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Lease Values & Extensions

Why would I sell a Freehold Property and buy a Lease?

One must decide whether funds are best invested into real estate or into a business. Real estate values are subject to fluctuations, but are generally seen as a fairly safe bet. Motel business values are of course also subject to fluctuations, however in our experience have always remained relative to the profitability of the business.

If the owner of a freehold going concern motel (meaning land, buildings and business), was to sell the business off by way of lease, a substantial portion of the owner’s equity would be sold with that. The purchaser is buying a business, not really buying a lease. The lease is of course a very important document and has a bearing on the viability and security of the whole operation, but it is primarily the vehicle which separates the real estate from the business.

Business values (lease values) have over the years maintained relativity to the 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 30 plus years. This happens when the profitability of the businesses grow along with inflation and other factors affecting tariffs and profits.

There is one thorny issue in this equation though, and that is the value of the lease as it is affected by the years running down. As mentioned, the lease is really the vehicle which separates the business from the real estate, but the lease by nature, must have a finite term.

As with many markets, this one does not always work logically or scientifically and is subject to the market’s perception as to what constitutes a good lease term. These days, new leases can be for 30 or 35 years (sometimes longer), and generally people start to consider the term an issue once the lease gets under 20 years. The length of the lease does not directly affect the business profit and a lease with say 15 years on it still has a considerable length of time to run. If it were not to be extended though, its value would start to be affected as people would see that ultimately the outcome after 15 more years would be that the lease would run out. The land and building owner would probably be in a position to buy the chattels back and the business would revert back to them.

This very seldom happens though, unless the motel occupies a prime site upon which the motel no longer represents the highest and best use of the land. If the landlord under normal circumstances, took the view that it was best to allow the lease to run right down, then the value of the lease would continue to diminish. This may not really be in the landlord’s interests either, for a number of reasons:  

For these and other reasons, lease extensions are usually available. 

The cost of extending the term needs to be taken into account when assessing the value of a motel business where the lease years may be an issue. 

We are often asked if there is a formula for calculating the value of lease years. Because neither party can be compelled to negotiate lease extensions, unlike say rent reviews which must follow the procedures laid out in the lease, neither can be compelled to accept any formula.

There is an exception though. In 2012, the Motel Association of New Zealand (now part of Hospitality New Zealand), released an industry standard lease to be offered as a template when new leases are being drawn up. This template contains a right of extension clause whereby the lessee can, subject to certain conditions, have the right to extend the lease at a cost of no more than 5% of the current annual rental at the time of extension, per extra lease year. We would be pleased to see more of these types of leases prevalent in the industry.

Please enquire for more details about this lease.

Kelvyn Coffey
Principal
© Coffeys Tourism Property Brokers Ltd

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