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Feasibility of Motels

Issues and questions commonly raised to the assessment of viability for motel and accommodation leases

As Tourism Property Brokers, we specialise in the sale of travellers accommodation businesses, with the writer having been involved in this industry since 1984.  We do not have the wider knowledge held by accountants who are involved in a much broader range of business assessment, therefore we comment only on the returns offered by this particular industry.

It seems that motel leases are valued in a way which is not consistent with general accounting practises.  Sometimes potential buyers receive professional advice not to purchase, this advice is often based on analysis of motel accounts using the more traditional approach whereby cost of capital, return to management and sometimes depreciation are deducted before assessing profitability.  In more recent years this has been less of an issue as more accountants have been involved in assessment of motel proposals and have gained a greater understanding of how this particular industry works.

There are many valuers throughout New Zealand who have specialised experience and knowledge in motel valuation.  As with all valuations, assessments are usually made on the basis of comparison with recent sales evidence.  While sales figures may be available to most valuers, the detail of comparative sales is not so widely available.  This is why it is very important to engage valuers with substantial and preferably recent market experience.  With a valuation report prepared by a recognised independent valuer, borrowing from mainstream banks to purchase accommodation businesses or properties is generally not too difficult.  For freehold properties, equity of around 35% to 40% of purchase price is normally required.  For leasehold, these can usually be funded on a minimum of 50% to 60% equity.  We are happy to provide details of financiers who specialise in this industry and can offer excellent advice and support for your purchase.

How do we value motel leases?

It is beyond the scope of these notes to go into detail about the various factors making up a good lease.  There are many variables, however for this exercise we are assuming that we are assessing a leasehold business where the lease is sound and the revenue and profitability are sustainable or have some growth potential.

Value is usually assessed by establishing the earnings (profit) before interest, depreciation, drawings and taxation, often referred to as E.B.I.D.T.  The profit is then multiplied by a factor consistent with other market sales evidence.  This factor is referred to as the capitalisation rate or the profit multiple.  The rate of return or multiple used varies depending on a number of matters, including the location within New Zealand.  (See separate article entitled What You Get Is Where You Buy.) Supply and demand in certain regions and their popularity or otherwise will affect the rate of return used.  Generally, the rates of return for a leasehold business range between 20 to 25%, or in other words four to five times the profit.

Why add back depreciation?

Most businesses claim depreciation on plant and chattels, and this may save or at least defer some tax.  In the case of say a high-tech printing and copying business for example, it is likely that new equipment will need to be purchased quite regularly and that the old equipment will lose a substantial portion of its value in real terms.  In this case, depreciation would be a real cost and would need to be allowed for when working out the actual profit of the business.

The chattels in a motel however could be compared to the engine in a car.  If agreement can be reached on the total value of the business based on its earnings, then the sum recorded for the chattels in the Sale & Purchase Agreement for the business is usually important in terms of tax implications for both buyer and seller.  There is one qualifier for this though.  When calculating motel profitability, it is important to be sure that there has been, and will be, adequate allowance for ongoing repairs, maintenance and replacement of plant and chattels as necessary.  (How much will usually depend on the age condition of the assets.)  Should an appropriate allowance for chattel repair and replacement have been made, then we would suggest that depreciation on chattels is really a book exercise for tax purposes.

In reality, one of the challenges when negotiating the sale of a motel business, is getting the parties to agree on the sum to be recorded as the chattel figure.  The purchaser usually wants to have a high chattel figure so as to be in a position to claim depreciation.  The vendor on the other hand would like to show the value at a lower figure, if possible, at book value, so as not to recover depreciation claimed on the chattels.  In other words, any figure recorded as the chattel value which is above the current closing book value (up to the original cost value) would be depreciation recovered and this would be taxable to the seller. (See separate article entitled Depreciation Recovery).

