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Net Leasing as a Divestiture Vehicle

By Jeff Wilder
2/10/98 for H&MM

These days, hotels are often put on the market because current ownership has neither the will and/or the capital to modernize its buildings to meet competitive pressures. The necessity to upgrade usually results from franchiser demands and guest product quality expectations. The funds required to do a modernization are not inconsequential, often ranging between $ 250,000 and $ 2M+. Usually, if the money is not spent the franchise goes into default and the business deteriorates. So the willingness and ability to make the capital injection is critical to the hotel’s financial health.

Realistically, the existing owner is faced with resolving the situation by putting in additional cash equity, borrowing the fix-up money, losing the franchise or selling the property. In addition, if the franchise is terminated because of product quality issues, often the franchisee (the owner) is obligated to pay hundreds of thousands of dollars in liquidated damages to the franchiser, as well. Of course, selling a hotel while it is under pressure to upgrade clearly has an adverse impact on its immediate market value. I would say there is often a 15 - 25% price discount when a hotel is sold under the conditions I’ve generally outlined.

Often, owners in these circumstances truly don’t want to sell. Rather, circumstances force them into that position. The result is not only a discounted sale price, but also the payment of significant transaction costs and income taxes, to boot. Of course, a hotel requiring major upgrading is usually not performing at peak profit levels so its ability to attract financing is limited by its reduced earnings performance. And, a portion of the new loan proceeds, and the buyer’s cash equity, must clearly go to upgrading otherwise neither the franchiser nor new lender will be satisfied. This creates a project cost gap that is inevitably filled by the seller’s both reducing his sale price and holding purchase money (secondary) financing.

In these circumstances, I’ve found that an alternative to outright sale is the Net Lease approach. Here, the owner decides it is in his interest to keep title to the hotel and locate an operator to take over the business under a long term triple net lease. He looks for an operator who is willing to invest the fresh capital necessary to do the required upgrading. The tenant’s capital investment is often treated as the security for the lease position being created. These leases are traditionally 30 to 50 years in length. The rent is usually a combination of minimum payments plus a percentage of sales or fixed future increases. Sometimes, both the owner and tenant recognize that as the property ages it is less able to carry earlier year rent loads and it is wise to consider this in structuring the transaction. After all, over time it is the tenant’s rent payments that retire the owner’s debt and all parties recognize that major capital expenditures will need to be made down the line.

In a Net Lease scenario, the savings that accrue to both parties can be significant. Eliminated are transaction costs such as real estate transfer taxes, mortgage pre-payment obligations, new financing fees, and capital gains taxes. The owner continues to receive its current depreciation benefits, often sheltering from income taxes a reasonable portion of the rent received. And, the cash flow that he receives in the form of rent may well be greater than what he otherwise would receive had he taken the after-tax sale proceeds and put it in the bank at today’s moderate interest rate levels.

From the tenant’s perspective, he is able to acquire control of the hotel today for a lot less out of pocket cash than were the real estate purchased, as well as the business. He needn’t incur expenses or experience the frustrations involved in soliciting new acquisition financing. The cash equity that otherwise might have gone toward the down payment can now be applied to the hotel’s upgrading, thus bringing the property up to snuff with the franchiser and satisfying the demands of the transient guest. Clearly, the wise expenditure of fresh capital in upgrading the physical plant enhances the business’s prospects for success, thus improving the positions of the owner, the new tenant and the existing lender.

Finally, a Net Lease deal structure allows the transaction to close a lot quicker than a sale--and with less risk of it cratering. This is because the transaction is not conditional on fresh third party financing, which often takes many months to achieve, and delays the closing. Once both parties agree on the terms of a deal, and the modernization requirements are determined, there is really nothing standing in the way of the deal closing right then and there.

The Wilder Group closes numerous hotel lease transactions precisely because it often makes a lot of sense to everyone to go this route in transferring operational responsibility, and risk, to the new operator.