Editor’s note: This is an updated version of the column that includes citation of forms 10-K and 8-K filed by Pebblebrook Hotel Trust. The citations were erroneously omitted in the previous version.
There is a significant difference between what “going concern” and “going concern value” means.
A “going concern” describes a property—most forms of commercial real estate, including shopping centers, garden apartments, multi-tenant office buildings and hotels that are not “dark.”
“Going concern value” is the monetary worth of an operated property where a portion of an asset’s net income, and hence value, are attributable to the owner's labor and/or knowledge of how to run the property effectively and more profitably than what is typical in the market. Going concern value encompasses the combined value of real estate, personal property and business knowledge.
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Dan Lesser |
Hotel operating companies (both chain and independent) maintain significant corporate investments in such assets as: assembled work forces; accounting systems; and standardized operational policies, procedures and manuals. Chain hotel companies also have major investments in trademark brand names and proprietary reservation systems.
The distinction between going concern and going concern value is substantial. An ownership interest in a hotel encumbered by a long-term, non-cancelable management agreement can only be sold subject to the encumbrance, and that encumbrance is owned by an entirely different entity than the party that owns the real and personal property.
During the past decade, a small but vocal group of valuation professionals along with property tax advisors have persuaded some hotel owners to retain their services in an attempt to reduce real estate tax burdens by contesting the inclusion of non-realty value in the assessed value of lodging properties.
Appellants have endeavored to prove the existence of intangibles, which they claim can comprise upwards of 65% of total property value in an effort to lower assessments of the taxable real and personal property portions. Tellingly, when these same owners attempt to obtain financing on their hotel properties, the claim is made that no intangibles and/or business value exists, and that the total market value of a property is entirely attributable to real and personal property. For any asset at any given point in time, there can be only one market value as well as one appropriate allocation of the market value, irrespective of the purpose of the valuation exercise.
Sale transactions of lodging facilities provide market evidence to support conclusions relative to the appropriate methodology for segregating hotel income attributable to real estate, personal property and business. The sale of a hotel as a going concern (open and operational), reflects the trade of real and personal property only, and its transaction price does not reflect going concern value. Hotel investors account for income attributable to intangibles/business through the payment of management fees and in most cases, the additional cost of franchise/license/reservation fees.
When analyzing hotel investments, sophisticated lodging sponsors initially consider whether an asset is “encumbered” or “unencumbered” by management. The market will typically pay a premium for an “unencumbered” hotel compared with one that is “encumbered” by a long-term management contract. A wider arena of prospective buyers exists for “unencumbered” hotel assets versus “encumbered” properties, the competition for which tends to drive prices higher. Investors that purchase “encumbered” hotels, such as pension funds, private equity funds and hotel real estate investment trusts, are passive stakeholders seeking pure property returns, albeit higher ones when compared with alternative real estate investments such as office buildings and retail centers.
Investors that purchase “unencumbered” hotels are typically lodging operating companies aligned with capital sources or hotel management firms that deploy their own sources of funds to acquire real and personal property that allows for leverage of their operating business platforms. Chain and independent hotel companies seek prospects to implement their own business operating standards and procedures to reposition hotel assets and create operational and investment upside. Furthermore, chain hotel companies seek opportunities that offer both operational control of real and personal property and the opportunity to brand assets with one of their own identities and supporting reservations system. During the past 30 years, chain hotel companies have invested in critical mass, creating widespread distribution channels and brand loyalty reward programs.
Both the purchase of a hotel unencumbered by brand, and the acquisition of a hotel encumbered by brand and management, represent an interest of value in a going concern and not the going concern value. When an unencumbered hotel property is purchased, the buyer is paying for the real estate and the personal property only. For example, when Hilton Worldwide obtains another hotel for its system, it widens its guest distribution channels and leverages its corporate-owned intangible assets, thereby expanding critical mass.
Hypothetically, if Hilton agreed to purchase an unencumbered 400-room hotel from Hyatt Hotels Corporation for $80 million and Hyatt bargained for an additional sum of money for its assembled work force, business name, patents, copyrights, working capital and cash, operating procedures, manuals, etc., it would not realize any additional proceeds.
Hilton, a global hotel company that has its own assembled work force, business name, patents, copyrights, working capital and cash, operating procedures and manuals, would not pay another hotel company for intangible assets that it already possesses. Actually, Hilton would be an unlikely buyer of a hotel if, as a requirement of the transaction, they also had to purchase another's assembled work force, business name, patents, copyrights, working capital and cash, operating procedures, manuals, etc. Furthermore, if Hilton were to acquire a hotel with an assembled work force bound by such a labor contract, the property’s real and personal property market value would be negatively impacted.
