The COVID-19 pandemic has ruthlessly exposed the weaknesses of traditional fixed-rent models. Rigid lease structures did not offer many landlords the security they had hoped for – on the contrary: rent defaults, renegotiations and insolvencies were the result. Today, hybrid leases are becoming increasingly popular. These combine fixed and variable components, thereby distributing risks and opportunities more fairly between landlords and operators. In this interview, you will learn why this ‘breathing’ model is considered the new industry standard, what role key figures such as the lease coverage ratio play, and how greater partnership strengthens the long-term stability of hotel investments.
Question: For hotels, the classic lease agreement with a fixed rent was long considered the standard for security-oriented landlords. Why is this contract model coming under increasing pressure?
Answer: For many years, this contract model offered landlords apparent security. The landlord receives a calculable, fixed return and has little or no involvement in the operational side of the business, i.e. the hotel's day-to-day running – the operational risk lies entirely with the tenant. The hotel's operations and the risks associated with them are virtually irrelevant; the landlord only has to monitor the timely receipt of the fixed rent. However, the COVID-19 pandemic has exposed the practical weaknesses of this model. When hotel operators' revenues collapsed overnight, the fixed rent could no longer be generated by hotel operations and was no longer affordable for many tenants. The result was rent defaults, tough supplementary negotiations on the adjustment of economic conditions and even a few insolvencies. However, if the tenant cannot generate the fixed rent, the landlord's payment claims will sooner or later come to nothing. It therefore became clear that a classic lease agreement with a fixed rent, which completely ignores the risks arising from the operation of the hotel, does not offer landlords the security that it appears to offer at first glance.
Question: In response to this, we are seeing more and more so-called hybrid leases. Can you explain this model and why it is referred to as a ‘breathing’ model?
Answer: Hybrid leases have been in practice for some time and are increasingly becoming the industry standard, partly because they draw lessons from the crisis and strike a balance between the operating risk for the landlord and the tenant. It combines the best of both worlds: a fixed minimum rent that is significantly lower than in a traditional lease agreement with only a fixed rent, and a variable rent that depends on the hotel's turnover. Unlike a lease agreement with a purely turnover-dependent rent, which shifts the operating risk to the landlord and is therefore hardly suitable for investment, the minimum rent payable by the tenant in any case ensures that the landlord's basic costs, such as debt servicing, maintenance costs and, if applicable, non-allocable ancillary costs, and thus offers him a certain degree of planning security. The turnover-based rent allows them to participate in the success of the hotel. In this respect, it is a ‘breathing’ model because it reacts flexibly to the respective market situation. In economically difficult times, the tenant is relieved by a comparatively low minimum rent, which secures their existence and the continued operation of the hotel, thus reducing the risk of insolvency for the landlord. In good economic times, the landlord benefits from the turnover-based rent, which often means that he ultimately receives more rent than with a traditional fixed-rent lease. This contract model therefore offers the opportunity to distribute the risks and opportunities of hotel operations fairly between the parties. It reflects a new understanding of the contractual relationship between landlord and tenant, moving away from a pure tenancy agreement towards a kind of economic partnership. Landlords are therefore no longer just ‘silent’ contractual partners, but ‘active’ supervisors of the hotel's operations. If a landlord identifies risks arising from the hotel's operations, they can react to them at an early stage and, ideally, work with the tenant to avoid them.
Question: If the rent becomes variable, how can you ensure that the turnover-based rent remains fair and sustainable for both parties when determining the rent? What role does the so-called lease coverage ratio (LCR) play in this?
Answer: When determining the turnover-based rent, the so-called lease coverage ratio, or LCR for short, has established itself as a key control instrument. The LCR is calculated by dividing the hotel's annual operating profit, the Gross Operating Profit (GOP), by the annual rent owed. The value therefore indicates how often the profit generated by the tenant covers the rent. A value of 1.0 would mean that the entire operating profit must be used for the rent. In this case, the tenant would have nothing left over – e.g. for investments in equipment (FF&E reserve) or to cover their business risk. In practice, an LCR of at least 1.4 is considered healthy, as this gives the tenant sufficient leeway for unexpected expenses or loss of income. Above the LCR, the range for determining the amount of the turnover rent begins. The LCR is therefore a key figure for ensuring the long-term viability and thus the sustainability of the hotel business for both sides. However, it is not only an analysis tool, but increasingly a subject of negotiation in order to determine the turnover rent and calibrate the partnership fairly.
