Coffeys - Tourism Property Brokers ltd. | LREA

30 years in business. 1984 - 2014

Financial Returns

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 may otherwise 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 for the first time, 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.  There is no intention to imply that any method of purchase is better than another.

A freehold motel really consists of two main separate components.  One is the land and buildings, (the real estate), the other is the business.  The business is comprised of basically 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 the two main components are quite different.

The land and buildings normally earn, by way of rental income, a return on capital of between 6% and 7% at this time.  The business (lease), will usually achieve a return of around 20% to 25%.  This profit is based on earnings before interest, depreciation, taxation and drawings for the operators, sometimes referred to in accounting terms as EBIDT.  (There are many variables including location, see separate article What You Get Is Where You Buy.)  Because around 65% to 70% of the total value usually lies in the land and buildings, which are showing the lower return of the two components, the overall return for a freehold going concern would often be between 10 and 11%.  This is based on a 7% return for the land and buildings component and a 20% to 25% 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 $360,000 a freehold going concern value of approximately $2,200,000.  (Of course there are numerous variables to take in to 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 $360,000, with “average” operating costs and appropriate rental, should sell for between $500,000 and $600,000, depending on locality and other factors.

So  

Land & Buildings value                                               say                  $1,710,000

Business value (assuming a good lease)                   say                  $   520,000

Freehold Going Concern value                                  therefore          $2,230,000     

Leasehold

“Rules of thumb” can be dangerous to use in isolation, so please do not take these notes as being definitive.  For the sake of this illustration however, we shall use such an approach.  There is an old rule of thumb for motel leases, which says that the total turnover from the business can be divided by three.  One third each being apportioned to running costs, rent and profit.  These cost ratios are changing with an ever-increasing percentage of revenue being paid to Online Travel Agents (OTA’s), however that 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 and higher costs.  Some of today’s upmarket motels are able to charge considerably higher tariffs, whilst keeping their costs similar to lower market  properties.  This results in higher profits and conversely lower costs as a percentage of revenue.)

For the sake of this example, we take one third each being apportioned to running costs, rent and profit.

So a turnover of $360,000 in this case, would go something like this:

• Annual G.S.T. exclusive turnover $360,000
• Rent say $120,000
• Running costs say $120,000
• 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 in this case 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.

Funding is usually 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 or your equity before borrowing, it pays to allow for $15,000 to $25,000 over and above the purchase price, to cover various apportionments and start-up costs.  Depending on the time of year, up-front payment for prepaid advertising can add considerably to the funds required on settlement.  Please ask your broker what to expect given the time of year of your purchase.

Freehold

For a freehold going concern there would normally be no rent payable.  The owner/operator in this example would effectively have $1,700,000 invested in the land and buildings.  The benefits of this would include the saving in rent of $120,000 pa, being approx. 7% 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 $360,000 less running costs of $120,000 = $240,000

$240,000 represents 10.76% of the freehold going concern value of $2,230,000.

Lending institutions have always favoured 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 60% 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.

The owner of the business, by way of lease, must consider the prospect of increased rentals, in line with inflationary pressures and income trends.  This of course, would presuppose that market values are rising, in which case the value of the lessee’s business should be growing, along with the profits.

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 are not inclusive of the value of “free living”.  Living on site is an integral part of a motel business.  All dwelling related living costs (rates, power, phone, insurance etc.) and some others, 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 is very much a matter of 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 is twofold investment.  It also gives the operator the opportunity to sell the business and retain the land and buildings as an investment.

Kelvyn Coffey
Principal
© 2018

 

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