These notes are based on the writer’s experience as a motel broker since 1984. The returns suggested here may be similar also for (some) holiday parks, motor inns and to some extent tourist hotels. In other categories, such as luxury lodges, boutique hotels and B & B operations, the rates of return can be quite different where the underlying real estate value could be higher than the business return alone may suggest. Freehold real estate is normally valued on the basis of “highest and best use” and where underlying real estate value exceeds the freehold business value, then the higher may apply.
When considering the purchase of a motel business, it could be helpful to gain an overview of the returns being offered by the current market. These notes are intended to outline the differences in return on investment for each situation. The content of this paper is limited to such comparisons, it does not address the broader subject of valuation or appraisal. There is no intention to imply that any method of purchase is better than another.
A freehold motel consists of two main separate components. One is the land and buildings, (the real estate), the other is the business. Basically, the business is comprised of the chattels and goodwill. (The goodwill is sometimes referred to as the benefit of the lease or the intangible asset.) Even if the complex is owned and operated as one entity, known as the freehold going concern, the distinction still applies. This is relevant because the returns from these two main components are quite different.
The land and buildings normally earn, by way of rental income, a return on capital of between 5% and 6% at this time. The business (lease), will usually achieve a return of around 20% to 25%. (There are many variables including location, see separate article What You Get Is Where You Buy.) This profit is based on earnings before interest, depreciation, tax, and drawings, sometimes referred to as EBIDT. Because up to around 80% of the total value may be in the land and buildings, which are showing the much lower return of the two components, the overall return for a freehold going concern could be under 9%. This is based on say a 5.5% return for the land and buildings and a 22.5% return for the business/lease component.
To illustrate
Current market values as determined by precedent would suggest a motel with a GST exclusive annual turnover of $400,000 would have a freehold going concern value of approximately $2,700,000, based on the expected profitability from the calculations below. (Of course, there are numerous variables to take into account, the scope of which is not covered by these notes.)
A motel business only, (by way of lease), with a GST exclusive annual turnover of $400,000, with “average” operating costs and appropriate rental, should sell for between $500,000 and $550,000, depending on locality and other factors.
So
Land & Buildings value say $2,180,000
Business value (assuming a good lease) say $ 535,000
Freehold Going Concern value therefore $2,715,000
Leasehold
For quite some years there was an old rule of thumb for motel leases, which suggested that the total turnover from the business could be divided by three. One third each being apportioned to running costs, rent and profit. These cost ratios are changing, due in no small measure to an ever-increasing percentage of revenue being paid to Online Travel Agents (OTA’s), which is another subject. The biggest single factor affecting running costs as a percentage of revenue, is the average room rate achieved by the motel - low rates mean smaller profit margins. Some of today’s upmarket motels are able to charge considerably higher tariffs, without significantly increasing their running costs. This results in higher profits and conversely lower costs as a percentage of revenue.
Our audited benchmarking survey, which at the time of writing this article has over 800 years of motel accounts from 2016 to 2021 in the program, shows that operating costs have increased and rents have decreased as a percentage of revenue over recent years. Running costs average around 40% and rents come in at just under 30%. Valuers, when preparing pro forma accounts, often suggest that rent should be no higher than profit, which is consistent with our findings.
For the sake of this example, we take the above ratios as being apportioned to running costs, rent and profit.
So, a turnover of $400,000 in this case, would go something like this:
| • Annual G.S.T. exclusive turnover | $400,000 |
| • Rent say 30% | $120,000 |
| • Running costs say 40% | $160,000 |
| • Profit, before interest, tax and return to management therefore | $120,000 |
This profit of $120,000, represents 20% of the value of the business at $600,000 or 25% at $480,000. Current interest rates are of course considerably lower than that, so any borrowed funds are more than self-servicing. From a cash flow perspective however, keep in mind that principal will usually need to be repaid over a period of 5 to 7 years.
Depending on a number of economic factors, funding can be available for motel leases for up to 50% of purchase price or valuation. In some cases higher loan ratios can be obtained, however this should not be relied on. If calculating your price range on the basis of your equity before borrowing, it pays to allow for up to $25,000 over and above the purchase price, to cover various apportionments and start-up costs. Rent apportionment can add to the funds required on settlement. Please ask your broker what to expect given the timing of your settlement.
Freehold
For a freehold going concern there would normally be no rent payable. The owner/operator in this example would effectively have $2,180,000 invested in the land and buildings. The benefits of this would include the saving in rent of $120,000 pa, being 5.5% return on that investment.
The overall return for the freehold going concern is not the average of both components. This is because the majority of the investment is in the land and buildings, which give the lower return of the two.
Thus
Turnover $400,000 less running costs of $160,000 = $240,000.
$240,000 represents 8.84% of the freehold going concern value of $2,715,000.
Lending institutions usually favour land and building security, however they will recognise the value of the business component (chattels and goodwill) in a freehold going concern. Working on a maximum of about 50% borrowing on total purchase price would be advisable when calculating purchasing power in these current times. In the case of freehold, repayment periods are generally much longer than for leases, so this helps with cash flow.
Other Pros and Cons
In a freehold going concern situation, the motelier has the advantage of accruing the benefit of the appreciation of the land and buildings. The owner’s outgoings or returns in this respect remain relative to interest rates and inflation.
It is not the intention to discuss here, by comparison with other options, the merits or otherwise of investment in this industry. There is a factor to bear in mind though, if making such comparisons. All returns suggested here don’t take account of the value of “free living”. Living on site is an integral part of a motel business. All dwelling related living costs (rates, power, internet, insurance etc.) are covered by the operating costs of the motel. There will be a variance of opinion in quantifying the value of this benefit. That is left up to individuals and their advisers to assess.
Summary
So the question may be, should I look at leasehold or freehold?
It may depend on whether the purchaser feels that they have enough equity to purchase a business, as well as the real estate from which it operates. Would the capital be best utilised at a higher return by putting it all into a business? Buying an investment property would normally imply that one has reserve capital to invest. If a good business is purchased and shows high cash returns, this may put one in the position to increase equity over time.
If sufficient capital is available at the time of purchase, then a freehold going concern could be a twofold investment. It also gives the operator the opportunity to sell the business in the future and retain the land and buildings as an investment.
