11 Jun 2014
Words Alex Cook

Breakthrough on motel valuations

 Presented for the first time at a conference convened by Resort Brokers Australia, the new methods provide systematic calculations to determine a fair price for motel lease extensions, and to value short-term motel leases. “We have come up with logical models that finally put some science and certainty behind these grey areas of motel valuation,” said Resort Brokers Australia managing director Ian Crooks. “Now it is vital they are embraced by the whole industry. “As the accepted standard, they will strengthen the position of both leaseholders and landlords, while creating a sound, uniform approach easily understood by everyone from professional advisors, financiers and brokers to vendors and buyers.” Solicitor David Burrough was instrumental in the breakthrough initiative. As partner in charge of the Tourism and Hospitality Division of Brisbane firm Hillhouse Burrough McKeown, he has been advising on all legal issues affecting motels since 1981. Burrough said the issue of diminishing lease terms had come to the fore in the last five years, as many of his motel clients found the years on older leases counting down. “We need to recognise the industry is maturing, the number of years left on a great many leases is coming down, and it is something everyone must be thinking about,” he said. “I spoke with Ian Crooks at Resort Brokers about the fact there was no science behind determining a fair price in negotiations between landlord and motel operator for the granting of a lease extension. Disputes were increasingly inevitable.” Crooks was already considering the emerging issue. Afterall, he had years before pioneered the now common system of motel leases, introducing the concept of splitting motels into separate freehold investment and leasehold business opportunities. Into the expert mix then came Tony Rossiter, a Director of Holmans and specialist in accounting, taxation and financial planning for accommodation industry clients. “Knowing how critical the issue was, we set about collaborating over probably an 18-month period to consider the matter and come up with solutions,” Burrough said. “Now we have the solutions, we need to educate and convince everyone – lessees, landlords, banks, and other professional advisors – of the wisdom of these formulas and their potential to be a great boon to the whole industry. “Not only will they be valuable benchmark tools to underpin investment certainty, they will reduce the need for protracted negotiations and lessen the likelihood of disputes.” Resort Brokers’ conference was attended by a cross-section of motel industry identities, including many valuers active in the sector. Burrough said the response was very positive. “A great many questions were asked, and there was broad acceptance that we have made very important progress in the right direction.” Consistent approach vital to price lease extensions A valid system for pricing motel lease extensions has finally been developed to provide business certainty for operators and fair reward for property landlords. The much-needed price calculation model, developed by Holmans partner Tony Rossiter, in consultation with Resort Brokers Australia and Hillhouse Burrough McKeown, directly relates the value of the proposed extension to the profitability of the leasehold business. According to Rossiter, the lack of a generally accepted method for calculating extension values has caused uncertainty for all parties, with the potential to destabilise the industry. “With no consistent methodology applied, premiums paid for additional years have varied widely, with landlords taking differing approaches, or just setting a price they’ve heard was paid elsewhere, even though it bears no relation to their property,” he said. “In picking figures, there seems to have been little regard for the motel size or indeed the profitability of the business. I’ve seen prices range anywhere from nil to $70,000 per year. “Such inconsistency is detrimental to everyone – landlord, lessee and the wider industry.” Holmans’ new model recognises the unique nature of a motel lease, compared to other commercial property leases. A formula to facilitate motel lease extensions is vital because the motelier’s business is inextricably linked to the premises. “A motel freehold can really only have one purpose – operation of a motel,” Rossiter said. “The goodwill of the business is location-specific, the tenant has goods and chattels tied up in the premises and, at expiry, they can’t simply move and start up elsewhere. So it is vital leaseholders have a sound basis for negotiating with landlords for an extension. “An extension has value to the operator because it provides them with the opportunity to generate additional profits over the period of the extension. “So the amount they pay must be a direct function of the value the extension creates in terms of future profits and current capital appreciation, not simply