Leases and the hotel sector
7th June 2019
Eversheds Sutherland property column: June 2019
Had I been preparing this article 15 or so years ago, I would have been explaining, in a reassuring way, the differences between management agreements and leases and bandying around the term "asset light" as if it were going out of fashion (which, fortunately, it has). The context at that time was that the biggest hotel brands were, other than in very high-profile locations, divesting themselves of their awkward-for-accounting and capex-gobbling leasehold and freehold interests and preferring management agreements and manage-backs. Understandably, given their expertise, these brands wished to shift their focus to operating hotels rather than asset-managing enormous property portfolios. Investors who were brave enough to grant the management agreements and banks who were willing to lend to these investors (despite the lack of any guaranteed return for debt service) would have been hearing from me (in an equally reassuring way) about the trend away from leases in the hotel sector.
The lease did not universally fall out of favour. By way of example, two well-known UK mid-market brands have continued to prefer freehold and leasehold ownership throughout this period, opting to retain control and flexibility and relying on their covenant strength to enable them to secure prime sites on favourable terms. Typically, those terms have included 25-year full repairing leases with five-yearly open market or, ideally, CPI-linked rent reviews. The developer landlord takes responsibility for delivering a hotel to these brands’ specifications, retaining liability for any inherent defects. In the recent Blue Manchester Ltd v North West Ground Rents Ltd  EWHC 142 (TCC) case, the court held that the landlord was obliged to replace defective glazing at Beetham Tower, Manchester, of which the first 23 floors were let and operated as a hotel. There were other factors at play in the case, but it helps to demonstrate that, especially at a time when new hotel developments are often part of mixed-use sites, leasehold ownership does not necessarily carry with it full responsibility for the repair of the building. It is also of interest to note that the court took the aesthetic appearance of the building into consideration in reaching its decision.
That is not to say that hotel leases are bad news for developers. From a developer's point of view, entering into a lease is a straightforward and more comfortable process than tackling the negotiation of a management agreement and the landlord's low level of risk associated with operating the hotel should mean no shortage of forward-funding buyers.
For several reasons, this is an exciting time for the hotel sector. We are seeing a number of new entrants to the market keen to secure sites in London and elsewhere in the UK. Many of these new models leverage technology and co-living concepts, some offering a no-frills but entirely comfortable experience for a good price and others borrowing from the hostel experience but upscaling it to appeal to a wider audience. Often, these models do not rely on a standard specification or an instantly recognisable design or fit-out and are instead better placed to refurbish existing buildings or squeeze into smaller spaces. The brand strength of, and concepts behind, these newer models are not so well established as to be compatible with a management or franchise agreement; they will typically look for leases of 25 years plus, securing, where they can, the certainty of capped, inflation-linked rent reviews or profit- based turnover rents.
There has been no change in the property investment approach taken by the biggest brands, albeit we are seeing an increasing movement towards franchise agreements over management agreements. However, another development has been the appearance of non-branded operators who are increasingly active in the UK market. These operators sit between an investor and a brand, taking on the day-to-day work of managing the hotel business for an investor who has entered into a franchise agreement but who wants to sit back and receive a fixed income from its investment.
This, in turn, has assisted in generating a shift in attitude towards hotels among real estate investors. Many investors have traditionally seen hotels as an "alternative" asset, deriving value from revenue rather than bricks and mortar and carrying the risks of employees, guest claims and unreasonable capex demands. However, with some areas of property investment now proving less attractive to pension funds, insurance companies and the like, these investors are starting to explore assets and transaction types that they have previously deemed too risky. This shift is assisted by increasing transparency in the sector as data becomes ever more readily available.
The picture is therefore changing but many investors will still seek, or be required by their constitution, to separate out the operating risk from their main business of property ownership and management. That separation can be achieved by an OpCo/PropCo structure, whereby the property-owning vehicle grants an operating lease to a subsidiary NewCo, which owns the hotel business, and enters into the management and franchise agreements. In these cases, the rental income derived by PropCo will very often be a percentage of the net operating profit of the hotel.
These are essentially turnover rents but, with references to matters such as, "Adjusted Gross Operating Profit", "Operating Expenses" and "the Uniform System", borrow some of their terminology from the management agreement.
So, hotel leases have evolved over the past 15 years. A few years ago, the market anticipated the man-ease (a lease/ management agreement hybrid) which I am not sure ever did make an appearance. Be that as it may, leases will continue to evolve to fit the needs of the hotel sector because they make good commercial sense. Leases are not for everyone but, for owner-operators and emerging brands, they are a viable means of freeing up capital and penetrating new markets and, for real estate investors, they generate a secure income.
For all that, I am pleased to note that leases are alive and well in the hotel sector.
For more information please contact Clare Whitaker