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Valuing the ‘family silver'

30 March 2006
Valuing the ‘family silver'

Warnings about the short-term gain and long-term perils facing hotel groups that pursue sale-and-leaseback deals have been gathering momentum recently. It was a hot topic for owners and operators at the International Hotel Investment Forum in Berlin earlier this month.

But it's hardly a new issue, and industry observers have been voicing concerns about hotel groups "selling off the family silver" ever since investors started to get an appetite for the sector.

It began when the City put pressure on hotel companies to deliver higher returns on their investment. Selling their property allowed them to raise finance for reinvestment - usually expansion - and to return capital to shareholders.

"It's difficult to criticise them for selling assets," says hotel industry consultant Melvin Gold. "There were good prices on offer. Whether it's strategically the best alternative in the long term, only time will tell."

Heavyweights
In the UK, as the market grows more sophisticated, hotels and investors have moved towards the sale-and-manage-back model - with Marriott, InterContinental Hotels Group (IHG) and Hilton International among the heavyweights leading the way.

From the hotel operator's point of view, manage-back deals are the most attractive option for raising capital, because they don't pay rent. But there are still risks, explains Clive Hillier, managing director of Vision Hospitality Asset Management.

"Management agreements give the operator a weaker legal position. If an owner were to terminate the contract, the operator could only sue for breach of contract, whereas, under a lease, an operator would have a legal interest in the property and only a court could evict the operator," he says.

They can also be seen as risky by investors, who might demand clauses requiring management companies to provide guarantees on profitability. Dan Griffiths, director at property agent Christie & Co, points out that manage-back deals also mean hotels "have no share in enhanced capital value if the property market improves".

But there are clear upsides. Hillier and Griffiths say fees from a management contract are less volatile than earnings from a leased property. Last year's terrorist attacks in London had a negative effect on hotels, but operators with management deals were less exposed because they were not tied into long leases.

Robert Seabrook, executive vice-president, Jones Lang LaSalle Hotels, says sale-and-manage-back is a win-win situation at the moment, but adds: "Long-term, if the investment companies are paying high prices, will they take into account the refurbishment of the hotels? And if trading performance falls away, then it looks like a poor investment."

Brands are, therefore, key, and companies that sell off their assets will need to strengthen their name in order to grow. While a strong brand is clearly an advantage for the investor, it might also be good news for the consumer. Note that the big hotel companies have brought in management expertise from consumer-led industries. Ian Carter from Black & Decker took the helm at Hilton International; Steven Heyer from Coca-Cola moved into the chief executive's chair at Starwood, and Andrew Cosslett took over the top job at IHG from Cadbury Schweppes.

Gold says: "They realised they had to focus on their brands, as they were no longer asset companies. They have got to prove their brand performs better than rivals. Arguably, it always has, but it hasn't always been as obvious when hiding behind property."

Strong brand
Adrian Bradley, vice-president real estate at Hilton International, believes that a strong brand will help when the asset is sold on. "We have 30-year management contracts," he says. "Our view is that we are one of the best-known brands in the world - there is no reason why we would lose contracts."

While hotels clearly need long-term investment in the property, the current wave of investors tend to be venture capital or private equity companies that want to crystallise their investments within three to seven years. The worry is that some owners might invest less as they prepare to sell on.

Looking ahead, many believe the next wave of investors could include pension funds and insurance companies, which tend to take a longer-term interest.

"Hotels are becoming more mainstream," says Seabrook. "There is more transparency, and operators have become more friendly. Investors are being forced to look at other forms of real estate, such as hotels. This all paves the way for longer-term investors."

So what's the best way forward? On the whole, it's down to the terms of the individual contract. "It has to be assessed on a deal-by-deal basis, and it has to work for both sides," says Jonathan Langston, managing director of TRI Hospitality Consulting. "It must be open and transparent so both parties understand the risk and recognise they must work together."

While the jury is still out on the longer-term merits of sale-and-manage-back in Europe, experiences in other parts of the world show a rising trend towards separating bricks and brains.

The franchise model is well established at IHG, and 75% of its worldwide rooms operate under this system. It has promised to return £2.75b to shareholders and has a market value of just under £4b. It also has 884 hotels in the development pipeline, representing an investment of £5.8b - of other people's money. Clearly, it couldn't afford to do this if its cash was still tied up in property.

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