Hotel Leasing: What Should Investors Know!
Hotel investments are capital intensive and have a long gestation period. While the investor is expected to meet 100% of the investment (via equity and debt in a ratio acceptable to the brand), very often the absence of any guaranteed return reduces the investor universe considerably. Return-focused investors are increasingly seeking fixed or operating leases in hotels. As a result, over the last few years, hotel leasing has gained traction where hotel management companies assume the role of a lessee and participate in the development risk by investing capital in hotel projects.
Different leasing models can be used based on multiple factors, such as the risk appetite of the investor, quality and location of the asset, market strength and investment philosophy of the lessee.
Fixed Lease: A fixed hotel lease has a fixed rental mechanism with standard annual escalation. The model works for investors who may not be willing to partake in operational risks and are comfortable with a steady rental return. The business risk, therefore, rests completely with the hotel company/lessee and after meeting all operational expenses and rental payments, the entire profit or loss belongs to the lessee.
Variable Lease: There are hotel leasing agreements that only comprise a revenue share to the investor. Such a model suits an investor with a high-risk appetite, who may seek a greater revenue share in lieu of forgoing any investment protection in the form of a fixed rental or minimum guaranteed rent. Clearly, the business risk for the investor is significantly higher in this model, and so are the returns during good performing years.
Fixed + Variable Lease: This is a hybrid model, where a fixed rental is committed to the investor with standard annual escalation, along with a variable lease payment in the form of a percentage of the sales turnover. The model works for investors who may want to protect their investment via an assured fixed rental (though the rent is often lower than a pure fixed lease) and earn additional returns through the variable lease component. Therefore, the investor also participates in the business risk to a certain extent.
Variable Lease with Minimum Guaranteed Rent: This model is most prevalent in the top-performing urban and leisure hotel markets. The investor gets a percentage of the sales turnover or a minimum guaranteed rent, whichever is higher. Prime location, visibility, and high-performance potential, among other factors, enable investors to command a higher revenue share protected by a minimum guaranteed rent in case of a market down cycle. This model enables a higher yield on investment in the long term.
Below is the summary of hotel leasing models discussed above:
|Benefits to Investor
|Benefits to Lessee
|• Assured returns
• No operational risk
|• Complete share of profits after meeting operational expenses and rental payments
• No investor interference in day to day operations
|• High returns in good performing years
|• No balance sheet liability as there are no fixed rental payments
|Fixed + Variable Lease
|• Investment protection
• Additional revenue from sales turnover
|• Lower fixed rental payments than under a pure fixed lease
|Variable Lease with Minimum Guaranteed Rent
|• Investment protection
• High returns in good performing years
|• Opportunity to expand in high-performing markets and locations
Most hotel lease contracts are negotiated for warm shell or fully fitted out structures. Having said that, investors always seek skin in the game from lessees in the form of capital commitments. The commercial terms of a hotel lease may vary based on the capital contribution of the investor and the lessee.
|Cold Shell Lease
|Warm Shell Lease
|Fully Fitted Out Lease
Investor scope: Land, construction approvals and licences, building civil structure.
Investor scope: Land, construction approvals and licences, building civil structure, services, interior fitouts.
Investor scope: Land, construction approvals and licences, building civil structure, services, interior fit-outs, Installing all movable items like furniture & fixtures, operating supplies & equipment.
|Lessee scope: Services, interior fit-outs, installing all movable items like furniture & fixtures, operating supplies & equipment, hotel pre-opening expenses.
|Lessee scope: Installing all movable items like furniture & fixtures, operating supplies & equipment, hotel pre-opening expenses.
Lessee scope: Hotel pre-opening expenses.
Numerous other elements in a lease contract need careful consideration and need to be negotiated, like:
- Lease tenure
- Lock-in period
- Advance lease rent
- Stages of investment by the lessee
- Security deposit and refund mechanism
- Investor’s scope of work
- Lessee’s scope of work
- Insurance and stamp duty charges
- Exit clauses
- Termination conditions
Poorly drafted clauses and imbalanced lease terms can adversely impact the business setup and the relationship. Thus, receiving professional guidance is of utmost importance to ensuring that a fair and tenable deal is obtained for both parties. Hotelivate has been actively involved in the hotel leasing space and expects this form of hotel ownership to grow over the next few years.
For more information, please contact Sameer Garg on [email protected]