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Outlook: Commercial

The Impact of Changes in the Motel Sector on Determining Rents and Market Value

Following on from our article Effects of the Global Financial Crisis and The Christchurch Earthquake on Nelson Commercial Property (Outlook – Issue 1, 2015), we also consider it relevant to discuss what effects these two events have had on the motel accommodation market in our region. It’s fair to say that the effects have been significant.

We set out below a brief summary of market trends over this time period.

The Ministry of Business, Innovation and Employment provide regular data on accommodation statistics throughout the country. For the purpose of this article we have focused on Motel Guest Nights and Motel Capacity in the Nelson region.


Motel Guest Nights


Motel Guest Nights for the Nelson-Tasman Region over the last seven years are as per the table.



After several years of growth the local motel accommodation market peaked in 2007 with the total number of guest nights at 448,953. Then, with the onset of the Global Financial Crisis, the market declined by 6.2% over the next two years.  This trend continued with a further decline of 6.4% between 2010 and 2012 even with the increased overseas tourist numbers that the Rugby World Cup brought to New Zealand. The trend turned positive in 2013 with an increase in guest nights of 4.2% compared to 2012. This trend continued with a further year-on-year increase of 5.2% in 2014. Current year-to-date guest numbers are also trending upwards. The recent year-to-date statistics cover the period when the Cricket World Cup games where held in Nelson. Anecdotal evidence suggests that this event had a very positive impact on the overall local tourism market.

Although the region has now experienced three years of growth, total guest nights are still 8.5% lower than they

were in 2007.  The graph below shows month by month guest nights for the last seven years to the end of 2014. This graph clearly demonstrates the extreme variation in guest nights in our region between the peak summer period (December through March) and the trough of the winter months.



Motel Capacity


Motel capacity has remained relatively flat over the last seven years with the total number of establishments increasing slightly from 91 in May 2008 to 93 in May 2015. The total daily room capacity in the region also increased from 1,158 to 1,282 over the same period.

Summary


The local motel accommodation market experienced a significant downturn following the Global Financial Crisis. Over the last seven years, the decrease in motel guest nights has resulted in average motel occupancy rates falling. This has generally had a greater effect on older style motels which have struggled to maintain market share against the more modern complexes or those located closer to the central city. This market downturn was further escalated by the Christchurch Earthquake. A number of older motel complexes or motels located out of the central city have historically relied heavily on the local tourism market as opposed to the corporate traveller or overseas visitors. Traditionally Christchurch residents have accounted for a large percentage of the Nelson summer domestic tourist market. Our research indicates that following the Christchurch Earthquake the number of Cantabrians holidaying in the Nelson region fell markedly. The local market however has recently experienced what a number in the industry regarded as the best summer period in a number of years. We consider that this is a clear sign that confidence is starting to reappear in the local tourism market.

Valuation of a Leasehold Interest 


The underlying market conditions over the past seven years have had a direct effect on the value of leasehold (Motel Business) interests. The leasehold value of a motel property comprises the chattels, together with goodwill being the business goodwill and the goodwill attached to the security of tenure of the buildings and location (lease). Like most businesses, goodwill can vary considerably. In the years leading up to the Global Financial Crisis willing buyers and willing sellers tended to have greater focus on agreeing to a purchase price based on a ratio to turnover. We consider however that this approach should only be viewed as a “rule of thumb” as it can greatly overstate the value of the leasehold interest for motel complexes with low profit margins. When assessing the value of a leasehold interest under current market conditions, we consider it is far more appropriate to assess the current market value based on the capitalisation of net operating surplus (trade surplus) approach. This method is based on the net trade surplus of the business and as such takes into account the profitability of each business.  Our analysis and research of recent leasehold sales
has further highlighted that purchasers are now more focused on the fundamental underlying profit generating potential of the business as opposed to simply having regard to turnover.

With regard to the above, at present there are a number of motel leasehold interests for sale on the open market in Nelson. Many lessees however still have an unrealistic expectation of the value of their interest based on historically outdated information. Our analysis of the four recent leasehold interest sales in the Nelson market has indicated that the increased cost of operating a motel business has far exceeded any increase in turnover over the last seven years. As such, the previous purchase price which was often based on a ratio of turnover, is no longer relevant. The recent sales do however indicate that there is currently demand to purchase if leasehold interests are placed on the market at a realistic asking price.

Valuation of a Freehold Interest 


The valuation of freehold motel interest (land and buildings) is generally assessed by way of the income capitalisation approach. This involves establishing the net maintainable income (market rent) which the property is capable of producing and then capitalising this at an appropriate rate of return. As a basis for establishing the market value level and the adoption of a capitalisation rate we have regard to analysed sales of other freehold interests which have taken place over recent times. The major factors which influence the value of a leasehold interest are the remaining lease term, quality of building improvements, passing and market rental, location and finally the alternative use potential of the property. 

With regard to the above, the most recent sales of motel freehold interests in the Nelson region have shown investment yields ranging between 6.80% and 7.60%.

Market Rental Assessment


Due to the underlying market conditions highlighted earlier, there has been limited rental growth in the motel market in the Nelson region over the past seven years. Historical hospitality industry ratios show rentals agreed on new leasing of motels were set at approximately one-third of turnover. Following the Global Financial Crisis our research indicates that there is now more acceptance of profit sharing between the lessor and lessee.  

A general ratio in the range of a 50% split of the trading surplus before wages of management, debt servicing, depreciation, capital reinvestment and taxation has been agreed. The return to the lessor provides for rent and return to the lessee provides for wages of management and return to the business being the chattels and goodwill.

Over the past seven years property rates and insurance costs have generally increased  significantly. As the majority of motel lease agreements are on a net rental basis, lessee’s have been obliged to pick up these additional costs. This in turn has resulted in little or no movement in the base rental income that the lessor receives. The increase in property rates and insurance costs has in fact resulted in the total occupancy cost rent paid by lessee’s increasing significantly over time, whereas the income generated by the lessor has held firm due to most lease agreements containing a ratchet clause which prevents the net rent from falling.

Conclusion


We anticipate a long slow recovery in the demand for motel leasehold interests, but as recent sales indicate, in addition to the increase  in visitor numbers,  things are certainly starting to head in the right direction. We consider that the demand for freehold motel interests will remain strong as interest rates look set to stay at historically low levels in the immediate future.