In this newsletter, we highlight 10 issues relevant to the potential acquisition of a portfolio of serviced apartment management businesses in Australia. There will, of course, be other key issues which will come to the fore in particular transactions (third party secured financing comes to mind). However, we have concentrated on issues that will have relatively universal application.
In mature markets, like parts of Australia, existing serviced apartment management businesses are one of the really useful ways of expanding business operations when development opportunities are scarce. This reasoning will apply to varying degrees in other comparable accommodation markets.
During the last twelve months in Australia, there have been a number of very significant and well-known serviced apartment hotel businesses that have changed hands – with another currently up for sale. The combined value of all these deals approaches A$1 billion.
In light of the interest in these substantial portfolio transactions, we thought that it would be timely to discuss 10 key issues which arise in the context of a serviced apartment business sale or acquisition.
This newsletter will be dealing with matters that relate to the acquisition of a serviced apartment business portfolio, rather than matters that relate to what comprises a serviced apartment business. As there are significant similarities between condo hotels and serviced apartment hotels, for those readers who are more interested in issues relating to the composition of a serviced apartment business, we refer you to our previous article
Many of the concepts discussed below, although based on Australian transactions, have broader applications and would be relevant to an acquisition of a serviced apartment business portfolio outside Australia.
What constitutes a serviced apartment hotel business?
The primary legal difference between a serviced apartment hotel and a traditional hotel with a single owner is that specialist property laws (generally known in Australia as "strata title laws") are utilised to enable separate legal ownership of each accommodation room and select aspects of the non-accommodation room components. This includes front of house and back of house, retail facilities and service areas.
All the access ways and other common aspects of the development such as foyers, hallways and lift wells usually reside on what we will refer to as "common property" and are able to be accessed by all the respective owners and their guests. Control of the common property usually vests with a statutory entity, which we will refer to as the "owner's corporation", and is controlled by all the building owners.
To bring a serviced apartment hotel into existence, a serviced apartment operator usually approaches the owners of either all, or a significant number, of the accommodation rooms and strikes a separate deal with each of them (usually by way of a lease or some form of management agreement).
If there are aspects of the building privately held, other than accommodation rooms (say by the developer or some other party), then control of these aspects (which typically comprise front of house/back of house and any retail outlets and other incoming producing features) will be achieved by some arrangement with the owner of these aspects of the building. Usually, these aspects are purchased by the serviced apartment operator.
To complete the arrangement, it is usually necessary for the serviced apartment operator to enter into an agreement with the owner's corporation and gain control of the common property. This is primarily important to give the serviced apartment operator access to the common property and allow entry to each of the accommodation rooms. Usually, it also gives the operator control of the maintenance and upkeep of these common areas, which is vital to the maintenance of brand standards.
So in summary, an operator's ability to operate a serviced apartment building as a serviced apartment hotel business is the product of an amalgam of rights, being:
- Control of the accommodation rooms by means of separate lease or management agreement with the owner of each of the accommodation rooms. The usual methods of calculation of payment of rent or a letting fee to the owner is either a fixed amount per year or a proportion of the revenue generated from the letting of the accommodation room.
- Control of any non accommodation lots (such as front of house and back of house and any non accommodation room income earning activities such as retail outlets) is usually by purchase of such areas.
- Control of the common areas by means of some form of lease or letting agreement with the owner's corporation.
It is the aggregation of control of each of these aspects of the building, which allows the serviced apartment operator to conduct a serviced apartment hotel business.
In this article, we are going to focus on the issues relevant to the potential purchase of a portfolio of serviced apartment businesses usually in different geographic locations. The portfolio of businesses engages with the public by means of common branding or a stable of brands together with a sophisticated reservation system. We will assume that the sale process is structured on the basis that each prospective purchaser of this portfolio has access to a data room. This enables due diligence to be undertaken on each of the management arrangements which comprise the portfolio.
The reader will appreciate that this is a fairly simplistic and generalised explanation. Because of all the components which go to create a serviced apartment hotel business matrix, there can be enormous variety in the way these businesses are constructed. That said, we consider that this explanation gives the reader enough understanding of the basic building blocks of how a serviced apartment hotel business is put together to understand the issues we will now discuss.
For the purposes of this newsletter, we assume that our target serviced apartment hotel business portfolio consists of 10 separate properties each consisting of 200 accommodation rooms. Thus, there will be 2,000 separate arrangements in relation to the accommodation rooms (assuming no multiple owners), 10 owners of 10 privately held lots (which are not accommodation rooms), 10 separate owners' corporations and other bits and pieces.
