Are hotel leases losing their luster in Europe?

Lease agreements remain prevalent in Europe—will that change?

The hotel lease format has been a mainstay in Europe. However, a recent article from HVS suggests that could be changing. 

Within the lease arrangement, the hotel company, or whoever is leasing the asset, takes on a significant bulk of the financial burden. They win in boom times and suffer in slack times. The asset owner, the lessor, is nothing more than a landlord, paid a fixed monthly amount or amount as a share of revenue or NOI. As such, the owner succeeds or fails on the back of the hotel company operating the asset.

A new article authored by HVS' Dayk Balyozyan, Sophie Perret and Chris Martin suggests that though hotel lease contracts have traditionally been popular in Europe and continue to be preferred or required by many institutional investors, "management contracts have become increasingly prevalent as many other investors have sought to share further in their hotel’s trading profit and, at the same time, most major international hotel operators have become far less willing to offer leases."

Hotel leases traditionally have been a preferred mode or arrangement for hotel operation in Europe because owners were less knowledgable or concerned about how a hotel is run for maximum ROI. As HVS points out, owners—from private equity to institutions—over time have generally developed a much greater understanding of hotel operations, and have become more sophisticated in their selection of operators and in the negotiation of contract terms. These investors usually separate asset ownership from operation of the business.

To be sure, hotel lease contracts provide hotel property investors with a certain amount of security that they wouldn't otherwise have working under the arrangement of a management agreement. On the one hand, within a lease, the lessor is paid without making any outlay to the lessor; in a management contract, that arrangement is flipped, but the owner, now, benefits the most financially for a well-run operation. The management contract or franchise model is widespread in the U.S. in the hotel space; leases are prevalent for office assets.

Choosing Sides

So, what's the better arrangement? In a hotel management contract, the operator assumes responsibility for managing the property and runs the hotel on behalf of the owner. In doing so, it receives a fee for its services, according to specified terms negotiated with the owner. As HVS points out, "A well-negotiated management agreement should align the interests of both parties. As an owner, the major goals should be to select the management company that will maximize profitability and therefore the value of the asset, and to secure the best possible contract terms with that operator, while at the same time ensuring the operator is properly incentivized to maximize profitability."

In this arrangement, the manager is a fiduciary unto the owner. 

On the other hand, a lease arrangement shifts risk from the owner to the operator. If the hotel has a bad month, the owner still gets paid; it's the owner's decision to negotiate a flat fee or variable. The former is a hedge against lean times, but a fee off of revenue or NOI can be a boon during strong demand periods.

Different investors have different appetites for risk. A high-risk, high-return investor will lean toward a management contract, while an investor more concerned with security would be drawn more to a lease agreement. On the flip side, a management company would oftentimes be leery to sign a lease, as their expertise lies in running hotels, not asset management, and by stepping into a lease, they then have a vested interest in the asset. 

HVS writes that from the owner perspective it makes more sense to lease properties that are liquid, such as mid-market hotels, that are easier to dispose of, unlike upscale and luxury hotels, which are illiquid and most always are run under a hotel management contract. 

Risk & Reward

When it comes down to it, both parties—management and ownership—should be equally incentivized to prioritize the profitability of the asset over everything else. This usually means that both sides should carry some of the asset's risk—which is why the lease arrangement has been so prevalent in Europe up to now.

Anders Nissen, CEO of Pandox AB, which owns a portfolio of 100-plus hotels spread through Europe, sure thinks so. He makes it clear: Hotel brands should share in the success and failure of a hotel.

As the business of running hotels has become further fragmented, hotel brands have carved out a particular space wherein their risk becomes negligible. Hotel companies like Marriott and Hilton made the decision to remove themselves form the ownership game and, via franchising, management, as well. Nissen, for one, finds fault in that, a reason he prefers a lease model if he is getting in bed with a brand.

“Two parties come together, invest together and share the risk and upside,” Nissen said. “If they don’t want to share our risk, why should we sign up with them?”

To lease or not lease, that is the question. So choose, but choose wisely.