Fixed rent from an operating lessee, or a share of the RevPAR, when you don't intend to run anything

Question

Working out what passive hotel exposure should actually look like for me, and the two structures I keep landing on behave completely differently in a downturn.

Structure one, own the real estate and lease it to an operating company on a long lease with fixed rent, sometimes with a percentage rent kicker over a revenue threshold. You get something closer to a lease payment. The operator holds the franchise agreement, hires the staff, eats the demand swings. If travel softens 15%, your rent check is the same size until the operator can't write it.

Structure two, own equity in the operating asset itself through an LP or a DST, with a third party or affiliate manager running it for a fee. You get the RevPAR. Good year, you're up more than any lease would have paid. Soft year, you find out what the fee stack looks like from underneath.

The case for the lease is obvious and it has one hole. Hotel operating lessees are usually thin entities with no balance sheet behind the lease, and the rent coverage in a bad year is the only thing standing between you and a renegotiation. A 20 year lease from a company with $400k of net worth is a 20 year lease until it isn't. Also the capex question, because PIPs happen every six or seven years and somebody has to fund them.

The case for the equity is that you're paid for the risk you're actually taking, and in a strong economy skilled operators can drive rate in a way a fixed rent never captures. The cost is that the fees get paid first and you're last.

I can argue both hard. Curious where the room lands, especially anyone who's held one and then the other.

jessreyes12 · Accepted Answer

I asked a version of this to a broker last year and got a non-answer, so I worked it out myself eventually. The lease structure doesn't remove the RevPAR risk from your position. It moves it behind a credit, and then the whole question becomes the quality of that credit and the rent coverage.

So the test I'd apply to any hotel lease is the same one I'd apply to any single tenant lease. What is the coverage ratio of the lessee's EBITDA to the rent, and what happens at 1.0. On hotels that number moves fast, because a 12% RevPAR decline in a limited service box drops most of the way to the bottom line. Fixed costs don't shrink much when occupancy does. A lease written at 1.4 coverage on peak-year performance can be at 0.9 two years later, and at 0.9 the operator calls you and asks for a rent reduction rather than handing back the keys. Now you're negotiating with no leverage, because your alternative is to take back a hotel you have no ability to run.

Which is why I'd rather see the capex obligation and the PIP funding named explicitly than argue about the rent number. If the lessee owes the PIP and can't fund it, the brand pulls the flag and your building loses most of its rate overnight. If you owe it, you need a reserve schedule that assumes the second PIP too, not just the next one.

Equity in a well capitalized asset with a third party manager and a subordinated asset management fee is honestly closer to what most people think they're buying with the lease. It's just labeled scarier.

gregpowell66 · Answer

The capex split in these leases is where the money hides. I've walked properties where the lease said the tenant handled maintenance and repair and the landlord handled structure, and the argument was about whether a corroded riser was maintenance or structure. On a hotel that fight is annual, because everything gets used every night by people who don't own it. Whatever structure you pick, get the PIP funding and the reserve schedule written into the document, and get the definition of structure spelled out to the component level. compass is right that the lease just relocates the risk.

Fixed rent from an operating lessee, or a share of the RevPAR, when you don't intend to run anything

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