Valuation, Risk and Market Demand

In my last article I broached the subject of NRAS in the context of management rights.     

To my surprise (no, really) many of the parties who chose to provide feedback on the article simply failed to grasp the concept. The banks seem to have a wildly divergent view of the situation although discussions would suggest that some of the lenders’ policy makers need to have a cup of tea and a good lie down!

Like many new ideas I suspect that over time the NRAS model will find its place in the management rights landscape and in a year or two will hardly rate a mention.

You may recall in my last article that I mentioned the concept of certainty and value. Essentially the argument goes that the more certain a financial outcome, the more valuable the asset driving that outcome. This is a credo that I’ve long adhered to and it’s certainly the way in which valuers look at assets such as management rights. This month I’m going to take a stab at reviewing leasebacks in the context of value and certainty.

First a quick refresher. A leaseback arrangement is simply a business model whereby the resident manager leases a lot from an owner for an agreed time and under agreed terms. The resident manager is essentially backing himself to make more on the lease cost to rental income margin than could otherwise be made on standard letting commission and fees.

There can be numerous motives for a resident manager to offer a lot owner such an arrangement. Some of these motives are fundamentally flawed while others make good commercial sense. On the negative side offering a rental guarantee or leaseback in a holiday complex is, to me, fraught with danger. The lot owner might be motivated to enter into such an arrangement but it will only be because the rental returns are not meeting expectations. Offering a leaseback simply to keep a unit in a letting pool makes no sense to me at all.

In essence all the resident manager has achieved in this example is to shift the cash flow risk from the lot owner to himself. Given the cyclical nature of the holiday accommodation sector this strategy simply fails the certainty and value test. Similarly, for permanent complexes I believe that any leaseback arrangement is unlikely to drive higher net revenues than a standard letting appointment and again the cash flow risk is shifted to the resident manager.

So, we are left with the orphaned child of management rights and hotels, the strata titled, short stay serviced apartment. Also known as corporate short stay these management rights businesses have thrived in the past five years and show little sign of slowing down any time soon. Typically based in CBD and CBD fringe areas of capital cities and high population regional centres short stay serviced apartment based corporate buildings are the natural competitor to the more traditional hotel room.

In these buildings there is, in my view, a compelling argument for the leaseback model. When you are providing accommodation services to large national and multi-national companies certainty of supply and presentation is critical. It’s simply not good enough to have apartment availability and consistency of presentation impacted by the whims and budget of a multitude of individual owners. In this business model certainty is essential and a key driver of the business value. The solution is simple. Offer a reasonable permanent rental based leaseback income for the lot owner and take over responsibility for presentation, refurbishment and letting.

The model is not without its challenges. There remains an underlying monthly obligation to lot owners that the lease payments will be met regardless of the actual performance of the building. As such there is no doubt that letting risk has shifted from the lot owner to the operator. It’s all about the model. Given lack of supply and new product in the hotel sector what is the risk of serviced apartment demand falling substantially over the mid-term? To me the greater risk is not having control of the apartments in such a building and losing valuable corporate clients as a result.

The greater risk to operators is in situations where not all the apartments in such a building are on leasebacks. To me this creates a potential conflict of interest as there is a clear financial incentive for an operator to push bookings toward leaseback apartments. This dynamic needs to be carefully managed although in my view the better model is simply all leasebacks or none at all.

All this leads me headlong into the crux of this article. What to do with valuations when leasebacks are involved in a management rights sale? First, it’s essential to get the P and L for sale purpose right. By this I mean clearly showing the normalised and leaseback income streams as separate items within the profit and loss. The process is one of taking the P and L and arriving at essentially two profit and loss statements. One reflects a “what if” situation assuming the building is being run as a standard management rights with no leasebacks. The second P and L looks at the additional income derived as a result of the leaseback model.

Typically a valuer will place an industry standard multiple on the normalised profit and a discounted multiple on the leaseback profit. It’s the multiple on the leaseback profit that often causes some angst. Here’s the thing. If certainty = value and a short stay corporate management rights relies upon certainty of supply and consistency of product than I would argue that the leaseback model provides certainty. Yes, there remains a risk in respect of the rent needing to be paid to the lot owners every month but I would argue that this risk is mitigated by the ongoing demand for short stay serviced apartments. I would also argue that these types of businesses are not for the first timer and should only be taken on by experienced operators preferably with a background in hotel management and in particular real time tariff management.

I’m not a valuer so far be it from me to venture a thought on an appropriate multiple for leaseback profits. However, I think we could do worse than start by looking at yields on motel leases and some of established leaseback models such as the highly regarded Quest serviced apartment business.

On a final note a challenge for the valuers in our industry. Over time I’ve seen a number of management rights contracts reflecting agreed multiples on leaseback income that ended up being above the number attributed by the bank instructed valuer. In most cases the contracts have been renegotiated to reflect the valuation. At what point would the valuation profession take note of such a trend and determine that the valuation outcomes were driving the market rather than interpreting the market.

You can see why I’m not a valuer. Ask the hard questions but have no answer! I should have been a journalist.

Mike Phipps
Mike Phipps Finance

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