What Attracts Investors to Motel Land and Buildings?
Investors who already hold commercial property will generally understand its advantages over residential property. There are, of course, disadvantages. Entry prices are usually higher, and banks typically require greater equity, which can limit leverage. Some commercial property types also carry more risk than residential investments, although the nature of that risk varies considerably.
For investors considering commercial property for the first time, a key distinction is that commercial landlords commonly receive a “net” rental. This means the lessee is responsible for many outgoings, including rates, building insurance, and non-structural repairs and maintenance. Under a typical motel lease, the landlord is usually responsible only for weather-tightness and structural integrity. Weather-tightness is seldom an issue in a well-constructed modern building, and structural concerns can usually be assessed as part of due diligence. Purchasers should nevertheless confirm both weather-tightness and seismic rating. Seismic strength is generally expressed as a percentage of New Building Standard, or NBS. A building rated above 33% NBS is not considered earthquake-prone, while a rating above 66% is generally viewed as a stronger and more desirable position.
Most leased commercial properties operate on longer lease terms than residential properties, reducing the landlord’s exposure to frequent tenant turnover and day-to-day maintenance issues. Motel leases are unusually long by comparison, often up to 35 years, and sometimes longer. This benefits the landlord, but it is also essential for the lessee. Most moteliers operate by leasing the land and buildings while owning the business, plant, and chattels. When motel businesses are bought and sold, as they commonly are several times over the life of a lease, incoming operators require secure tenure. As leases shorten, lessees often seek extensions to preserve business value and saleability. In some cases, lease extensions may also involve a payment to the landlord, providing an additional return over and above rental income.
In many commercial property sectors, the lease itself has little or no separate monetary value. A premium may occasionally be paid for a particularly strong retail, hospitality, or office location, sometimes referred to as site goodwill or key money. More commonly however, a business can be relocated from one premises to another. Motels are different. The business is tied to the property from which it operates, so a long-term lease can carry substantial market value. Operators often pay significant sums to acquire a motel business, and that capital is at risk if the lease falls into default. Lessees may also invest heavily in refurbishments, décor, fixtures, and fittings. Unlike many other commercial fit-outs, these improvements are often directly relevant to the motel property and may retain value for the landlord. In practical terms, the lessee’s investment can operate much like a substantial bond.
What Are The Risks?
All investments carry risk, and a sensible assessment should consider not only the likelihood of something going wrong, but also the options available if it does. In that respect, motel land and building investments can offer a different risk profile from many other commercial properties.
Many investors are initially drawn to residential property because, under normal market conditions, a dwelling can usually be rented if the price is adjusted appropriately. By contrast, a retail, commercial, or industrial property can remain vacant if a tenant elects not to renew or if the tenant’s business fails. Re-letting may take time and may require capital expenditure to adapt the premises for a new occupier. During that period, the landlord receives no rental income and also will become responsible for rates, insurance, and other outgoings. Motel property is different because the business remains connected to the real estate. If a landlord takes possession, it may be possible to appoint a manager and continue generating income. Given the lessee’s investment in the business and lease, however, one of two outcomes may occur before that point:
If neither outcome occurs and the landlord takes possession of the motel, several options may still be available. While a motel business failure is never desirable, the landlord may have more alternatives than with many other commercial assets. The lessee may have paid several hundred thousand dollars for the business, while the landlord may have the opportunity to purchase the chattels at their in-situ value, typically a much smaller figure. Rental arrears may also be deductible from the amount payable for those chattels, whether payment is made to the lessee or to a lender holding security over them. The landlord may then be able to on-sell the lease and recover some goodwill or appoint management to maintain cash flow while the business is rebuilt.
There is, however, an important offset to consider. If the business must be re-leased at a lower rental, the land and building value may fall significantly when the reduction is capitalised. That loss could exceed any goodwill recovered from the sale of a new lease. This represents a potential worst-case scenario, although there can be practical ways to manage the impact.
In the relatively rare cases we have seen where a lessee’s business has failed and the landlord has taken possession, a new lessee has sometimes been prepared to pay goodwill for the business in addition to chattel value, provided a stepped or tiered rental structure is adopted. This can allow the landlord to preserve the “passing” rental at the level that applied before termination, while offering the incoming lessee a rental discount for the first two or three years. The discount gives the new operator time to rebuild the business before moving to the previous market rental, assuming that the earlier rental was sustainable by market comparison. Purchasers of motel investments should, of course, satisfy themselves that the current rental is sustainable under normal trading conditions. In these circumstances, the land and buildings may be valued or sold on the basis of the passing rental, with the temporary rental discount accounted for dollar for dollar, rather than capitalised as a permanent reduction in the property value.
The Current Market
We have consistently found a ready market for motel investment properties. In our view, this reflects many of the factors outlined above and is supported by the long-term approach commonly taken by motel investors. Unlike motel business owners, who may buy and sell on a more regular cycle, motel land and building investors often hold their properties for extended periods. When we hear from these investors again, it is often because they are considering another motel investment or seeking advice in relation to a rent review.
We hope this overview is useful for those considering motels or accommodation property as an investment. Questions and comments are always welcome.