a random amount nominated by the landlord,” he explained. “The price must fairly recompense the landlord, recognising there is an opportunity cost to them for granting the extension, while providing sufficient financial incentive for the tenant to proceed with the lease extension.” BENCHMARK CALCULATION METHOD Step 1: Calculate the Adjusted Net Profit of the leasehold motel business. This should be done on a consistent basis, applying accepted industry standards for calculating profit on a ‘for sale’ business. Step 2: Determine the capitalisation rate appropriate for the business (ideally done by a valuer). Divide the Adjusted Net Profit by the capitalisation rate to determine the value of the motel lease. Step 3: Calculate the value per unit of chattels owned by the lessee, and multiply by the number of units. Reduce the value of the motel lease by the value of chattels to determine the Goodwill Value of the lease. Step 4: Calculate 45%* of this amount as the value of the premium for the lease extension. (* In the case of a ‘Freehold Going Concern’, the owner-operator retains 100% of profit. There is widespread industry acceptance that, when a motel is split, the freehold investor (landlord) is paid 45% of the gross profit in rent, while the lessee retains 55% for operating the motel.) Here’s how it works: Let’s look at an actual example. This calculation applies to a 25-unit motel where 15 years remain on the original 25-year lease. The maintainable Adjusted Net Profit of the leasehold business is $200,000, and the capitalisation rate is 30%. Chattels are valued at $2,000 per unit. The lessee is seeking a 10-year extension. Adjusted Net Profit $200,000.00 Divided by Cap Rate of 30%= Value of Lease $666,667.00 less Value of Chattels - $50,000.00 (25 units x $2,000) = Goodwill Value of Lease $616,667.00 Divide by original lease term (25) = $24,666.70 Multiply by lease extension period (10) = $246,667.00 x 45% = Value of Lease Premium 110,000.00 Therefore, the value per year of the lease extension equals $11,000 The table below shows the calculated outcomes of this model at varying levels of Adjusted Net Profit, if all other variables remain the same.

  Timing is important Timing is important to the correct application of this model. Holmans recommends the optimum window for seeking an extension is when the lease has between 15 and 20 years left to run. “In our experience, it is unusual for a tenant to seek a lease extension when they have an existing term in excess of 20 years,” Tony Rossiter said. “At that stage, we expect a lease extension would be worth less because it is not necessary for business certainty. “Conversely, if fewer than 15 years remain, the value of an extension would likely be more than determined by our model, because the lessee has greater need for the extension. “With each year that goes by without an extension, the underlying value of the lease diminishes at an increasing rate,” he said. “Which is why our collaboration with Resort Brokers has also yielded a vital solution for valuing short-term leases.” Price consistency clears the way forward Adoption of these logical formulas for motel lease valuations will be the catalyst for improved relations between leaseholders and landlords. With price consistency will come options for everyone. “Both landlords and lessees grapple with the issue of lease extensions,” said Resort Brokers MD Ian Crooks. “Now the question of price has been resolved, the path to sound business decisions can be much clearer.” Should a landlord be averse to granting a lease extension (perhaps for redevelopment or family succession reasons), the leaseholder now has the reassurance of a sound short-term lease valuation formula when it comes time to sell. When a landlord agrees to an extension, with the fair market price clearly defined, both parties are well placed to make sound financial decisions and payment arrangements. Should the property be in need of an upgrade (eg. new bathrooms), one option would be to finance the project using the money paid for the lease extension. “Then, as part of the lease extension arrangements, there may be an agreement whereby the lease document is varied to state that, on completion, rent will increase by an agreed percentage of the total upgrade cost,” Crooks said. “So, if $300,000 is spent by the landlord on improvements, annual rent might go up by 10% or $30,000 a year.” Rent adjustments also provide an option to spread the cost of the lease extension for the leaseholder, and avoid potential tax implications for a landlord receiving a lump sum payment in a single period. Formula makes short-term leases a valuable option Short-term motel leases will remain viable and valuable thanks to a new valuation formula that protects capital investment and returns, while allowing for goodwill or capital growth. Resort Brokers Australia and fellow industry experts, financial advisors Holmans and solicitors Hillhouse Burrough McKeown, say the valuation