Pebblebrook Hotel Trust organized in December 2009 to opportunistically acquire and invest primarily in upper-upscale, full-service hotel properties located in urban markets in major U.S. gateway cities. Pebblebrook invests in “passive” ownership of hotel real and personal property, as indicated in the company’s Form 10-K from March 2010:
Since federal income tax laws restrict REITs and their subsidiaries from operating or managing a hotel, we will not operate any hotel properties we acquire. Instead, we will lease substantially all of our hotel properties to subsidiaries that qualify as TRSs, under applicable REIT laws, and our TRS lessees will retain third-party managers to operate our hotels pursuant to management contracts. Our cash flow from the hotels may be adversely affected if our managers fail to provide quality services and amenities or if they or their affiliates fail to maintain a quality brand name. In addition, our managers or their affiliates may manage, and in some cases may own, invest in or provide credit support or operating guarantees to hotels that compete with hotel properties that we acquire, which may result in conflicts of interest and decisions regarding the operation of our hotels that are not in our best interests.
We will not have the authority to require any hotel property to be operated in a particular manner or to govern any particular aspect of the daily operations of any hotel property (for example, setting room rates). Thus, even if we believe our hotels are being operated inefficiently or in a manner that does not result in satisfactory occupancy rates, RevPAR and ADR, we may not be able to force the management company to change its method of operating our hotels. Additionally, in the event that we need to replace any management company, we may be required by the terms of the management contract to pay substantial termination fees and may experience significant disruptions at the affected hotel.
A review of the 2011 Purchase and Sale Agreement of Pebblebrook’s $110-million acquisition of the 450-room Westin San Diego Gaslamp Quarter illustrates that its purchase was of hotel real and personal property only. Pebblebrook’s March 2011 Form 8-K/A filing states:
The Parties hereby agree that the Purchase Price shall be allocated among the Land, the Improvements and the Personal Property as set forth in Schedule 3.4 for federal, state and local tax purposes. The Parties acknowledge and agree that the allocation set forth in Schedule 3.4 represents an arm’s length agreement based on the Parties’ best judgment as to the fair market value of the Land, the Improvements and the Personal Property, respectively.
Schedule 3.4 Purchase Price Allocation: Land: $25,537,000; Improvements: $81,649,000; Personal Property: $2,814,000; Total: $110,000,000.
Note that Pebblebrook attributes no value to intangibles/business.
A passive investment in a first-class hotel encumbered by a long-term hotel management agreement is riskier, but no different than a passive investment in a Class A office building occupied by a long-term creditworthy tenant. Both investments yield a risk-adjusted return on property, and not a business.
Irrespective of whether a hotel is encumbered or unencumbered by a management contract, its market value is reflective of an interest in a going concern, not a going concern value. Market participants allocate income attributable to intangibles/business through the deduction of management fees and in many cases, the additional cost of franchise/license/reservation fees. The free market and many courts of law have proved time and again, that the sale of an open and operating hotel reflects the transfer of real and personal property only.
During the past 30 years, Mr. Lesser has specialized in real estate appraisals, economic feasibility evaluations, investment counseling and transactional services of hotels, resorts, conference centers, casinos and timeshare properties on a worldwide basis. He provides services to corporate, institutional and individual clients and municipalities on all facets of hospitality real estate including: litigation support and expert testimony, site evaluation, highest and best use analysis, appraisals for mortgage, acquisition, and portfolio management, workout strategies, operational analysis, property tax assessment appeal evaluations, economic impact studies, deal structuring and fairness opinions. He is president & CEO of LW Hospitality Advisors. Previously he served as the senior managing director-industry leader of the Hospitality & Gaming Valuation Advisory Services Group which he established at CB Richard Ellis Hotels. For 11 years prior to joining CBRE, Mr. Lesser founded and led the Hospitality & Gaming Group at Cushman & Wakefield. Mr. Lesser was a member of the original team at HVS International when it was launched, spending 13 years there expanding the firm’s practice. Prior to his hospitality advisory and transactional experience, Mr. Lesser held operational and administrative positions with Hilton Hotels Corporation and Eurotels-Switzerland. Mr. Lesser can be reached at 212.300.6684 X 101 or Daniel.lesser@lwhadvisors.com
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