Bright future for ground rents

Fresh from a pandemic stress test, ground rent investments in the hotel sector look poised to build in volume once more, as investor demand continues to rise.  

The vehicles are also turning, post-covid, into a sensible option for cash-strapped hotel owners to tap a new source of capital to support businesses as they rebuild trade. As with any debt instrument, there are some ground rent vehicles in distress 

In London, one recent deal saw hotel owner Vivion pull in GBP54.3m by agreeing a ground lease on the St Martins Lane Hotel. Investment manager LaSalle acquired the 200-year lease, which will pay GBP1.2m a year – reflecting a yield of around 2%. Accor manages the property, branded under its SBE collection, and the hotel is owned by Luxembourg-based Vivion.  

Vivion owns 56 UK hotels, largely mainstream branded, and in 2019 acquired the Sanderson and St Martins Lane hotels from Qatari investors for GBP255m. Shortly after completing the ground lease transaction, it was able to pay down GBP58m of secured debt, doing away with a GBP1.9m per year interest bill. St Martins is the largest hotel asset in the portfolio, which also includes large Holiday Inns in London’s Regents Park, and outside Heathrow airport.   

James Miller of CMS has advised on a number of ground lease transactions in this sector. He says the market for the instruments is recovering, after a quiet year: “In 2020, there was a scarcity of new deals, because as a lessor, there was pretty much nothing you could do if they didn’t pay.” 

Now, with an exit from the pandemic clear, “I think the positive to come out of the government’s roadmap is that there is something to work with. We are working on several heads of terms.” 

Miller sees several reasons why a hotel might look at the opportunity. “A ground lease is a good way to fund capex, or bail out shareholders who have been supporting the business.”  

He says any deal needs to thoroughly assess the risks. “You’re entering into a long term arrangement with a counterparty who is not an investment grade covenant. So you need to look at the underlying business that pays the rent. But right now, the problem is working out the income stream for 2021-22.” 

At Alpha Real Capital, Patrick Grant, co-head of long term income is looking to sign more ground leases: “Over the next year, we’re expecting to be net investors in hotels.” In general, demand from investors such as pension funds is there for an asset that they can simply hold long term, and earn a fixed return from.  

Alpha has substantial interests in commercial ground leases, with just under GBP2bn under management and around GBP400m worth of those in hotels. “Our commercial ground rents are 90% in operational real estate. And we’re always focused on diversity, but we do like hotels.”  

Grant said one of the positives to emerge from the pandemic is likely to be “it will put a stop to the overgearing of ground rents.”  

Alpha preference is for exposure to no more than 15% of sustainable NOI. A typical ground rent deal will have a 125-175 year length, with a final GBP1 buyback option for the tenant. “We’re judicious in where we set rents, and our experience has been relatively benign.” Tenants have been prepared to pay this first slice of costs in the capital stack, with a few moving to monthly payments to ease cashflow, but no defaults.  

Grant said ground leases stand in the current market as a potentially useful capital source. “The issue that people have is that banks are trying to deleverage,” and won’t want to lend further: “There are going to be liquidity issues.” The vehicle can provide a permanent, low cost option.  

Grant said Alpha is writing new leases, but will be wary of writing rents that are too high in the current environment, or of taking on assets that may see a slower return of their hotel guests. “For us, the issue is not the next two to three years, but we need to be comfortable about how they will stabilise.” It is always possible to revisit arrangements later, he said: “For us, it is easier to put more capital in, than take it out.” 

In December 2020, infrastructure investor Macquarie Asset Management launched a move into the niche. Hugo James, who moved from Alpha to be managing director in the group’s private credit team, told Hotel Analyst: “We believe that ground leases could provide an attractive new source of capital for hotel owners as we come out of lockdown – both for funding new acquisitions, and to help restructure existing investments. For stressed investment structures, the introduction of a commercial ground lease may allow the senior debt provider to have their debt materially reduced in quantum and allow working capital for the business without the need for equity holders to put in more capital.”  

“We are actively considering a number of opportunities in the sector as the long-term fundamentals of the sector remain strong,” said James. “Well-located, suitable assets with realistic forecasts and sensible capital structures remain attractive investment opportunities for us to consider.” And the main reason for turning down opportunities, he added, is where the overall leverage is simply too high, taking account of a ground lease, senior and junior debt.  

HA Perspective [by Chris Bown]: It wasn’t so long ago that ground leases were seen as financial alchemy, a sort of 2+2=5 of investment valuation – with consultants worrying out loud about how they would fare.  

But they’ve made it from that stage to what looks now to be an acceptable part of the funding landscape. Well maybe not entirely, though those involved with punchy deals, that have fallen over in the last year, were not going to talk openly to us. However, below the punchy debt threshold, there’s an appetite for the solid, very long term income streams right now, and there’s a formula that has survived one of the most turbulent periods of business in most people’s lives.  

There still remains the small issue of buying and selling hotel assets that are encumbered with ground leases, but those inside the niche believe that should not really be more than another line in the valuation spreadsheet, as an asset comes to market. With some ground rules established for that, it appears ground leases have made it from edgy financial instrument, into mainstream funding tool.  

Additional comment [by Andrew Sangster]: There is a paradox at the heart of the ground rent debate. Many capital structures featuring ground rent are seen as vulnerable in the current environment and yet, as we report, ground rent structures can be used to fix problem capital stacks. 

As with many financial instruments, particularly new or unfamiliar ones, the problem is not the approach itself but rather how it is applied. In the case of troubled capital stacks featuring ground rents, the problem has come because owners have tried to pile on too much debt, usually to bridge what was an overly ambitious acquisition price. 

In such scenarios, additional equity is usually the only solution, either from the existing owners or via the asset or assets trading. How, then, can ground rents be used with already stressed structures? The answer is found in the old joke about how porcupines make love: by being very careful. 

If there is headroom for more debt in the capital structure, which can be possible for deals struck before the market became frothier in the last few years, then there is a deal to be done. 

Traditional sources of debt capital have mostly dried up in this environment. What is available is priced, to quote one hotelier I have spoken to recently, at “eyewatering” levels. Ground rents, on the other hand, can be a much more economical way to raise debt. 

And this brings us on to the valuation issue and whether there is indeed room to take on more debt. Given how well prices have held up, the answer is that in previously well-structured deals done a few years ago, there is probably space. 

The REIT Land Securities released its full-year results this week that showed its 23-strong portfolio of hotel properties, 21 of which are let to Accor, had suffered a decrease of 13.4% in the year to 31st March. 

There is a similar decline of 10% or so that is emerging across numerous portfolios of good quality hotel assets globally, although much of this evidence is so far anecdotal. Were these assets to trade, however, it is doubtful there would be much of a decline at all. Where assets are trading, pricing is holding up at levels achieved in 2019. 

As well as the good news about values being relatively robust – remarkable given the depth of the trading downturn – there is the correspondingly good news about yields. In the case of Land Securities, it said the equivalent yield on its hotel portfolio was 5.5%. This is better than leisure at 6.9% (22.9% drop in valuation); better than regional shopping centres at 7.6% (down a massive 38.2% in value); better than retail parks at 7.6% (down 10.1% in value). 

Offices, London retail and Other Central London were better than hotels (4.6%, 4.5% and 4.4% respectively with valuation drops of 4.3%, 26.7% and 1.2%). 

This is a remarkable situation and proves that hotels are well and truly a stable asset class. 

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