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Sale and leaseback in the hotel sector

  • 2006-01-25
  • By Kristine Kolosovska
New hotels have begun to spring up like mushrooms in the Baltics given the tourist boom over the past two years. In Riga, at the end of 2004 the total number of hotels was just 45, and the total number of rooms 8,600. But last year alone 14 new hotels opened their doors, increasing the total number of rooms in the capital to 10,000. And according to construction permits issued by authorities, 50 new hotels are to be commissioned in the next two years.

The new buildings cover nearly all segments of the market, from small guest houses to luxurious hotels. The broad choice will make regional hotels more diversified in terms of price, quality and location and increase competition in the hospitality market. The newcomers, of course, will have to deal with the specifics of Baltic tourism, which is notorious for its short season and tourists' brief stays. In an atmosphere of intense competition, hotel operators will be forced to focus on their core competency 's namely, concept development, cooperation with travel agencies and, inevitably, pan-Baltic growth.

From a strategic point of view, the nature of the hospitality business may be split into two distinct components 's e.g. hotel operation and ownership of the property beneath the hotel. But if a company's core business is hotel operations, does it need to own the building too? Does the hotel operator need to hold the property that may become a cumbersome non-performing asset? If the answer is "no," then the excellent strategic option that may be perused is to sell and rent back the real estate.

The key advantage of such a transaction is the possibility to free up cash tied up in the bricks and mortar. If a company needs to attract financing, "sale and leaseback" is considered to be the cheapest way to do so.

First of all, it is an opportunity to raise investment capital without the obligation to pay interest, and secondly, to get 100 percent of the fair value of the property, which is much higher than the company may receive from a bank by pledging the property as collateral.

Sale and leaseback transactions are similar to long term financial leases. The property is rented for 20 - 25 years, often with the option to buy it back at the end of the lease. In addition, the rent deductions are usually higher than amortisation deductions, which may help optimize a company's tax bill. These operational schemes are considered to be "strategic" all over the world. Industry giants like Hilton, Marriott and InterContinental (owner of Crowne Plaza and Holiday Inn brand names) have raised billions in sales and lease back transactions.

With real estate in the Baltics overpriced in a majority of sectors, including hotels, hotel operators may evaluate the possibility of outsourcing non-core assets now. Who might be the potential investors to finance such transactions? First of all, they are financial investors 's e.g. real estate funds and pension funds. There is growing interest in the real estate sector from international institutional investors. The primary investment drivers for them are higher yields in comparison with EU15 countries: real estate transactions in the Baltics are being conducted at the yields of 8 's 9 percent, while in Europe they are as low as 4 's 5 percent. Local institutional investors are expected to become significant players on the market as well. For example, real estate investments may offer an opportunity for private pension funds to diversify their portfolios from bonds and stocks to meet the profitability targets.

Despite the definite advantages, sale and leaseback strategies remain unexplored, and the market needs further "education" and development. There was an attempt recently, when the Neringos Viestbutas hotel in Vilnius was sold to L&R Nordic, a real estate fund, which holds real estate investments of over several billion euros across Europe. Some transaction targets are being explored in Riga and Tallinn as well, where the potential market size for sale and lease back transactions in the hotel segment may be estimated at 100 's 130 million euros.

However, there are some objective factors impeding these transactions. First, there is a lack of investment grade properties. Also, as a rule investors are interested in hotels with more than 150 rooms, good location and a reputable tenant. The operational risks are associated with high seasonality impact and low accommodation rates during the winter months. Taking into account current real estate market prices and investor return requirements, the house profit of hotels may be insufficient to cover its rent payments. The situation may improve, if the region succeeds in developing business and SPA tourism to fill up hotels year-round. o

Kristine Kolosovska is an analyst at Bridge Capital