Why the hotel lease could challenge traditional U.S. deal structures

Union Investment acquired LondonHouse in Chicago from Oxford Capital in April 2016 via a sale-and-leaseback arrangement.

Hotel deals in the U.S. are primarily structured via a franchise or management agreement, but the lease structure, widely used in Europe, is an attractive alternative to more traditional models, a potential win-win for tenant and lessor. 

Union Investment Real Estate, headquartered in Hamburg, Germany, manages open-ended funds. Among other asset classes Union Investment is investing into hotel assets, in Europe and the US, which explicitly are structured via lease agreements. With these types of arrangements the asset owner and the lessee are aligning their fundamental interest of a profitable operation. This has proven to be a “compelling proposition” as Theodor Kubak, head of U.S. investment management hospitality, said. 

A lease agreement is typically consummated through what is known as a sale-and-leaseback, whereby a hotel owner or developer sells an asset to a new owner, who in turn allows the prior owner to lease the property. The tenant then usually pays the owner a fixed fee or a residual based on the gap between net operating income and the minimum rent. As Kubak put it, "When there is profit, we participate in the upside."

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The developer may, for instance, create additional value through a sale-and-leaseback, which is quite common in Germany. This means that, after the completion and opening of the hotel, he would "stay in the game," said Andreas Loecher, global head of division investment management hospitality at Union Investment. "This means that the developer, once the deal was completed, would lease the hotel back and manage it on its own account, granting a long-term lease agreement to the investor. He could take benefit of external know-how through entering into a management agreement with one of the leading hotel companies for instance."

It also allows them to move on and free up capital for other potential deals and can improve loan terms for those future projects.

The structure also allows the owner, in this case Union Investment, to pick up hotels without having to enter a traditional management agreement, which can be cumbersome and onerous, while a lease allows for sustainable income. The tenant then has the choice to operate the asset themselves or via a franchise agreement. 

Leasing is an arrangement that Union Investment has used to break into the U.S., where it currently owns four hotels: LondonHouse in Chicago, The Godfrey in Boston, the Courtyard by Marriott World Trade Center in New York and the Hilton Garden Inn in Seattle. In the case of the LondonHouse and Godfrey, both hotels were sold before they opened then leased back to Chicago-based Oxford Capital, the original developer, for $315 million and $173 million, respectively.

In an interview with the Boston Business Journal, John Rutledge, CEO of Oxford Capital, had this to say about the Godfrey deal: "If you sell a hotel, or any property, before you open, you sell it on projections. We had very detailed projections, which drove a very strong operating pro forma over the next five years. The price [Union Investment] paid, assuming we can deliver on our projections... gives them a compelling return on their investment. This business model that we have is a very efficient, highly profitable business model."

Meanwhile, in the case of the Courtyard by Marriott and Hilton Garden Inn properties, the lessee is Boston-based Pyramid Hotel Group, which in turn operates the properties via a franchise agreement with Marriott and Hilton, respectively. This arrangement is commonly referred to as a sandwich lease

"The seller not only realizes proceeds from the sale, but they remain long term and create value over time as the operating company," Loecher said.

Others are catching on. Caesars Entertainment recently announced agreements to sell and leaseback the real estate assets associated with Harrah's Las Vegas to VICI Properties. In July, Deka Immobilien, the real estate arm of Germany's DekaBank Group, signed a deal to buy the 257-room room Hyatt Centric The Loop Chicago and then leased the hotel back to the property's developer, an affiliate of Murphy Development Group. 

Union Investment is still actively pursuing deals in the U.S., where, Löcher said, returns are more attractive over the markets in Europe. The investment group is also scoping out potential deals in destinations such as Australia and Mexico.

The group also is a proponent of soft brands, which Loecher refers to as "advantageous" in particular situations: “You may, on one side, benefit from the name of a landmarked building and, on the other side, get the backing of a branded reservation system, all on a reduced management fee scheme." The LondonHouse Chicago, for example, is part of Hilton's Curio Collection. "As long as the story is right, we’ll invest in branded, soft-branded and unbranded hotels," Loecher said. 

Lease Attraction

Hotel leases have and continue to be a traditional and proven investment arrangement in Europe. According to a just-released report from HVS Hodges Ward Elliott, cap rates for fixed income prime hotel investments, such as lease contracts, have reached below 5 percent. The number of investors buying into leased hotels has also grown since 2009, the report says, as the asset class has become an "increasingly attractive investment target for institutional investors."

“Leases remain an attractive operating format in Europe for many brands, particularly in the budget sector with operators, such as Premier Inn in the UK or Motel One in Germany, most commonly seen to sign lease contracts due to their low-risk operating model enabling them to take on long-term, index-linked fixed leases,” said the report's author Peter Szabo, associate at HVS HWE. "They are an effective way to separate the risk associated with hotel operations and real estate ownership—and the new-found popularity of leases now makes commercial sense for both developers and long-term owners, particularly in this economic cycle."