I was recently approached by a client who was perplexed about cursory information relative to a hotel sale transaction that just occurred in a highly desirable, major East Coast metropolitan area.
The 10-year-old, limited-service property, which traded for approximately $85,000 per key, is located in a thriving submarket and is in excellent physical condition, enjoying a strong occupancy rate, increasing average room rates and a profit margin of approximately 30%, or $13,800 per available room. No new supply is under development, and with relatively high surrounding land costs, a fundamental barrier to entry for new product exists for the foreseeable future. Replacement cost new of the property is estimated to be $150,000 per key.
Since its opening, the subject property has been affiliated and managed by a category killer brand under a long-term contract, with an inability to terminate the agreement upon any future sale. The contract, which created an encumbrance on the property, requires the owner to compensate the hotel company a base management fee of 5% of gross revenues, plus an incentive management fee equal to 20% of gross operating profit before deduction of the base fee.
Additionally, the contract calls for payment of a franchise fee (royalty and group advertising) of 9% of gross rooms revenues to the hotel company for use of its brand identification and other benefits that accrue to having a chain affiliation.
The property is essentially encumbered with a long-term, no-cut agreement for both management and branding—or in industry parlance, a “manchise agreement.”
Analyzing the sale price
Upon first glance, the puzzling question about this transaction was how a desirable hotel asset performing as well as the subject would trade on a capitalization rate as high as 16% ($13,800 divided by $85,000)?
A detailed analysis of the transaction revealed two significant issues that affected the sale price: 1) The long-term, no-cut management and franchise agreement did not include the entire bundle of rights that exist with an unencumbered hotel property, limiting marketability of the ownership interest, which in turn heightened perceived risk associated with the position. 2) The economics of the hotel company charging above market management and franchise fees diminishes the available cash flow to this ownership interest.
The legal ownership of realty implies a group of property rights likened to a bundle of sticks where each stick represents a right or stream of benefits. The bundle expands as “sticks,” or rights, are added and gets smaller as sticks are taken away. Significant landowner sticks include the right to sell, lease, operate, mortgage, donate, subdivide, grant easements, etc.
When someone purchases a piece of property, he or she isn't necessarily afforded all of the rights. The rights can be broken up and divided among different parties.
The inability to terminate the subject property management and franchise agreement has resulted in a reduced bundle of rights (interest in the property) that would be a challenge to sell. Moreover, the arena of prospective acquirers for a passive interest in a brand managed limited-service (125 to 150 room) suburban hotel is very narrow, which exerts negative pressure on the market value of the ownership interest in the property.
The fact that the property’s net income is reduced by above market base and incentive management fees, yields a lower cash flow and resultant value when compared to typical agreements and fee structures that are achievable when contracting market rates and terms with a hotel brand for a franchise agreement, and a separate contract with a competent third party management firm at market rates and terms.
In the above referenced transaction, if the property’s net operating income were adjusted upward to market to reflect typical fees and the long-term management encumbrance did not exist, resulting in a lower risk rate, the value of the available cash flow to the ownership position would equate to approximately $175,000 per room, or approximately 15% higher than replacement cost.
Essentially, entering into an above market long-term franchise and management encumbrance bifurcated the property’s bundle of rights and reduced available cash flow, resulting in the permanent erosion of the subject developer’s value of its ownership interest in the property by almost 50%.
When analyzing sale transactions of hotels and other forms of commercial real estate, it is crucial to first consider what rights have been conveyed and its impact on the agreed upon price.
During the past thirty 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 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 eleven 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 thirteen years there expanding the firms 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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