Overview
Navigating the intricate landscape of the hospitality industry requires making informed strategic decisions. As a hotel owner, one critical choice you may encounter is whether to purchase a hotel situated on owned or leased land. While the conventional path involves acquiring both the property and the land, an increasing number of hotel owners are exploring the alternative—buying the building while leasing the land it sits on.
This article aims to provide clarity and assist hotel owners in this crucial decision-making process. We’ll examine the potential advantages, such as lower initial costs, the potential for higher cash-on-cash returns, the ability to direct more investment toward business operations, and the opportunity to secure properties in prime locations. Concurrently, we’ll also scrutinize the disadvantages, including limited control and flexibility, unpredictable costs, lack of equity, lease expiry risks, and potential difficulties in securing financing.
Whether you’re an experienced hotel owner considering expanding your portfolio or a novice evaluating your first investment, understanding these factors will help determine if buying a hotel on leased land aligns with your investment goals. Our aim is to empower you with the information needed to make an educated, informed decision that best supports your business objectives.
Types of Leases (& Associated Risks)
When considering the purchase of a hotel on leased land, it’s essential to recognize that not all land leases are created equal. Depending on the property’s location and the overseeing authority, different land leases come into play, each with its own set of rules, terms, and inherent risks. These lease types can range from those managed by federal and state entities to those governed by local bodies or private individuals. Before diving into a lease agreement, it’s paramount for hotel owners and investors to familiarize themselves with the specific type of lease they’re encountering, as this will largely dictate the scope of their operations and future planning. Understanding the type of land lease and its associated risks is crucial for potential investors, ensuring alignment with their business strategy and risk tolerance.
US Forest Service Leased Land
Description: This pertains to land owned by the U.S. Forest Service (USFS). Individuals or businesses can lease this land under a “special use permit” for various purposes, including establishing resorts or recreational facilities. The new owner establishes a new lease with a 25-35 year term at Closing. USFS works very well with resort owners to encourage use by the general public and ongoing business operations. Permit holders do not need to be US Citizens.
Risks: The lease agreements can have strict environmental protection clauses. There could be limitations on structural modifications or expansions. There’s also the possibility of non-renewal if the land is required for conservation or other federal purposes.
State Leased Land
Description: State governments own vast tracts of land available for lease to businesses and individuals, each state having its criteria and purposes for leasing. State leases have the advantage of being very secure in that the State receives benefits from the lease and would not otherwise have a use for the land, making the likelihood of reversion small.
Risks: The terms and conditions can vary significantly from one state to another. Stringent regulations may be tied to state policies or goals, and lease renewals might be influenced by changing state priorities or leadership.
Airport Leased Land
Description: Airports, especially those in large cities, lease out land for various commercial purposes, including hotels, restaurants, and retail stores that serve travelers. The Federal Aviation Administration (FAA) prohibits ownership of the land surrounding airports due to the heightened need for security. Therefore, anyone desiring to own an airport hotel must be willing to work within the land lease requirements.
Risks: Given the strategic nature of these lands, there could be higher rents. Leases might be subject to periodic reviews based on airport expansion needs or security concerns. There’s also the inherent risk of noise and other disturbances associated with proximity to an airport. The FAA has to approve changes of a substantive nature to lease agreements for hotels located on leased airport land.
Port Authority Leased Land
Description: Ports, serving as hubs for maritime transport, often have lands they lease out to businesses, including warehouses, business complexes, transportation, and hospitality services. These leases tend to be low risk as long as the conditions for the Port are met because the Port is generally not interested in taking control of the leased assets.
Risks: Being in a dynamic and often congested environment, there might be limitations on structural changes. The lease terms could change based on port expansion or trade volume growth. Environmental regulations can also be strict, given the proximity to water bodies. As with any transportation hub, noise may also be an issue.
Private Leased Land
Description: Privately owned land that’s leased out to other businesses or individuals. The terms are often dictated by mutual agreements between the parties involved and can vary widely in terms of scale and scope.
Risks: The landowner’s financial health or intentions can influence such leases’ stability. Lease terms might be less standardized compared to government-owned lands, leading to potential oversights. Negotiations might also be more intensive, with the balance of power often leaning towards the landowner.
Advantages Of Leased Land
Lower Initial Costs
One of the main advantages of buying a hotel on leased land is the lower initial investment. In this scenario, you’re essentially purchasing the building or structure, not the land on which it sits. This can substantially reduce the amount of capital required to get started in the hospitality industry. Lower initial costs can be particularly beneficial for new entrants to the industry, smaller hotel owners, or those who want to expand their portfolio without tying up large amounts of capital. This also leaves more funds available for contingencies and operational expenses, which can provide a stronger financial buffer for the business.
