Trading standards

The hotel sector is generally acknowledged as an industry that is one of the first to enter into and last to emerge from a recessionary period in the UK. The current downturn would appear to be no exception, with revenue declines being recorded from the middle of 2008 and little sign to date of any real sustainable recovery.

Virtually all hotels characteristically have high fixed cost operating structures that convert relatively moderate reductions in revenue to significant falls in profit. This is most pronounced in full service four or five star operations.

As a result, current trading levels are exposing landlords to the threat of tenants defaulting on their rent.

We might therefore benefit from understanding some of the challenges that are faced when attempting to establish a ‘sustainable’ rental level for a hotel and to look to see how better protection could be incorporated into the provisions.
With the exception perhaps of limited service or budget hotels, setting rental levels for hotels is extremely subjective due to their individual trading characteristics and the lack of available comparable evidence in the market. Virtually no two full service hotels are the same when it comes to setting rents. Therefore looking at average rents across portfolios or reviewing any comparables is not necessarily a sensible guide or useful benchmark to refer to.

The UK hotel sector is cyclical in nature mainly due to it tracking the economy’s peaks and troughs. The hotel industry is also sensitive and directly affected by world events such as the volcanic ash clouds, bombings in July 2005 and more positively the forthcoming London Olympics in 2012. As a result of these factors trying to estimate a ‘stabilised’ trading position upon which rents are based is also very subjective, particularly when there is little trading history to rely upon when setting initial rents on new build, refurbished or repositioned hotels.

Given the risks that arise from the judgements described above it is perhaps surprising that there is not better protection provided for landlords within the usual lease provisions. It is common to find obligations upon the tenant to provide details of an annual maintenance programme or to restrict certain uses of the hotel. It is not however common for provisions that require the tenant to provide regular high level key performance indicators or an annual sales and marketing plan for example. All too often, the landlord is the last to know that the tenant is struggling to pay the rent.

So when your tenant can’t afford the rent – what next? In the current economic environment it is unlikely that most landlords would be satisfied with forfeiting and regaining possession. Apart from the daunting operational difficulties of assuming responsibility for what is a very management intensive business there lies the question of who or what are the alternatives.

Providing support and advice in this type of situation is unfortunately becoming a more frequent request to CB Richard Ellis Hotels Consultancy services, either acting on behalf of the landlord or the tenant. In a recent, example a landlord contacted us after their tenant defaulted on the rent for a portfolio of their hotels. The tenant’s business was moving towards administration unless a solution could be found to rebase the rents for the future.

Under previous ‘normal’ or better trading conditions, the rents were manageable. However, with average falls in hotel room’s revenue in the UK regions of up to 12 percent in 2009, it meant that the tenant’s earnings were insufficient to cover the rent. The landlord required professional support with their rental negotiations, advice on alternative market rental levels and a view on potential new operators.

Our immediate attention turned to exploring whether it was possible to put in place a temporary easement arrangement on the rents to bridge the current downturn period. New tenants are not as readily available today and it is very unlikely under current conditions that a new lease is going to attract the same rent. Therefore if the rent looks to be serviceable by the tenant in the medium-term, we wanted to work to preserve the existing lease and monitor future performance. Assessing current market levels for rents required a detailed review of the physical assets and modelling future trading projections to establish a stabilised position. As a result of this work, the landlord was placed back in control with a number of options available.

The risk in a situation described above is that as a consequence of the tenant defaulting on their rent, the landlord is likely to be at risk of defaulting on servicing their own debt. Many transactions on hotels in the past have been highly geared and with yields moving out, LTV covenants may have already been breached. This potential domino effect can therefore quickly place the bank in control, so it is important under these circumstances to act swiftly and seek expert advice.