What Is The Attraction Of Motel Investment?
Readers who already have commercial property investments will understand the advantages over residential. Clearly there are some disadvantages, such as generally a higher priced entry level and, the ability to borrow for more leverage is curtailed by the banks requiring greater equity levels. Certain types of commercial property can carry more risk than residential, but more on risk later.
For those contemplating a commercial investment for the first time, we point out that the commercial landlord usually receives what is known as a “net” rental. This means that the lessee (tenant) is responsible for all outgoings, including rates, building insurance and repairs and maintenance. In a motel lease, the landlord is usually responsible only for weather-tightness and structural integrity. Weather-tightness is seldom an issue in a properly constructed modern building. Structural issues are less likely to be a problem, however one would certainly wish to verify this when purchasing an investment property. It would also pay to establish the building’s seismic rating. This rating is generally expressed in terms of a percentage of New Building Standard or NBS. A building with a rating of more than 33% NBS is deemed not to be earthquake prone, however the most desirable result is above 66% which we understand is the equivalent of 100% of the old building standards.
Almost all leased commercial properties operate on reasonably long-term leases (compared to residential), meaning that the landlord does not have to be concerned with finding new tenants as parties come and go, or worry about minor maintenance issues etc. In the case of motels, leases are for an exceptionally long period, up to 35 years (or sometimes more). This sounds good from a landlord’s point of view, however it is also desired by the lessee. The majority of moteliers these days operate by way of leasing, meaning that they own their business (including plant and chattels) but not the real estate from which it operates. When the businesses are bought and sold (as they usually will do a number of times during the term of the lease), it is considered important that there is a long term lease in place in order to give secure tenure to the incoming operator. So, apart from the landlord starting with the benefit of a very long-term lease, as the leases get shorter, the lessees generally look to extend them for sale purposes. This can also involve a payment to the landlord, which is a bonus over and above the rate of return provided by the rent.
In most commercial properties, the lease itself usually has no monetary value. Occasionally there may be a premium paid to secure the lease for a very good retail/hospitality site or office development, this is sometimes referred to as site goodwill or key money. Often though, the business is moveable and can be taken from one commercial location to another. Because the business of a motel is inseparable from its building, the long-term lease usually has a substantial market value. Motel operators pay significant sums to purchase their business and this capital is what they stand to lose should they find themselves in breach of the lease. Additionally, it is not uncommon to see the lessee making significant improvements to the property, in terms of refurbishment of décor, fixtures and fittings. While other commercial tenants may often try to enhance the value of their business similarly, it is frequently the case that their fixtures and fittings are of little or no value to the landlord should they move on. This is not the situation of course with a motel. With hundreds of thousands of dollars at stake, one could consider this a very substantial bond.
What Are The Risks?
There is always potential risk with any type of investment, so it would seem logical to suggest that the property type that offers the least amount of risk would be desirable. One way of measuring risk is by considering what options are available should things go wrong.
Investors starting out, often prefer the security of residential property because they know that a dwelling can always be let at a price, reduced if necessary, under normal circumstances. A retail outlet in a shopping strip or a commercial or industrial building on the other hand, could become empty either because the lessee has elected not to renew their lease or has gone out of business. Sometimes these properties can sit vacant for a considerable time and may even require capital expenditure by the landlord to adapt the building for a new tenant. An empty commercial building such as this would not generate any cash flow. The motel business remains inseparable from the real estate and a landlord in possession could employ a manager and continue to derive income from the business. Given that the lessee has invested so much in the business/lease though, in the event of difficulties one of two things may happen first:
In the event that neither of these scenarios play out and the landlord ends up in possession of the motel, there are a number of options. As undesirable as it is to see a motel business fail in this way, the commercial reality is that landlord may have more alternatives. The lessee will often have paid several hundred thousand dollars for the business and the landlord would usually have the option to purchase the chattels at in-situ value, which would be a small percentage of that amount. As an additional buffer for the landlord, any rental arrears could probably be deducted from the sum payable for the chattels. This sum would be payable either to the lessee or the lender who had a charge over such chattels. The landlord could be able to on-sell the lease and recoup some goodwill from that sale or as previously mentioned, put management in place to keep the cash flow coming in and look to build the business up again.
As an offset, one must consider that if the business were to be re-leased at a lower rental, then by capitalisation of the reduction in rental, the land and building value could be reduced by a reasonably significant sum. This sum may well be in excess of any gain picked up by the landlord from the sale of the “goodwill” on the new lease. This is probably a worst-case scenario. There is however a potential solution to this as well.
We have been involved in some of the rare cases where the lessee’s business has failed, and the landlord has taken possession of the business. A new lessee has been found who was prepared to pay a certain sum of goodwill for the business (over and above the chattel value) on the basis that a stepped or tiered rental structure was implemented. The landlord was able to set the “passing” rental at the level of rent prior to the termination of the lease. This was done by providing an incentive to the incoming lessee, such that the rent would be discounted for the first two or three years enabling the new operator time to rebuild the business before having to pay rental at the previous market level. This assumes that the previous market level was reasonable by market comparisons and would be sustainable under normal circumstances. (When buying a motel investment, one should of course ascertain that the current rental is sustainable under normal circumstances.) The buildings were then able to be valued and/or sold on the basis of the passing rental, with the discounted rental sum in the interim being accounted for on a dollar for dollar basis. In other words, the reduction in rental in the first two or three years detracts from the land and building value on a dollar for dollar basis, not on a capitalised multiple of that discounted rental.
The Current Market
We have always found a ready market for motel investment properties. We believe that this may be for the reasons outlined above and is evidenced by most investors taking a long-term position with their properties. We would not be able to sustain a business from repeat clients in this regard as motel investors do not usually come back to us to sell on a cyclical basis, as the business owners do. (In fact, when we hear from them again it is often to look to buy another motel investment property, or perhaps to seek advice at rent review time.)
We trust that this information is helpful to anyone contemplating motels or accommodation property as an investment. Any questions or comments would be most welcome.