Potential for Higher Cash-on-Cash Returns
The lower initial investment can result in a higher cash-on-cash return, especially in the early years of the investment. All else being equal, a hotel on leased land could generate a higher annual return relative to the initial amount invested than a hotel on owned land. For example, if both hotels generate the same amount of annual profit, the hotel on leased land will have a higher return percentage due to the lower initial investment. This increased efficiency in capital use could make the business more financially resilient and profitable.
Greater Investment in Business Operations
The money saved on purchasing the land can be used to enhance other parts of the hotel business. This could include improvements to the property, like renovations or upgrades to amenities, which could increase the property’s appeal and guest satisfaction. It could also include investments in staff training, marketing, promotional activities, or technological advancements, all of which could drive more traffic to the hotel and potentially increase revenue. It provides more room in your budget to invest in the operations and growth of your business.
Prime Location Accessibility
Leased lands are often situated in prime locations such as city centers, tourist hotspots, or beachfront, where the cost of outright purchase would be prohibitive for most investors. By leasing the land, you can position your hotel in a highly desirable or high-traffic location that could attract more guests. This could not only boost occupancy rates but also allow for premium pricing, both of which can contribute to increased revenue. Moreover, hotels in prime locations often enjoy better visibility and access to local amenities, which can enhance the guest experience and potentially result in better reviews and repeat business.
While these advantages can make leasing land attractive, it’s important to remember that each business situation is unique. These factors should be carefully weighed against the potential downsides, and the specifics of the lease agreement should be thoroughly reviewed with a real estate broker or legal professional.
Disadvantages Of Leased Land (& Some Solutions!)
Owning a hotel property may not be for everyone. As hotel brokers, our goal is to match the perfect person with a property that meets both their short-term and long-term investment needs. Some leases are more strict than others. For example, an airport hotel will have more restrictive guidelines than a hotel located in a national forest area.
Leased land may seem like a disadvantage for a hotel owner, but it’s important to remember that hotel properties have the opportunity to renegotiate the terms of the lease as part of the hotel sale.
Limited Control and Flexibility
Landlords may restrict how the leased property can be used or modified, potentially limiting your capacity to expand or renovate the hotel as your business evolves or as market trends change. These limitations can obstruct your long-term business strategy and potentially stifle the growth of your business.
Solution: Negotiate Terms To Increase Flexibility
Ask yourself, “Why was that limitation/guideline put in place? What purpose does it serve?” Some limitations for development may add to the hotel’s desirability from a guest experience standpoint. (It’s hard to argue with a spa resort nestled in the woods…) Can your hotel brand thrive and grow in such an environment? Does this “limitation” stifle your hotel’s ability to offer hospitality and upgrades to the guest experience in a way that might impact your bottom line, and/or is this something worth negotiating with the leaseholder?
Hospitality hotel brokers work with lease agreements all the time. In fact, they are quite common in this industry. As with hotel negotiations, changes to the lease (at the time of the sale) are commonplace. It may be possible to craft a lease agreement that allows for property modifications and expansions now or in the future. In this way, hotel owners can exert a more significant influence over how the property is used. Including a “Right of First Refusal” clause in the lease can be especially beneficial, ensuring that if the landlord decides to sell, the lessee has the primary option to purchase, thereby capitalizing on potential land value appreciation and retaining control over the property’s trajectory.
A copy of the current lease agreement is available through the due diligence process. Viewing the current lease agreement will give you some idea of the existing lease parameters and help you decide whether or not to explore negotiations.
Unpredictable Costs
Lease agreements often contain clauses allowing for periodic lease payment increases, usually linked to inflation or changes in the market value of the land. This can render your costs unpredictable and more challenging to budget for. Any increases in lease payments will also directly influence your hotel’s profitability.
Solution: Include Provisions That Control Lease Rate Changes
The prospect of uncertain expenses can make some hesitant about buying a hotel on leased land. However, lease agreements often incorporate strategies to counter this unpredictability. For instance, a lease might detail a steady increase, such as an annual rise of 3%. Additionally, some leases tie rent changes to the Consumer Price Index (CPI), aligning costs with the broader economy and ensuring they stay abreast of inflation.
Step-up leases provide a structured insight into upcoming expenses by designating rent increases at set periods. Certain leases adopt periodic market rate evaluations to balance competitiveness with current property market dynamics, although these might introduce some degree of flux. The ‘cap and collar’ method limits these adjustments, preventing extreme shifts. For parties seeking adaptability, some leases endorse rent re-negotiations at predetermined intervals, fostering mutual agreement tailored to current circumstances and market realities.
