Do encumbered hotels really sell at a discount?
Do encumbered hotels really sell at a discount?
18 OCTOBER 2018 8:06 AM

Conventional wisdom suggests that hotels unencumbered by a lease or hotel management agreement will fetch a higher sale price, but research proves differently.

Hotel owners face a critical decision when determining whether to operate their hotel independently, or sign a lease or hotel management agreement (HMA), as this choice may have a great impact not only on the property’s operating income but also its terminal sales price.

This is because the options carry unique risks and therefore provide distinct expected returns from both the operations and from their attractiveness to potential buyers of the asset. For example, while leases tend to provide stable returns and HMAs provide greater upside potential, both, according to the real estate community’s conventional wisdom, will force the owner to sell the asset at a discount compared to unencumbered properties which supposedly attract a larger potential investment pool.

This would imply, for example, that owners who sign an HMA may be sacrificing a greater terminal sales price in exchange for the superior operating returns promised by hotel management companies.

On the other hand, if vacant possession does not sell at a premium, this would imply that the improved or more stable NOI achieved through HMAs and leases are not in any way detrimental to the owner’s overall returns.

Choosing the wrong management structure, therefore, could be financially detrimental for hotel owners since previous research has shown that their returns have historically tended to depend more on capital appreciation due to the hotel’s market value rather than on its operating income.

My colleagues and I, however, could find no research confirming a relationship between encumbrance and hotel market values, and we therefore set out to investigate this.

The data and analysis
We used a hedonic valuation model, a well-established statistical approach often used to examine real estate prices in other asset classes, to test the market value of 442 hotel transactions conducted in the United Kingdom between 2000 and 2015. We fed the 442 hotel transactions into a computer model, which also included important property and market conditions, and deciphered the pricing patterns to disaggregate the asset price premiums. We controlled for many variables to ensure that any price differences were due to the management structure and not due to hotel size, age, affiliation, property class, location, etc.

The conventional wisdom may not be so wise
We found that overall hotels under management agreement sell at a higher premium than those under lease contracts, and that both outperform unencumbered assets. We suggest that while the security of cash flows stemming from leased properties may be attractive to some investors, many are willing to pay an even higher premium for the potential financial upside offered by HMAs.

This finding may also reflect the fact that given their development and growth strategies, which encourage their use of HMAs, hotel management companies have signed agreements which favor the owner, thereby making them attractive or at least acceptable to potential investors. These findings clearly contradict the common industry perception that management encumbrance lowers a hotel’s value.

Geographies matter
We dug deeper and examined whether this held true across different geographic areas. We suspected that because the regional U.K. is a riskier market environment than the London, hotel investors would prefer management structures which best limit their financial risk while stabilizing expected returns in such areas.

Our expectations were confirmed as we found that outside of London, leased hotels sell at a premium to hotels under HMAs, which in turn sold at a premium over unencumbered assets.

However, we could not find any statistically significant overreaching pattern within London. Instead, as compared with the rest of the U.K., the London market seems to be more complex and irregular with regards to the perceived value of the three management structures. We suspect this may be because the supply of hotels for sale in London is very limited, and a large number of investors are regularly looking to enter the market and will do so for the right property regardless of management structure.

This may suggest that primary sought-after markets may function differently than regional or secondary markets given the varied investor profiles and high demand for hotel properties.

It’s (also) the economy
We also thought the encumbrance impact could depend on economic conditions as risk appetites often depend on economic situations. We found that our overall results, namely that HMAs achieve the highest premiums followed by hotels under lease contracts, held true during economic expansion.

We believe this is because HMAs allow hotel owners to benefit from the strong financial performance of their property during such times. While our data for the recessionary periods was not statistically conclusive, it did suggest that unencumbered hotels sold at a premium compared with hotels operated under HMAs.

We believe that investors during such periods are generally opportunistic, looking to “buy low and sell high” and to reposition such properties, and as a result the flexibility provided by unencumbered assets is highly sought-after as opposed to more restrictive HMAs and leases.

Bottom line: Don’t be afraid
While our data and findings were U.K. specific, and more research is needed to see if the results hold true in other markets, we suggest based on our results that owners need not necessarily refrain from signing management agreements or leases out of concern about their negative impact on their hotel’s sales price.

In addition, while owners have often sought flexible termination clauses and short contract terms to more easily sell the asset unencumbered, such terms can be very costly due to the concessions the operator demands in exchange. Our results suggest hoteliers should reconsider these terms as HMAs and leases appear to have the potential to increase a property’s value under the right conditions.

Investors may also be best served by maximizing operating income through beneficial management structures without being undermined by the fears of these negatively impacting the asset’s sales price.

Note. This article is based on the following research paper: Hodari, D., Balla, P. and Aroul, R. (2017). The Matter of Encumbrance: How Management Structure Affects Hotel Value. Cornell Hospitality Quarterly, 58(3), 293-311

Demian Hodari, Ph.D., an associate professor of strategic management at the Ecole Hôtelière Lausanne (EHL)-HES-SO// University of Applied Sciences Western Switzerland. Demian has won numerous research prizes in recent years for his work on the evolving relationship between hotel owners, operators and general managers, and for the performance and managerial implications of hotel management agreements. His academic research is regularly published in leading academic journals focused on the hospitality industry.

This article is based on academic research which utilized hotel sales data kindly provided by CBRE Hotels Europe and hotel characteristics information provided by STR’s SHARE Center, which provides support and data resources to professors and students in hotel and hospitality fields of study at colleges and universities worldwide. The assertions expressed in this article do not necessarily reflect the opinions of Hotel New Now or its parent company, STR, and its affiliated companies.

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