Freehold Going Concern
Traditionally, owner-operator dominated New Zealand’s accommodation and hospitality sector, and it remains the preferred option for many. With the development of motel leases, progressively most Freehold Going Concerns have been split into a Freehold Investment and a Business Investment leaving few Freehold Going Concerns in place. There are obvious advantages in owning and controlling both the business and the land and buildings. Under this model, your asset is both an income-generating enterprise and a substantial commercial property investment. It is both home and creates your livelihood. Each component offers growth opportunities.
The real estate asset, independent of the business, can continue to appreciate in value. Prime sites may afford excellent prospects for gain, particularly where future expansion or redevelopment potential exists. Owners are also free to capitalise on the real estate value through improvements, knowing all the effort and money invested in upkeep and upgrading will benefit you by enhancing the value of your asset.
At the same time, the value of the property relates to how well the business is run. This is because normally 25 – 33% of the gross accommodation revenue is regarded as the “Landlords” rent and it is this “notional” rental figure that is capitalised to establish the value of the real estate. The capitalisation rate (cap rate, also described as the yield) can vary depending on location but typically around 7 – 9%.
At any time, you may sell the business, (typically sale includes the chattels, goodwill and a new lease for 20 – 35 years) as a separate operation, retaining the freehold land and buildings investment. This can realise a substantial sum to invest elsewhere, while you earn on-going income from annual rental to a lessee. This option is frequently the goal of buyers who purchase a freehold going concern, fully intending to build the business before on-selling the lease.
Accommodation properties are widely considered excellent commercial investments. They generally offer far greater stability of tenancy than conventional commercial investments (shops, factories, offices) because they provide both home and business to a lessee who has made a significant financial commitment to be there. Lessees are reluctant to walk from their investment as they have too much lose. Banks favour such investments as they generally have long term leases with the freehold owner having little commitment to ongoing repairs and no commitment to the business operation. These are generally “bottom drawer” investments highly sought after by family trusts and wealthy individuals. The location of these properties is usually exceptional being on main arterial routes or high profile positions. A legally binding long term lease agreement is established, often with the landlord having first option to buy the lease should the operator wish to sell. In the unlikely case a lessee defaults on rent payments, the investor can re-sell the lease to a new lessee for another full premium and restart the lease term. We know of no other investments where the freehold owner could be financially advantaged by a lessee’s failure.
The lessee buys the lease and signs a commitment to pay rent to the landlord for use of the land and buildings. Usually the lease includes an initial term with further renewal options. Rental is based on market and is reviewed every 2 or 3 years and normally cannot fall as it is held by way of a “ratchet” clause.
The lessee must comply with the terms of the lease, paying all costs incurred in running the business, including repairs, maintenance, rates and insurance. The main responsibility of the investor is to normally cover all structural maintenance/repairs. Because your tenant has bought their business, which is also their home and income source, they will work hard to maintain and build its value – which, in turn, can be positively reflected in the value of your property asset. The better the lessee/tenant does then the more rent they can afford to pay and ultimately your investment vale will grow as well.
Purchasing a tourism accommodation or hospitality business lease is, for many, a very attractive and more affordable alternative to making the substantial commitment required for freehold ownership. Over 65 – 70% of motels in New Zealand are now owned by two parties; a landlord and an operator. Buying a lease offers higher return on investment and a much lower entry price than freehold purchase. Because you don’t have to fund the real estate component, you have a choice of larger, higher quality properties. Resale is also easier, given more buyers can afford to buy a lease than can fund a freehold purchase.
The business operator or lessee, under the standard lease model, purchases the business including chattels (all moveable items required to run a business, e.g. furniture, decor, soft furnishings, bar and office equipment), benefit of the lease term, and goodwill.
The lessee is normally responsible for the maintenance and replacement of chattels as necessary to maintain the goodwill of the business. They are also responsible for paying the rates and insurance and for day-to-day repairs and maintenance of the land and buildings. Include these items in your budget when reviewing the accounts of a business .
Under the lease, the landlord (lessor) is normally responsible for structural repairs and replacement of fixed items of equipment when required. The lessee pays the landlord an agreed annual rental which represents a commercial return on their property investment.
As leasehold owner, the business is yours to market, manage, and build for maximum profit and growth. The more business you generate, the more you earn and the more your business is worth for future resale as the Net Operating Surplus generated is used as the “profit” to be multiplied by 3 – 5 times depending the location, condition of chattels, term of lease left to run, rights of renewals and many other modifiers to the basic industry multiplier.
Management rights is the term that describes the business of looking after strata (unit) titled properties. Management Rights operate in unit-titled corporate, holiday and residential properties where a significant number of unit owners are investors, providing an effective management model for real estate investors.
It is a concept which combines property, business and lifestyle in one package. Developed and refined in Queensland, this successful management model is now widely accepted and is being adopted throughout New Zealand, Australia and a growing number of other countries including USA.
The Management Rights for an apartment building or complex are initially created by the developer or, in the case of an existing building, may be established at a later date. The package consists of long-term caretaking and letting agreements and usually includes a manager’s unit and an agreed manager’s salary. The rights are sold by assigning or transferring the agreements with the approval of the body corporate.
Management Rights are normally operated by a resident manager or corporate hotelier who:
- has a caretaking service contract with the body corporate and attends to caretaking, gardening, pool care and cleaning duties specified in the contract, as well as coordinating the work of other service contractors;
- has a letting authorisation to conduct a letting business on the premises and is the only person who can conduct a letting business on site. The resident manager is not currently required to be licensed under relevant legislation in New Zealand – unlike their counterparts in Australia;
- owns a unit in the building (or leases a designated unit) and either lives on the site or has an employee living on site;
- is a member of the body corporate (as a unit owner);
- has a financial investment in the scheme and therefore has an incentive to ensure the scheme operates well;
- maintains an office on site, either on title or with exclusive use on common property, from which the letting business is conducted.
Management Rights buyers come from diverse backgrounds. Specific qualifications are not necessary, but good management and communication skills are vital. Successful owners usually enjoy living and working in a chosen location, combining business and lifestyle advantages.
Corporate and Holiday letting Management Rights offer high returns on investment, generating income from rentals and service charges. The tourism component affords the opportunity to grow both the income and value of the business through strong marketing.
Leasehold Going Concern
The leasehold going concern scenario is fairly rare but is usually found where the Government, a Council, Church, Maori tribe or other passive investor owns land and is not interested in developing it or operating a business on it. It would have been sold to someone with a long term lease (some in perpetuity) and the purchaser developed buildings on the land in order to operate the business. That person usually pays the land owner a rental every year and the ground rent will be reviewed periodically – typically 7 years to 21 years.
In any event it is like owning a freehold going concern but you don’t own the land. Some people argue that the ground rent is the same as having a mortgage and often the return rates are lower than the banks will charge so it can be a very good deal. You will need to make your own inquiries and decisions on the issue but in any event the capital outlay required is lower and it may allow you to buy a much bigger business than a FHGC.