Lack of Equity
As a lessee, you don’t gain equity in the land, which can limit the total value of your investment over the long term. If the land’s value appreciates, you won’t benefit from that increase. If you decide to sell the hotel, this can diminish potential profit.
Solution: Maximize Potential Profits With Equity That Isn’t Being Used On Land Purchase
While it might seem counterintuitive, there are distinct advantages to owning a property on leased land, especially when considering equity dynamics. When you lease the land, you primarily invest in the business operations and the physical hotel structure, not the underlying land. This lease agreement can result in a significantly lower initial capital outlay, freeing up funds for other ventures or investments. Furthermore, even though you don’t gain equity in the land, the hotel can still appreciate value due to factors like brand reputation, operational efficiency, or improvements and renovations.
This approach allows for more fluid capital management, higher returns on investment, and the ability to pivot swiftly in response to market changes. Additionally, while you might not benefit directly from the land’s appreciation, the saved capital from not purchasing the land can be strategically invested elsewhere for growth and diversification, thus maximizing potential profits in a broader sense.
Lease Expiry
The risk associated with the expiration of a lease can be significant. If you’re unable to renew the lease or if the cost of renewal is prohibitively high, you may be compelled to move or sell your business. Even the uncertainty surrounding lease renewal can create complications, such as difficulties in future planning or potential devaluation of the company.
Solution: Negotiate Lease Expiration When Ownership Changes
When a sale of a hotel property (on leased land) is negotiated, the lease agreements will also be reviewed. Both the duration of the lease and the lease terms will be considered and revised. Opting for a long-term lease provides stability, facilitating more effective long-term business planning and a competitive advantage in prized locales. With hotels, the lease terms tend to be incredibly generous, and the length (depending on location) can span more years than you may expect to own the property. If your investment goals include turning over properties in a five to ten-year window, then a fifty-year lease really isn’t cause for concern.
Challenges in Securing Financing
Acquiring finance for properties on leased land can be more challenging due to perceived higher risks by lenders. They might be concerned about what happens if the lease expires before the loan is paid off or if the lessee defaults. This can complicate the process of securing a mortgage or loan, possibly requiring a larger down payment or acceptance of higher interest rates.
Solution: Hospitality Lenders Are Well Positioned To Offer Financing To Hotels On Leased Land
Owning a property on leased land can present unique financing opportunities. While it’s true that securing financing for such properties can sometimes be viewed as riskier by lenders, this perception can be leveraged to your advantage with the proper preparation and strategy. By demonstrating a comprehensive understanding of the lease terms, showcasing a clear business plan, or negotiating longer lease durations, investors can assuage lender concerns about the lease’s expiry or potential defaults.
Furthermore, due to the absence of land acquisition costs, the total loan amount required may be significantly less than traditional property purchases. This reduced principal could translate into smaller monthly repayments.
For investors with a solid credit history and financial acumen, there’s an opportunity to negotiate favorable loan terms, even with the intricacies of leased land. This model can also appeal to specialized lenders or those familiar with the local real estate market, potentially opening doors to more competitive financing options.
Is Owning A Hotel On Leased Land Right For Your Investment Goals?
Some Key Takeaways
While it’s essential to carefully consider the associated disadvantages, purchasing a hotel on leased land offers a compelling array of advantages that align well with many hotel owners’ strategic goals. The significantly lower initial costs provide an accessible entry point into the hospitality industry or an opportunity for existing hotel owners to expand their portfolios without tying up large amounts of capital. This financial flexibility opens the door to higher cash-on-cash returns, making the most efficient use of your investment dollars.
One advantage is that the savings on the land acquisition can be reinvested directly into the business operations. Upgrades to property, investments in staff training, increased marketing activities, or the introduction of advanced technology can all contribute to a heightened guest experience, driving increased traffic and revenue to your hotel.
Perhaps one of the most appealing benefits, however, is the potential access to prime locations. Leased lands often reside in the heart of cities, popular tourist hotspots, or picturesque beachfront, or even at international airports—locations that could be prohibitively expensive to buy outright. By leasing, you could place your hotel in a high-demand area that can attract a steady stream of guests, contributing to higher occupancy rates and increased revenue.
As with any major business decision, it’s essential to consider these factors within the context of your specific circumstances and future plans. Also, consult with a seasoned real estate broker or legal professional to fully comprehend the terms and implications of any lease agreement.
Click To View CIP Listings Located On Leased Land
