UK: Hotel Leases At Variable Rents

The "Leases vs Management Contracts" debate is a perennial feature for panellist sessions at conferences for the hotels' sector. For some, for tax or regulatory reasons, there really isn't any choice – usually this means it has to be a lease. If in the current market, there is a heightened yield differentiation between managed and leased hotels, perhaps (at least in the short term) Owners will favour leases, bucking recent trends towards management contracts. In the UK, the usual expectation is that a lease between commercial parties will be on "FRI" terms (an Anglo-Saxon concept). This model does not necessarily work for hotels.

It seems to me there are two reasons why this is so: first, the operational side of the hotel business is integral to the real estate, its value and the income derived from it (so, whatever the rent structure a hotel lease will need specific provisions to deal with operational requirements and the handing-back of the hotel when the lease comes to an end); second, rent profiles for hotel leases are quite different. It is this second distinguishing factor that I am going to focus on.

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The "Leases vs Management Contracts" debate is a perennial feature for panellist sessions at conferences for the hotels' sector. For some, for tax or regulatory reasons, there really isn't any choice – usually this means it has to be a lease. If in the current market, there is a heightened yield differentiation between managed and leased hotels, perhaps (at least in the short term) Owners will favour leases, bucking recent trends towards management contracts. In the UK, the usual expectation is that a lease between commercial parties will be on "FRI" terms (an Anglo-Saxon concept). This model does not necessarily work for hotels. It seems to me there are two reasons why this is so: first, the operational side of the hotel business is integral to the real estate, its value and the income derived from it (so, whatever the rent structure a hotel lease will need specific provisions to deal with operational requirements and the handing-back of the hotel when the lease comes to an end); second, rent profiles for hotel leases are quite different. It is this second distinguishing factor that I am going to focus on.

The "FRI" model of lease works well for fixed-rent leases of generic assets where the commercial objective is to preserve clean income streams in the immediate (i.e. from the current tenant) and long (i.e. on re-lettings) terms. Few hotel leases have just a fixed rent. Most hotel leases will have variable rents with no, or limited, or capped fixed-rent elements. Primarily, this is operator driven and for a number of reasons: the impact of fixed rents on balance sheets; operator reluctance to guarantee continuing sector performance (particularly so for more significant assets); and (perhaps more so in the past than now), operators have some hold over the supply chain. Also (often, in instances where the Owner cannot directly own the business), rent arrangements particular to this sector have been devised to try to replicate the commercial position under management contracts.

Leases to branded hotel operators predominantly will have a variable rent based on EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization - although to be technically precise the measure should be EBITDAR or EBITDARM when rental commitments and/or management fees are added-back). Some operators, however, prefer turnover-based rents. Obviously both EBITDA and turnover are dependent on the operator's performance to generate business revenues. A well-drafted variable rent lease should contain appropriate tenant's covenants relating to operational requirements, coupled with appropriate benchmarking criteria with the goal of driving revenues. There should be mechanisms for monitoring performance, and a framework for transparency of revenues and, where the rent is EBITDA-based, operating costs. All the provisions throughout the lease need to take due account of the relevant accounting measure used to calculate the rent. EBITDA, obviously, is more sophisticated than turnover (because of what is to be deducted). So, control of operating costs, will be an issue in an EBITDA rent lease. Conversely, for turnover-rent leases the focus is on revenue rather than profit: so, here, there will be a greater sensitivity on issues such as outsourcing of food and beverage, for example, through subletting of restaurant areas.

All in all, hotel leases are quite different from what is the "norm" for more vanilla "FRI"-type lettings. This is all the more so where there are variable rents. Great care needs to be taken to ensure that the lease has measures to enable the landlord to push the tenant to optimise the rent. Some people call these sort of lease arrangements "management leases" or, "operating leases".

Here are just some pointers to (but nothing like all of) the sort of provisions you might find in a "management lease":-

Operational Requirements

The measure for operating standards commonly is referred to as "Hotel Standards". Often these are defined by reference to comparable hotels of an equivalent category and geographic location. These standards set the measure throughout the lease: so for example, in terms of provision of services or FF&E provision/replacement. For more substantial hotels, specific individual comparables may be identified as the relevant "Competitor Set" used not just for defining "Hotel Standards" but also to benchmark EBITDA or turnover.

Brand

For branded hotels, obviously the brand and brand continuation is an important control. Down-branding will be more sensitive in turnover based leases: it may even result in a higher rent where the rent is EBITDA based.

Operator default

There are inherent difficulties bringing an action against a tenant where there is an EBITDA rent. Some leases provide for rent gross-ups or for a fixed default rent to kick-in for any sustained period for which there is tenant default (i.e. upping the rents to what had been achieved in the immediate period prior to the relevant event of default). Similar arrangements may apply in instances of outsourcing, or hotel closure.

EBITDA/turnover

Care needs to be taken as to how EBITDA/turnover is defined and calculated. It would be wrong to assume that industry standard definitions (for example, as used under the Uniform System) can simply be transplanted into the lease. For example, in calculating EBITDA under the lease, the parties need to consider how to treat FF&E reserves or costs shared with the landlord (e.g. CapEx). In calculating revenues, do you catch all remote bookings? Is there appropriate treatment for corporate and/or staff discounts offered by the operator?

This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq

Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.

The original publication date for this article was 15/06/2009.