We will now discuss key issues relevant to determining the true value of each of the serviced apartment hotel businesses, which comprise the portfolio that the incumbent operator is offering for sale.
- This is generally not a real property transaction.
The acquisition of a serviced apartment hotel business portfolio is generally not considered to be a real property play. The essence of the value of the business is tied up in the fees or return generated principally from the letting of accommodation rooms (and any other ancillary income earning aspects of the building such as retail outlets).
For this reason, entities which invest in bricks and mortar hotel assets tend not to be attracted to this form of investment. On the other hand, some traditional operators approach it as an extension of their existing hotel management operations.
- No two hotels are usually structured the same way.
Because these are fundamentally contract based arrangements, it is more likely than not that contract documents will not be uniform with respect to each of the hotel businesses. This means that a threshold decision needs to be made as to the nature and extent of the due diligence that needs to be undertaken on each of the hotel businesses.
Normally, it can be very expensive to undertake a fully detailed analysis of the documents for each of the hotel businesses. There is usually a need to prioritise the hotel businesses ideally creating a list starting with the business, which generates the best return and grading all the businesses through to the business that generates the least return. So, with our portfolio of an assumed 10 businesses, the intent would be to rank the hotels in order of respective return, allocate the businesses into bands and then determine the nature and extent of work which needs to be undertaken with respect to each band. For example, a full review of all the documents, or a review of the key documents, or reliance on epitomes of the contract documents prepared by the seller etc.
This is usually done on the basis of discounted present value of the fees or return generated by the incumbent operator for each of the businesses for the balance of the term of the respective management arrangements. This sounds simple enough, but can be tricky in practice. There are many variables at play which factor into the assumptions to be used to undertake the discounted present value calculation.
As lawyers, we try to take advantage of our experience with respect to such assignments to focus upon those aspects of the documents that are of particular importance to the value equation. This includes termination provisions, operator obligations to make payments to contractual counter-parties and any significant restrictions on the ability to grow the operator's income. The determination of the correct assumptions is critical to the determination of an appropriate price for the portfolio. For example, if the fees generated for a particular business are substantial, but the arrangements in place expire within a short period, then what assumptions should be made that the new operator will be able to extend the term and if so by what period. If the assumptions are too lax, then the price offered will potentially be too high, and if too stringent, then another bidder may win the opportunity without overpaying for the portfolio.
- Security of tenure.
At the heart of the due diligence exercise is a desire to come to a view on the true value of each of the hotel businesses which comprise the portfolio.
The first step is to decide which of the contractual terms, for each of the contracts that comprise the management arrangements, would give the counter-party the right to prematurely terminate the contract. The most common of these would be an ability to prevent an assignment of the contract as a consequence of the sale process. However, there can be others buried in the fine print of each of the contracts or otherwise available under relevant statute.
Once any of these impediments to assignment is identified, it becomes critical to form a view as to the likelihood that the counter-party will actually seek to exercise this contractual right. In other words, although the counter-party has a contractual right to block the assignment, is there a realistic risk that this right will be exercised?
- Statutory factors that can affect tenure.
In Australia, these types of arrangements are generally regulated as quasi-securities. The consequence is that there are a number of statutory provisions that need to be considered when determining what extraneous factors can impact upon the value of each of the management arrangements.
For example, certain statutory provisions give a right to the private owner to terminate its contractual arrangements with the serviced apartment operator by giving a specified notice period irrespective of the terms of the contractual arrangements themselves. Other provisions allow a majority of the owners to band together and vote for the entire management arrangement with respect to a particular property to be terminated. Yet other arrangements carry a further obligation for the serviced apartment operator, in such an event, to divest itself of any property that would be required by a subsequent operator to effectively take over management. For instance, if the front of house and/or the back of house is held by the operator on a separate lot.
These statutory provisions can be highly complex and apply in different ways to different aspects across the portfolio. Hence, these provisions need to be understood in great detail as they can have a material impact on the analysis that goes in to determining the value of each of the management arrangements.
Separately, Australia has licensing requirements that apply to these kinds of management arrangements, which do not necessarily apply to the operation of traditional hotels. These licensing requirements need to be understood comprehensively as failure to comply can have criminal as well as civil consequences.