The total business value should not be otherwise affected by the chattel apportionment, except that the “goodwill” or “intangible assets” will need to be adjusted to make up the total purchase price.  If a loan application is supported by a registered valuer’s report, lenders are not usually too concerned as to the chattel figure, as long as it is reasonable.

Why shouldn’t a return to management or owner’s salary be taken out of the figures before assessing the profit?

Sometimes such an approach is used in valuations.  Some valuers prefer to allow for a manager’s salary before arriving at the profit upon which the value of the business is calculated.  In this case though, the valuer will use a lower capitalisation rate (or higher multiple) on the profit left over after allowance for the manager’s salary.  The end result may be similar though, if a lower multiple of profit is applied before allowing for the manager’s salary.  Because opinions vary as to the amount that should be allocated to the owner/manager’s salary, we prefer to use the more consistent approach of applying a multiple of profit before return to owner/management.

Also, taking a set manager’s wage (or owner’s salary) out can produce different results depending on the size of the business involved.  For example if two motel businesses were selling at 20% return on EBIDT, one for $1,000,000 with a $200,000 bottom line and the other for $300,000 with a $60,000 bottom line, the effect would be quite different.  A $50,000 return to the manager from the first example, leaves $150,000 profit or 15% return on purchase price.  In the second example though, there is only $10,000 left after removing the owner’s return, suggesting that the business is worth little if anything.  In the case of the smaller lease, it can be argued that one is only buying a job and to some extent this is true, however it is also a job that can be sold again in the future.  Another thing to keep in mind is that a business at this lower level can be bought to satisfy the purchaser’s requirements for independence, lifestyle and the benefits of “free living”.

Why has the market settled at this level of return for motel leases?

As mentioned at the outset, this document does not intend to comment on specific comparisons for motel returns relative to other small businesses, some of which may show better returns.  So why are motels different?

One reason may be the relative stability of the motel industry in normal times, compared with potential volatility of some other small businesses.  Take for example buying a sports shop in a provincial town, this may show a better return on capital and return to management than a motel lease.  It may also involve say 60 hours a week and not the 24/7 commitment a motel requires.  In this hypothetical example, should Rebel Sports decide to set up a major outlet nearby selling say Nike Shoes for less than the small business owner can buy them, the writing is on the wall.  What was a good return on investment may no longer be so and possibly the business could be in jeopardy.  Simply put, the bigger player can have huge advantages over the smaller operator.

How does this differ with the motel and accommodation industry in general?  A large hotel company, intending to develop, will usually still have to pay market value to buy land.  The same applies for building costs and the cost of fixtures and fittings.  At today’s prices for land and at current building costs, developers of new accommodation, large or small, find that the financial viability is questionable at the present tariff structure for accommodation in New Zealand.  Also larger accommodation operations do not necessarily enjoy the benefits of economies of scale as in the case of some other industries.  Hotels and Motor Inns generally have a far higher fixed overhead structure, particularly in regard to wages.  Larger operations also usually require food and beverage facilities to be available and these often run at a loss, which adds to the cost of operation.  In other words, a new hotel or motel opening in today’s market is unlikely to be able to compete on tariffs if it is to remain viable.  When tariffs are able to rise, new complexes tend to set a higher benchmark for the whole industry.  This enables older complexes to find more defined market segments in which to operate.  In other words, with the new properties being more expensive, the older ones can compete quite comfortably by offering their standard of accommodation in a different price bracket.

Another factor for the motel operator is the benefit of free living.  The running costs of a motel include rent, rates, power, insurance, broadband etc. for the owner.  A motelier is able to claim the GST back on these dwelling related costs as well.  Accountants use different methods of dealing with this for tax purposes, but the sums declared as a taxable benefit are usually less than the real value of the perk.

Why would I sell a freehold property and buy a lease?

