Is it time for market rent reviews in the motel industry?
20 Aug 2018
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The single biggest expense in a motel business is the rent, and what we see occasionally is the position where the rent has increased slowly over time to a point where it is out of sync with the market. It is coming up more and more as an issue in the motel industry.
It is also an issue that sometimes comes up in the management rights industry – but in reverse (for example, where the agreement provided for a caretaking remuneration with fixed 5% increases over a 25 year term). These style of increases are generally unsustainable for bodies corporate and more often than not are negotiated away by a manager at some point.
Similarly rents that have increased in line with CPI only, will at some point need to be checked.
We are not accountants, nor do we express to be, but the consistent rule of thumb that we are told applies to a successful motel business is that the largest fixed overhead – being the rent – should not be more than around 30% to 40% of the operating revenue.
When it gets higher than this, the financial pressure starts to build and that pressure can be akin to the frog in the pot. Put it in and keep turning the temperature up slowly, and the frog doesn’t know it is boiling until it is too late.
Financial pressure that builds over time is like that. If you get a short, sharp hit you know about it, but if it drags out over time, every month becomes a grind.
As a general rule, in most motel leases the rent goes up by CPI every year regardless of external circumstances of the market. If your town or region starts to struggle economically, then your rent will almost certainly increase as a proportion of your revenue but your income may go down.
Motel leases are different to most long-term retail or commercial leases which usually have market review provisions built into them – usually at the time an option is exercised – but sometimes just during the term of the lease. This allows the rent paid by a retail or commercial tenant to be reviewed to what the market rent is at the time of the review. Sometimes these leases have caps and collars in terms of the maximum movement that can be applied to that market rent – be that a fixed sum or a fixed percentage.
Often motel leases do not have a market review clause in them. The reasons for that can be easily debated from both sides of the fence:-
- From a tenant’s point of view;
- if there is a market review then the rent should be able to go both up and down – that is what a true market review is;
- if the tenant has worked hard to build the business then they do not necessarily want to be rewarded for that effort by paying more rent;
- they often do not want to provide all their financial information to the landlord.
- From a landlord’s perspective;
- they want some certainty of income, so the concept of a rent which could decrease is not often welcomed;
- often the landlord is not privy to the financial information of the tenant, and so cannot see the writing on the wall, so to speak;
- if the fall in revenue is as a result of poor management on the part of the tenant, why should that impact on the landlord’s revenue?
So if your motel lease does not have a market review (like most don’t) what do you do?
The first thing is to recognise there is an issue. If things are not working financially, get some external advice. That is not necessarily from us (yet) but you should start with your accountant or financial adviser. When you are under financial pressure it is easy to lose objectivity about where you are and what you need to do. Some hard number crunching is usually where you need to start.
Once you have done that, you can assess what it is you need to do, and here is where the art is. It then becomes a commercial negotiation between yourself and your landlord.
For the most extreme of cases (which are rare but do happen), it might be that the combination of too much borrowing and a completely cratering market (perhaps along with new competition) means that by any definition the motel business you have is simply unsustainable.
The walk away option is Armageddon, but if the business is fundamentally broken, then that is what it is. There is nothing worse than working for everyone else in the deal, like the bank and the landlord, and having nothing for yourself. Flogging dead horses is no good for anyone, especially when you are the horse.
There is a range of issues that flow from that in terms of dealing with banks and personal solvency issues, which can be brutal. But in our experience knowing you have a problem, and then dealing with it in the best way possible, is all you can do. What is absolutely certain is that if nothing changes, nothing changes. You need to do something.
Most banks (especially in these times of a Royal Commission) are being increasingly less vindictive about personal action against borrowers after a business goes bad. Landlords are usually the same. Why throw good money after bad?
Assuming it is not all over, the easy answer is to ask the landlord to reduce the rent.
That sounds good in theory but is harder in practice. The value of the freehold investment to a motel tenant is largely tied back to the income paid by the motelier and the tenure of the lease itself. If you reduce the rent paid, the landlord’s capital value will be affected the next time they have a valuation – or go to sell the freehold.
The other thing is that the landlord might already be squeezing every last cent out of the property to fund their lifestyle or other commitments. Reducing the rent for them might be difficult in light of their other expenses.
It helps to know the landlord’s position before you ask, so having some form of personal relationship with them is good business insurance.
Of course, the counter-argument is that a landlord would much rather have a tenant in there paying rent as opposed to a vacant property or a motel they need to manage themselves. If the reality is that the market has changed substantially, then that might be a bitter pill they have to swallow.
It can be a help or a hindrance if the landlord is a former motelier of the property you are running. They will know the market and may think it is simply poor management on your part. They may also know that you are good operators and are being buffeted by factors beyond your control.
Either way, you need to start that conversation if you are in trouble.
The longer-term issue is how the industry deals with the risk of rent running ahead of whatever the magical benchmark may be. Our solution is true market reviews, which will take agreement from both sides of the fence. It is commercially accepted in every other leasing market, and for the sake of the sustainability of the industry, we think the time has come for the motel industry to join the club.