As lending tightens, the sale-leaseback model can help owners extract 100% of their property’s value and get cash up front. The model has been popular in Europe and is now gaining momentum in the U.S.
REPORT FROM THE U.S.—How can owners sell their hotels but keep them at the same time?
While it might sound like a riddle, it’s not so tricky when hoteliers consider the sale-leaseback deal model.
Here’s how it works: An owner sells a hotel to an investor, and the property gets leased back to the seller. The existing mortgage or debt is then paid off via this transaction. A lease—typically 15 to 20 years—is signed by both parties whereby the seller, still the operator, pays a monthly lease payment to the buyer. The seller can use the sales proceeds to pay off debt or build more hotels; it’s like a different form of financing that gives the seller 100% value of the real estate versus a bank loan with 70% loan-to-value.
“What you have with a traditional loan is equity that is stagnant. You can’t do anything with that. The idea of a sale-leaseback is to be able to free up capital in order to grow,” said Stephen Y. Schwanz, president and managing director of Franchise Capital Advisors, whose firm has advised on several of these deals in mostly the limited-service space. “Banks are getting tighter in lending, and rates are going up. This gives hoteliers a vehicle to free up stagnant equity.”
It’s a model that has been popular in places such as Europe, but the deal structure has been making its way to the U.S. market. Tax-law changes might have something to do with that, according to a recent report from Marcus & Millichap. Companies that have loans on purchased assets that they operate from have historically been able to deduct the interest on their real estate. Under the new rules, however, companies with average annual gross receipts of $25 million or more face limits on their overall interest deductions. That has led to some seeking out new approaches.
“It’s the way that the lease expense is treated that helps offset the taxes is my understanding of it. It’s how that income is treated by each entity. On one side of the balance sheet it’s an expense so that brings the income down. On the other side, it’s dealt with as income, but it’s income from an investment property so it’s handled in a different way,” said Peter Nichols, VP and national director of Marcus & Millichap’s National Hospitality Group.
“What it all comes down to is the land underneath the hotel is untapped value. When you look at selling it or refinancing it, land typically is not factored into equation. That piece of the asset we can untap and bring that money to present value,” said James Meng, VP at Colliers International’s Greater Phoenix office, who has worked with partner Jon Grantham, associate VP, on sale-leaseback deals.
Recently, the two helped close a $20-million, four-hotel deal including properties branded under Red Lion Inn & Suites, Hampton Inn & Suites, Holiday Inn & Suites and Residence Inn.
He said it’s a creative way to finance a project beyond a typical bank loan, and if worked right it can lead to additional profits.
“In a sales-leaseback, you get the money upfront. You have a present-usage value, and you can deploy that money however you see fit,” he said, adding that the funds can go toward things that can earn a return, such as renovations or investing in another property. “You know the cost is 5% to 6% on the monthly organic payout on a lease. As long as you return a rate above that payout cost, you are making additional profit you would otherwise not attain.”
Sources said the sale-leaseback model offers a win-win for both parties with little downside, if the deal is done correctly.
Grantham said developers and private investors make up the majority of lease-hold owners and simple sellers in sale-leaseback transactions, and the structure leads to several benefits for them.
“One, it lowers your basis, so they have less exposure to any market shifts. Also, you have an increased (internal rate of return), so it’s going to be much higher than it usually is. You can get rid of lease-hold and be done with the deal,” he said. “Third, it acts as a low-cost source of capital compared to today’s equity. Right now equity is running anywhere between 12% and 18% on returns, and the escalations on this sale-leaseback model are much lower than that.”
Grantham has also seen some long-term holders use the sale-leaseback model combined with financing of the lease-hold with subordinate debt to paint a much higher cash-out.
“It has a much higher LTV than going with a fee simple finance,” he said.
On the other side, he said the buyers typically comprise equity funds and family offices.
“They like acquiring the fee simple interest because it’s an unsubordinated position and it’s triple net, so it’s basically mailbox money,” Grantham said. “They acquire fee simple interest at a low cost to value compared to appraised fee simple, so they can be in for 55% of appraised value. They are protected on all ends there.”
Sources said the model can also set up hoteliers in a good position in event of a downturn. For example, Meng said sellers are locked into today’s high water mark should a downturn happen. If a downturn doesn’t happen, it’s still a win because the seller has the cash now.
“As long as you have the right coverage and you are underwriting correctly, it’s a safe bet,” Schwanz said, adding that the deal structure will only continue to gain steam. His firm has about $300 million of sale-leaseback deals in the pipeline.
While sources said that generally the model doesn’t offer many disadvantages, Meng said working with the wrong team can lead to disaster.
“If you don’t negotiate the lease terms correctly to avoid pitfalls, then it can be a devastating process to exit,” he said.