The question is whether available funds are best invested in real estate or into a business.  Real estate values can rise and fall but are generally seen as a fairly safe bet over a reasonable length of time.  Motel business values (leases) can also have their ups and downs, however in the past the values have always remained relative to profit.  If the owner of a freehold going concern motel (meaning the land and buildings as well as the business and chattels) were to sell the business off by way of lease, a substantial portion of the total value of the motel would be sold.  The purchaser is buying a business, not just buying a lease.  The lease is of course a very important document and has a bearing on the viability of the whole thing, but it is primarily the instrument which separates the real estate from the business.

Business values (lease values) over the years have largely remained relative to real estate values.  As they say, “past performance does not guarantee future performance”, however lease values have increased more or less in line with property values over the last 35 years.  This is because the profitability of the businesses have mostly grown along with inflation and other factors affecting tariffs and profits.

There is an important issue with leases though, and that is their value can be reduced by the years running down.  As mentioned, the lease is really what separates the business from the real estate, but a lease by its nature must have a finite term.  Like many industries, this one does not always behave logically or scientifically and is influenced by the market’s perception as to what is a long enough lease term.  These days new leases can be 30 or 35 years (sometimes longer).  The length of lease can become an issue once it drops under 20 years.  The time remaining on the lease does not affect the day to day profit of the business, and a lease with say 15 years remaining clearly still has a considerable length of time to run.  If the lease were not extended though, its value may start to decrease as the lease runs further down.  If it were to run out completely, the land and building owner would usually be in a position to buy back the chattels and then would own the business as well.  This very seldom happens though, unless the motel is in a location where the value of the land increases to the point where the motel is no longer the best use of that land.  

If the landlord took the view that it was best to allow the lease to run right down, then its value would continue to decline. This may not really be in the landlord’s best interests though, for a number of reasons.  The more the lease is worth the better protection the landlord has that the lessee will continue to pay the rent and look after the premises.  As long as the lease has a reasonably good value, it will always be in the lessee’s (motel operator’s) best interests if they find themselves in financial difficulty, to sell the lease to another party.  If the lease had little or no value, it may be tempting to walk away, and the landlord would have no tenant and may not be able to find another prepared to pay the same level of rent. (The lessee usually cannot unilaterally terminate the lease and its obligations, however that is another topic.)  If the lease has a low value, the lessee does not have so much to lose nor the landlord so much to gain, by picking up the goodwill of the business by terminating the lease.  It makes more sense for the landlord to negotiate a payment to extend the lease before it gets too short.  This way the landlord has already received the benefit of the years declining (in other words has been able to charge to extend the lease) and has protected the business value.

The lease will have maintenance provisions which must be fulfilled, however there can be some difference of opinion as to what is the minimum requirement.  A lessee who had a short lease with not much prospect of a good capital sale value would surely have a different attitude towards maintenance.  If the lessee can see the benefit of spending money on the property, by way of improving the profit and as a result the business value, then surely this must benefit the landlord as well.  If the lease years and the business were running down, it is also possible that the landlord’s ability to increase rent would be reduced in the later years of the lease.  This is important to the landlord because the rental income has a direct bearing on the capital value of the property.

For these reasons as well as others, we normally see lease extensions negotiated.  The cost of buying more years needs to be taken into account if looking at a motel business where the length of lease is a concern.

Motel leasing has been around since the early 1980’s.  From the mid to late 80’s there was a noticeable trend in motel leasing as a way of separating the real estate from the business.  With quite significant growth in property values during the last decade, record low interest rates and a strong demand for commercial investments, the capitalisation rates (rate of return) for land and buildings has dropped significantly.  About 65 to 70% of the value of freehold going concern motel is in the land and buildings and these provide a lower return than the business does.  So, to buy a motel freehold going concern with most of the money invested in the real estate, the return on investment for an owner operator running a 24/7 operation is quite low as a business return.  Separating the two components (see Financial Returns article) so that a business person can obtain a higher rate of return by working the business, while providing the land and building owner with a return appropriate for commercial property investment, seems to work well.

Questions, comments, or criticisms of these notes would be most welcome. 

Kelvyn Coffey
Principal
© 2021

 

 

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