Recently, hotels worth billons of pounds have been sold by hotel groups in sale-and-management-back transactions. This reflects a growing trend among European hotel chains away from hotel real estate and leases towards management contracts.
These sales raise the question of whether they have been “win-win” deals or whether there has been a winner and a loser. If the latter is true, it seems strange that the market applauds the hotel chains, presumably for being the winners, if buyers are some of the most sophisticated and smartest investors.
Are the markets missing something?
Given the anticipated hotel market recovery across Europe, it could be argued that hotel groups have sold a lot of growth, reduced the control of their core business and weakened their balance sheets, once they have returned the cash to shareholders. One wonders whether these deals have pleased equity markets for short-term gains, leading to a share price overrating for hotel operators that is not in their long-term interest.
Management contracts limit growth
Management contracts offer hotel chains fees as a small percentage of turnover and operating profits, but do not offer significant upside in absolute terms. Typically, it takes five or six hotels under management to generate the same impact on a hotel chain’s bottom line as two or three leased hotels or one owned hotel of a similar size.
As it is not likely, in many of the mature, urban hotel markets in the EU, for hotel chains to open dozens and dozens of new hotels under management contracts to compensate for the lost income from the sale of owned hotels, where will future growth come from? Moreover, under a management contract, the hotel chain is simply an agent or service provider to the owner, so neither owns nor controls the business.
A management contract offers less control of service levels, budgets, investments in new concepts, and renovations, as all have to be agreed with the owner. Hence, it is difficult for a hotel group to maintain consistent standards of service and product among large portfolios of managed hotels, where there are a multitude of owners across different countries with often disparate resources and objectives.
Also, management contracts often include performance targets. If they are not met, hotel groups can lose their contract and presence in that market, resulting in a weakening of their network and brand image. It is a rare business where not being in control of your core trading business is applauded by the markets.
One can argue that hotel groups should focus on hotel trading and not real estate, as this is too capital-intensive, burdens balance sheets and reduces return on capital employed. But, on the other hand, management contracts have various strategic and financial shortcomings and appear only appropriate for riskier emerging market countries such as Africa, the Middle East, Latin America and Asia.
There is a middle way
In major EU cities, operating leases offer a more attractive, clear middle way of separating hotel trading and real estate. What are the benefits and how should they be structured?
●Operating leases give full control and most of the long-term upside of the hotel business to the hotel chain.
● Medium-term leases with turnover, profit and fixed rent elements and limited guarantees allow off-balance-sheet treatment and minimise balance sheet impact.
● Investors have security of some rental income, share in the growth, and maintain control over the real estate investment asset.
● Leases can range from fixed rent to turnover- or profit-based leases, with investors taking on the full risk, and thus offer flexibility for different investors to fit a risk/return profile to their needs.
Operating leases create a partnership via an alignment of interest, with hotel chain and investor reflecting the inseparable link between hotel real estate and the business.
From a financial and strategic perspective, properly structured operating leases offer an attractive way to separate hotel real estate from the business, and structure investments in hotels in major urban centres. This explains why many major hotel chains are still using operating lease structures today, albeit with a lower risk for operators, and others are studying whether they should.
