Coffeys - Tourism Property Brokers ltd. | LREA

30 years in business. 1984 - 2014

Valuation of Accommodation Businesses

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

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 banks to purchase leases is generally not too difficult.  For the right proposals lenders may advance up to 40 to 50% of the purchase price or valuation, sometimes a little more.

How do we appraise accommodation businesses?

It is beyond the scope of this article 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 calculating the earnings before interest, depreciation, drawings and taxation, sometimes referred to as E.B.I.D.T.  The profit is then multiplied by a factor consistent with market evidence.  This factor is referred to as the capitalisation rate or the profit multiple.  The rate or multiple used varies depending on a number of matters, not least the location within New Zealand.  (See separate article at www.coffeys.co.nz/News-Articles/What-You-Get-Is-Where-You-Buy/)  Supply and demand in certain regions and their popularity or otherwise will affect the rate of return applied.  Generally the rates range between 20 to 25% return, or 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 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 assessing the actual profit of the business.

The chattels in a motel could be compared to the engine in a car, insofar as they are required for the business to function.  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, (as opposed to depreciated or actual value), has more relevance to the tax implications for both buyer and seller.  There is one qualifier for this though.  When calculating profitability, it is important that there has been and will be adequate allowance for ongoing repairs, maintenance and replacement of plant as necessary.  (How much will depend on the age of the property.) 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 lease, 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 chattel value at the lower end, if possible at book value, so as not to recover depreciation on the chattels.  Any figure recorded as the chattel value which is over and above the book value (up to the original cost value) would be depreciation recovered and this would be taxable to the vendor.  The total business value should not be 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 remove owner’s remuneration before assessing the profit?

Some valuers prefer to allow for a manager’s salary before arriving at the profit on which the business value is calculated.  In this case though, they will usually use a lower rate of return (or higher multiple) on the profit.  The valuation result may be similar. Opinions will vary as to the allowance for the owner’s or manager’s salary, so it is usually preferable to use the more consistent approach of applying a multiple of profit before return to management.  

Also, reducing profit by deduction for return to management can produce different results depending on the size of the business.  For example if two motel businesses were selling at 25% return on EBIDT, one for $800,000 with a $200,000 bottom line and the other for $240,000 with a $60,000 profit, the result would be as follows.  A $50,000 return to the manager from the first example, leaves $150,000 profit being 18.75% return on purchase price.  In the second example, this leaves only $10,000 after removing the owner’s return, suggesting that the business is worth little if anything.  In the case of the low-priced  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.  Also, a business at this price level can be bought to satisfy the purchaser’s requirements for independence, lifestyle and the benefits of “free living”.

 

ACCOMMODATION BUSINESS LEASES, STRUCTURES AND VALUES.

It is not intended to comment on specific comparisons for accommodation returns relative to other small businesses, some of which may show better yields.   So why are these different?  One reason may be the relative stability of the accommodation industry. Take for example a retail sports shop in a provincial town, this may show a better return on capital and return to management than an accommodation lease.  It may also involve  60 hours a week and not the 24/7 commitment.  In this hypothetical example, should say Rebel Sport decide to set up a major outlet nearby, selling Nike Shoes for less than the small retailer 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 accommodation industry in general? 

A large hotel company, intending to develop, will have to buy land at market value.  The same applies for the costs of buildings, fixtures and fittings.  (At current land prices and building costs, the financial viability is questionable at present room rates.)  Larger accommodation providers do not necessarily enjoy the benefits of economies of scale as do some industries. Hotels and Motor Inns generally have a higher overhead structure, particularly as it relates to wages.  These operations also usually require food and beverage facilities, and these often run at a loss, which adds to the cost of operation.  A new hotel or motel opening in today’s market is unlikely to be able to compete on current tariffs if it is to remain viable. When room rates are rising, new properties tend to set a higher benchmark for the whole industry.  This enables existing properties to find their market segments in which to operate. With the new properties being even more expensive, the older ones can compete quite comfortably by offering their standard of accommodation in a different price bracket. 

Another factor for the smaller operator is the benefit of free living.  The running costs of a motel include rent, rates, power, insurance, telephone 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 no where near the real value of the perk.  

Why sell property and buy a lease?

Is capital best invested into real estate or into a business?  Real estate values can fluctuate, but are generally a fairly safe bet over time. Accommodation 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 property (meaning the land & buildings as well as the business and chattels) were to sell off the business by way of lease, a substantial portion of the total value of the property 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 vehicle which separates the real estate from the business.  

Business values (lease values) over time have mainly stayed 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 30 years.  This is because the profitability has mostly grown along with inflation and other factors affecting tariffs and profits.

Leases values can reduce as the years run down, and a lease by its nature must have a limited term.  As new leases have got longer the market’s perception as to what is long enough has changed.  New leases are now often 35 years (sometimes longer).  The length of lease can become an issue once it gets to 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 on it obviously still has a considerable length of time to run.  If not extended though, its value may start to decrease as the lease term diminishes.  If it were to run to its end, the landlord may be able to buy back the chattels and would then own the business as well.  This very seldom happens however, unless the property is in a location where the value of the land increases to the point where the existing buildings are no longer the best use of that land.  If the landlord thought it best to allow the lease to run right down, then the value would continue to decline.  This may not really be in the landlord’s best interests, for a number of reasons.

Longer lease also better for the landlord.

The higher the lease (business) value, the better protection the landlord has that the lessee will pay the rent and maintain the premises.  With a valuable business, it would be in the lessee’s best interests if they find themselves in financial difficulty, to sell to another party.  If the lease had little or no value, it seems more likely that the lessee may default and the landlord may not be able to find another operator prepared to pay the same level of rent.  If the business 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 re-entry.  The landlord may negotiate a payment to extend the lease.  This way the landlord has already received the benefit of the lease years declining and has also increased the value of the business.  

The minimum lease maintenance provisions must be observed, however there is often some interpretation around this.  A short lease with less prospect of a good capital sale value provides less incentive towards maintenance.  If the lessee can see the benefit of investing to improve the profit and the business value, then surely this must also benefit the landlord.  If the lease years and the business were running down, it is also possible that the owner’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 being available.  The cost of buying more years, if necessary, needs to be taken into account when considering an accommodation business.

Motel leasing has been around since the early 1980’s. The capital intensive investment in the land and buildings provides a fair rate of return for a commercial investor, while providing the business owner with a higher rate of return for their hands on involvement.

Kelvyn Coffey
Principal
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