strong backing from their Japanese parent companies. This “yield guarantee” model was conceived right when the market experienced an investment boom period which led to a compression in yields and subsequently a supply increase, depressing average rates to the point where EBIDTA was not sufficient to cover the yield guarantee. The limited flexibility by the owner required substantial support from the operator parent towards rent payments. Once it became apparent that the target yield could not be met in the new market environment, operators stopped signing leases under these burdensome terms.
More recently, as foreign investors took ownership of hotels, leases evolved with a fixed rent to cover debt payment (as compared to yield) and a variable rent for an equity return to the owner. This de-risking of the lease structure is more favourable to the lessee, which is a promising sign for the market from foreign investors.
Because institutional investors in Korea are not permitted under local regulation to hire staff (assume employee risk), they are unable to enter into management contracts. In the current market environment of the pandemic, even a management contract with a guarantee is not attractive for local investors. Thus, any developer looking to exit to a domestic fund or institutional investor would avoid management contracts, although they remain popular with foreign investors.
Amid COVID-19, the market environment continues to evolve to the point where leases are not attractive for operators unless property yields decompress. This could happen should interest rates increase, though such a scenario is unlikely in the short term. Unless the market recovers and average rates perform very strong, leases will remain out of favour in Korea due to the price gap. We would not see domestic investors change their return requirements in the short-to-medium term. Management contracts with or without a (small)guarantee are the norm for the time being. In this environment supply growth is anticipated to slow and once absorbed could set the market right for the next cycle.
Singapore is a relatively small hotel market and leases are not overly common outside of Real Estate Investment Trusts (REITs). Some leases exist for full-service hotels that originate from sale-leasebacks or close relations between the owner and operator. Like in most markets, these leases are deal specific and no market standard terms have materialized. The underwriting of these kind of leases is critical and without stress-tests and a balanced fixed-variable ratio, lessees can face significant downsides.
After Japan, Singapore was the second country in Asia to establish a REIT code in 1999 which have proven to be a successful business model, more so than in Hong Kong. In general, Singapore’s REITs are opportunistic towards leases as they provide a way to significantly reduce or eliminate the business risk from the income stream in their portfolio. Many S-REITs were started by large real estate developers who act as their sponsors and are the largest shareholders. These developers also have hotel (or serviced apartment) operators among their subsidiaries. By controlling both entities, the developer can monetize their holdings from the development pipeline once stabilized by injecting them into the REIT. While they have control of the REIT, they manage the properties under a management contract, so to speak ‘inhouse’. In order not to burden their operators’ balance sheets, the REITs are stapled with fully controlled Business Trusts that acts as OpCos, creating a quasi-sandwich structure. At the same time, the REIT is de-risked and can get more favourable interest rates from lenders and better manage its more stringent reporting requirements compared to a Business Trusts, where less disclosure is required.
In general, S-REITs are hard pressed to find suitable acquisition targets in Asia where they are not outbid by private capital or cash rich conglomerates, who have different return requirements. As a result, a healthy pipeline of assets to inject into the REIT directly from the sponsor is critical for these REITs to sustain their business. These ‘internal’ leases are usually balanced between the fixed (based on debt coverage and costs) and variable rent components, where the variable component can be on revenues/turnover or even EBITDA. Notably in stronger locations, the fixed component can be significantly larger than the variable rent component.
One key aspect the manager needs to consider is the liability created by the leasehold interest on the OpCo’s balance sheet, which increases the costs of capital. The term of the lease thus needs to be balanced between REIT shareholders requirements and the balance sheet of the OpCo.
In the course of the pandemic, it has become evident that many operators’ underwriting of leases did not include any form of stress test for unlikely scenarios. The lack of or only limited sensitivity analysis may not reveal the potential downside risks that could aid in structuring more resilient leases.
Looking beyond COVID, operators would thus be required to underwrite leases more carefully to better understand the implications of worst-case scenarios. Any structure with a higher variable rent component may also warrant the owner to have transparency on the business to understand performance and associated risks, particularly around food and beverage. While the lessee may not think favourable of disclosing too much information, there needs to be a rethink already observed in other real estate sectors such as offices and shopping malls. In order continue bridging the price gap, lease terms need to stay attractive for lessees while structuring the underlying risks better. For example, it may become necessary for a REIT to assume pandemic risk. Ultimately the onus is on the operator to identify and present innovative ways for structuring a lease the owner can then feedback on. In the long run, this may negatively impact the returns an S-REIT can generate from a for-like asset. Thus, it is becoming more important for REITs to move up the value chain, which is easier to accomplish when the REIT’s affiliate hotel operator is appointed as manager. A self-reinforcing cycle. The inherent need to value-add will become a larger task for REIT managers who will have to work harder to maintain the model’s success.
Thailand & Malaysia
Thailand and Malaysia have some similarities in how their securities commissions have drafted their REIT code. Both were arguably influenced by Singapore, which set an example for the region. We will focus mostly on Thailand in this discussion, but many aspects on REITs also apply to Malaysia. One distinction in these two markets is that leases longer than three years must be registered or stamped with the land office and a fee paid (1% of the total rent payable in Thailand, less in Malaysia). At the same time, these REITs cannot assume contractual risk; guarantees and liabilities are also discouraged. Another challenge in Thailand is that leases are not binding for an incoming(even related) buyer, rendering a lease largely ineffective when owners shuffle the asset among different entities. At the same time, operators in these markets find themselves up against some of the most powerful groups in the region where they have limited recourse on management contracts drafted under local law.
However, the operators have learned their lessons, arguably the hard way and found ways to accommodate the lease structure, while maintaining their position as manager. The workaround is the stapled sandwich structure seen in Singapore between the REIT as the Property Company (PropCo), an OpCo controlled by the sponsor of the REIT and a management contract with an operator – with a guarantee from REIT shareholders or a tri-party agreement. Along with liquidated damages this provides a scenario where the operator can manage the property for the term of the management agreement and the sponsor has flexibility in structuring multiple three-year term leases between the REIT and the OpCo.
In terms of non-REIT leases by operators there are only few. Some foreign operators would seek out lease opportunities to enter the market. Chinese operators are known to have probed the market in this way. These leases may be relatively short and convert to management contracts for a 10-year term to give the owner reassurance during towards the rebranding process.
In general, there may be only a limited impact from the pandemic on Thailand and Malaysia, as most hotel leases are between related parties under the sandwich structure and do not directly impact the operator.
In part 4 of the series, we will review key characteristics of leases in Europe (UK & Ireland and DACH).