Ground rents face downturn test

Growing interest in the lodging sector from institutional investors looking for steady returns has spurred an increase in ground-rent deals.

The structure was traditionally a route to raising debt, but, moving into a downturn, there were concerns around how some hotels may fare. 

Patrick Grant, partner, Alpha Real Capital, told our IHIF newsletter: “In the U.K. it’s still a very niche area, but in terms of the past five years it has grown enormously, predominantly across EBITDA-valued assets. Initially, it started in hotels but has spread into other areas such as healthcare and other alternative asset sectors.”

 Earlier this year Alpha Real Capital acquired the ground rents of four hotels in two separate deals, giving its fund some £1.5bn of assets under management in commercial ground rents, of which hotels and hospitality accounted for just over 40 percent

 According to Grant, “Roughly half of our deals were done as part of a transaction or shortly afterwards, working mainly with private equity groups who are buying portfolios of operational real estate. Historically, most other investors in U.K. ground rents, such as other fund managers, acquired ground rents as part of their wider long-income strategy with only a couple of other devoted ground-rent funds. This focus has allowed us to target specific areas of the market and, as a result, the vast majority of the deals have been done off market.

 “For our investors, the appeal is getting long-term, inflation-linked income streams as an alternative to long-term, index-linked gilts, with a better rate of return, so there is a growing appetite from the pension funds.

 “For asset owners, there are typically two reasons to do it; more-expensive mezzanine debt replacement or complementary with traditional senior debt to lower overall cost of capital. We’ve also spent a lot of time working with banks to get them more comfortable lending against a long leasehold, as against a freehold. The idea behind ground rents is that the owner can operate pretty much as if it is still a freehold,” said Grant.

A Variety of Drivers

Driving the interest in ground rents has been a global macro-environment of low yields and reduced risk of inflation, leading pension funds, insurance companies and other fixed-income investors unable to get their required returns from sovereign bonds.

The structures have been growing in popularity in recent years, with Park Plaza agreeing the sale and leaseback of the Park Plaza London Waterloo for £161.5 million in 2017, taking a lease of 199 years. CBRE Global Investors acquired the hotel’s freehold for £161.5 million, with the initial rent of £5.6 million per year having annual inflation adjustments subject to a cap and a collar [i.e., a cap limits the amount rent can be increased on review; a collar stops the rent falling below a certain level].

Knight Frank reported that in 2018, a total of nine ground-lease transactions were executed, involving 14 individual hotel assets, of which 95 percent of investment targeted regional U.K. deals. Institutional investors dominated the ground-rents market, with 96 percent share of the total investment, with ground-lease transactions representing 9 percent of total institutional investment.

The company said the ground rents being set were typically in the region of 15 percent of EBITDA and when combined with the record low yields, such deals could often achieve as much as 47 percent of the freehold value. Overall, across the market the average net initial yield moved during 2018 to 2.6 percent compared to 2.8 percent in 2017.For the developer, the ground-lease structure provided an alternative to development finance. Though the ground-lease structure increased the yield on the building, the lower-yield ground-rent portion and the decreased financing costs could help developers unlock additional value.

Karen Friebe, partner, Bird & Bird, said, “If they can get the financing right, the pension fund gets a good return, with an escalating rent. You have to have a good covenant and both parties need to ensure that the rent is sustainable.

“Pension funds and investors like to see steady returns,” she added. “One of the main issues is the balance of power between the two parties. The landlord will want appropriate operating controls; there has to be regular investment in the hotel at regular intervals. They want to keep the hotel from becoming run down and no longer attracting customers. You need to have a fully performing hotel to support the rent.”

Sources close to this publication suggested the terms of ground-rent agreements have been tightening, with one observer seeing under 20 years.

Inefficiency Being Worked Out

Tom King, senior director, specialist markets/licensed and leisure, CBRE, told our newsletter,  “What we’re seeing in the market is that inefficiency in pricing is being worked out. Previously, ground rent was something you used if you had to do a deal which you couldn’t otherwise and there was a 150-year buyback. Now you are seeing new deals whereby you can buy back earlier; at year 40 or year 75, as long as the investors can hit their targets, they are willing to give the freehold back.

“That’s a positive aspect for the person selling the freehold, as they reduce their rental liabilities from 150 years to 75. The shortening of the term is a positive thing, but it’s a bit of a myth there’s a shortening of terms and chaos is going to ensue. The reality is that you sell a 200-year lease, but with a buyback at 75 years, so that you have the reassurance of 200 years of tenure. Below 100 years has an impact on the lending criteria.”

Grant added: “The idea of the ground rent is that it should not be the cause of any issues further down the line. It’s all about finding ways to work with the tenant as both parties are aligned in their interest. The better the tenants do, the more secure our income over the period. Our investors are very benign.

“We’ve seen some deals done on more aggressive rent gearing on the market but we are cautious about these structures as they could potentially cause issues for the tenant further down the line on refinance or exit. Typically, ground rents should be stabilizing at sub-15 percent NOI to make it sustainable in the long term for investors, operators and lenders,” said Grant.

The ground rents in the sector were so far functioning, as hotel performance has remained good. Pressure on the market looks likely to increase, after the HVS/Alix Partners market tracker for the third quarter reported that, while London recorded another strong quarter, with 6.2 percent RevPAR growth on the year, the regions saw a 1.1 percent decline.

Graeme Smith, U.K. hospitality and leisure industry leader at AlixPartners, said, “There are areas where trading performance is under considerable pressure at the moment. The big cities are performing very well. The secondary and tertiary locations are struggling more, with rising cost pressures and a top line nowhere near where it was.”

King was confident quality would out, commenting: “If your NOI stands to reduce because you’re underperforming, then that’s the same whether you’re freehold or a long lease. The best operators will be fine”.

Looking at the potential to resell, he said, “Given the evidence we’ve seen so far it’s difficult to see an impact [of having a ground lease in the mix]. The obligation to pay rent sits in the business, but it doesn’t vary like utilities might; you have an understanding of the cost line. At the moment it’s hard to see a discount being applied to long leaseholds.”

Smith said, “In good markets there is an active secondary market in the leasehold interest in hotels, in ground rents, but as yet there is no evidence whether people will buy a distressed hotel with a ground-rent aspect and if they will, what pricing will be. If hotel operating profits drop and you have lease costs rising, do people still want to buy it? As ever with these things, ground rents started out as a sensible financing structure, but people will always push the boundaries.”