There are a number of other jurisdictions outside Australia that have in place statutory provisions similar to the kind referred to here. These would need to be understood and factored in to the value assessment process for similar reasons.
- The likelihood that management arrangements can be extended.
This topic tends to occupy a lot of time when assessing how much value to place on each hotel business. For example, assuming that one of the hotel businesses generates substantial fees, but is subject to management arrangements that expire in the short term (say, in 12 months' time), what steps can be undertaken to determine the likelihood that the management arrangements can be extended and who needs to be consulted?
The incumbent operator may be unwilling or unable to answer this question. Ultimately, it is a question of the predisposition of each private owner and the owners' corporation to extend the term of the management arrangements. Because of the sheer number of people involved, it can be very difficult to make contact with enough of these people to gauge which way they will decide when the question is ultimately put to them. Therefore, various strategies need to be put in place in an effort to arrive at a rational view as to what assumptions can be made when determining the value of each business. Usually, these assumptions cannot be applied universally for all the businesses, which can introduce a further complication into the mix.
In the absence of significant under-performance or other dispute between the owners and the incumbent operator, the tendency seems to be that the owners will be inclined to extend the management arrangements. From their perspective, the prospect of finding a new operator can be difficult. This tends to result in the ability for a prospective purchaser to assume that the management arrangements should be able to be extended for a reasonable period, thus positively impacting upon the value of existing management arrangements.
- Determining how many hotels need to be acquired before the purchaser is required to proceed with the deal.
This can also be a vexing issue. Because each of the management arrangements within the portfolio may have different factors that determine how readily available assignment will be, a decision needs to be made as to which of the management arrangements need to be capable of assignment to the purchaser within a specified period. This is further complicated by the fact that the vendor and purchaser will often have competing views. It is even further complicated if the sale is being undertaken on a tender basis with more than one prospective purchaser competing to put forward the most attractive offer.
- Scope to change brand.
In some situations, the aim of the prospective purchaser is to change the branding of each of the management arrangements. The incumbent operator will usually be very resistant to entertaining this potentiality prior to completion. So, in addition to all the other factors that need to be considered, the prospective purchaser will need to weigh up the likelihood that it will be able to convince all the relevant stakeholders (i.e. all the private owners and the owner's corporation) to agree to a brand change. Similarly, the purchaser must appreciate the consequences (if any) of being unable to do this.
- The prospect of mixed use.
Mixed use occurs with respect to a particular building, where some of the private owners agree to enter into contractual arrangements with the operator and some do not.
This prospect exists in respect to buildings, where only a subset of accommodation rooms form part of the management arrangements involving the incumbent operator, with the remainder of the accommodation rooms being used for other purposes such as residential accommodation or letting through a third party letting agent. It also needs to be considered for management arrangements, where all of the accommodation rooms are currently made available to the incumbent operator. There is always a risk that some of the owners may seek to terminate contractual arrangements rather than agree to an assignment to the incoming operator.
This can create a variety of issues which need to be worked through. At a practical level, it can create friction within the owners' corporation as the owners who do not have contractual arrangements with the operator usually have significantly divergent views as to how the building should be operated. This can range from relatively substantial issues, such as the cost required for the upkeep of the common areas (with potential adverse impact on the maintenance of brand standards) to relatively trivial issues, such as the concentration and length of time that the lights should be kept on in the common areas. Over time, these kinds of issues can become quite distracting and debilitating to the operator's personnel, who are required to deal with disgruntled owners.
- The manager usually employs the employees.
In this respect, the operation of serviced apartment businesses is different from traditional hotels. With traditional hotels, generally almost all the employees are employed by the owner and not the operator. With serviced apartment businesses, the employees engaged in the business are usually employed by the operator. Hence, a significant aspect of the due diligence process would relate to matters relevant to these employees. This can be somewhat of a culture shock to traditional hotel operators who lack experience in being the employer of large numbers of operational employees. The potential legal risks and responsibilities that this entails usually requires detailed consideration.
- One and one can sometimes make three.
As a final comment, it has been our experience that when an existing operator of traditional hotels or serviced apartment businesses acquires a new portfolio it may also acquire individuals or an organisation with a different approach to the way these businesses can be operated to maximise value. In some instances this approach can be applied to the other businesses already operated by the acquirer. Thus the value of the acquisition should not only be considered in the context of the acquired portfolio but the added value it can potentially provide to these other businesses.