method must be embraced industry-wide to strengthen the long-term viability of motel leasing. “As a lease term shortens, dropping below the 20-year mark, goodwill begins to erode,” advises Resort Brokers’ sales manager, Trudy Crooks. “Presently there is no protection against this because there hasn’t been a logical and widely accepted method for valuing shorter leases. “Our approach will underpin and strengthen the industry. It will protect novice motel buyers from paying too much for a depreciating lease and, at the same time, will make short-term leases appealing investment options comparable to longer leases.” The starting point had to be the already widely recognised formula for calculating the sale price of a standard 30-year lease, ie. based on the net profit capitalised at an agreed rate, depending on the location and standard of the property. “Most leases are sold on a 30% return,” Ms Crooks said. “In desired CBD locations it may be 26 to 30%, while regional locations can show 32 to 40%. “So we start by calculating the price of a lease as if it were a standard long lease, then divide that price by the number of years remaining on the lease in question. This is vital as buyers look at many different properties, and motels with shorter leases need to be easily compared to those with longer leases.” The second step addresses a key issue for buyers – the desire to achieve capital growth. “People buying a business obviously want an annual return, but most also expect to be able to sell the business for more than they paid for it. In the case of short leases with a diminishing term, that is unlikely,” she said. “So, to be appealing and comparable to other investments, the short-term lease needs to be valued so it shows a greater annual return in lieu of capital appreciation. “It means you can buy a shorter lease, make bigger returns and, although you sell for a lesser value, you are just as well placed as if you bought a longer lease, made a smaller return, and sold at a higher price.” Resort Brokers’ new valuation method for short-term leases will open opportunities for people with less capital to invest in motels with much higher turnover and net profit, where the price of a longer lease on a comparable property would have been out of reach. “This makes short leases great cash flow businesses with strong appeal to a wider market,” Ms Crooks said. By dividing what we know would be the value if it was a long lease by the number of years remaining, you arrive at a figure representing the extra profit a buyer should earn to compensate for the decreasing value of the asset. “While they sell for less in the end, they have banked their capital growth along the way.” Subtracting the ‘extra’ annual return from the total net profit reveals the new ‘true’ business profit of the short lease. Finally, you capitalise this new net profit figure at the appropriate rate to calculate the fair market value of the short-term lease. Method shows real value for buyers Here are two examples illustrating how the short-term lease valuation method is applied: In 2013, a motel lease with 12 years remaining shows a net profit of $150,000 p.a. Step 1: If this were a new 30-year lease, based on the $150,000 net profit, capitalised at 30%, the business would be worth $500,000. (net profit divided by cap rate) Step 2: Divide $500,000 by remaining 12 years = $41,666 p.a. (extra profit earned) Step 3: Subtract $41,666 from $150,000 to ascertain the new ‘true’ net profit = $108,333 Step 4: Capitalise the ‘true’ net profit of $108,333 @ 30% to calculate short lease value. SHORT LEASE VALUE = $361,110 In 2018, this motel lease has 7 years remaining, and achieves a net profit of $150,000 p.a. Step 1: If this were a new 30-year lease, based on the $150,000 net profit, capitalised at 30% the business would be worth $500,000. (net profit divided by cap rate) Step 2: Divide $500,000 by remaining 7 years = $71,428 p.a. (extra profit earned) Step 3: Subtract $71,428 from $150,000 to ascertain the new ‘true’ net profit = $78,572 Step 4: Capitalise the ‘true’ net profit of $78,572 @ 30% to calculate short lease value. SHORT LEASE VALUE = $261,906 Banking growth along the way The average stay in motel businesses is 4-5 years. So, while you may happily buy a 20-year lease, by the time you sell, without an extension, the value will be starting to erode. Implementing this new formula for valuing shorter leases, will mean buyers can see the opportunity to bank gains during the life of a short-term lease. In our examples, the leaseholder who buys in 2013 for $361,110 can sell in 2018 for $261,906 – roughly $100,000 less than the original purchase price. But, along the way, they have ‘put away’ extra profits (capital growth) of $41,666 p.a. for five years – a total of $208,330 or double the price drop. This, added to the 2018 sale price, shows they have actually realised a total of $470,236. Having paid $363,000 in 2013 … that figure demonstrates a very solid gain.