Coffeys - Tourism Property Brokers ltd. | LREA

30 years in business. 1984 - 2014

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 of the whole thing, 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 20 to 30 years. This is because the profitability of the businesses have mostly grown along with inflation and other factors affecting tariffs and profits.

There is one thorny issue in this equation, 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.

Like many markets, this one does not always behave 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 30 or 35 years (sometimes longer), and generally people start to consider the term an issue once the lease gets under 20 years. Clearly the length of the lease does not affect the day to day 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:

  • The value of the lease would continue to diminish. The value of the lease is, in a way, the landlord’s bond or insurance policy that the lessee will continue to pay the rent. If the lease retains a reasonable capital value, it will always be in the lessee’s best interests, should they get in to financial difficulty, to on-sell the lease to another party to recover what they can, as opposed to defaulting under the lease and allowing the landlord to re-enter. This keeps the lease intact and, more importantly from the landlord’s perspective, the level of rental which determines the capital value.

  • If the lease was quite short and had less value, the lessee would have not much to lose, nor the landlord much to gain by picking up the goodwill of the business through re-entry under default clauses in the lease. If the landlord had accepted payment earlier to extend the lease, then he would have already received the benefit of lease years declining, and locked in the value of the lessee’s interest.

  • The lease will have maintenance provisions which must be adhered to, however there is often some scope for interpretation. A lessee who has a short lease with no realistic prospect of a good capital sale value, would surely have a different attitude in interpreting the maintenance requirements. If a lessee can see the benefit of injecting capital into the business, then they are more likely to do so by way of property improvements and enhancements. The lessee’s reward would be to improve the profit and hence the business value, then this surely must also benefit the landlord as well.

  • If a lease were to run right down and the business was running down also, it could be argued that the landlord’s ability to increase the rent would be detrimentally affected during that period. Rental income of course equates to the landlord’s capital value.

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. The new MANZ endorsed draft motel lease (released 2013) provides an inbuilt mechanism for lease extensions to provide a greater degree of certainty. Please enquire for more details about this lease.

Kelvyn Coffey
© 2013

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