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James Canavan, the founder of the Regency Group had a piece of land of 4000 square meters and is planning to develop a hotel on such land which was a lifelong dream for him. There were many options available to him by which he could finance the hotel. The initial option was to get it capital financed from a bank which was at a higher cost as there was no brand name involved and James had no experience in the hospitality field. Then there was an option franchise under a renowned apartment hotel chain but the ownership will be of the Cest Group and James would merely be a landlord. The option as proposed by the Allwood group was the most feasible as they provided the sale and leaseback which will transfer the risk and rewards and will also provide the brand name to the new hotel. Allwood's hotel was due in 2020 which when combined with James' hotel will fetch him a good deal and will be beneficial for James.
Table of Contents
Evaluation of deals and scenarios
The founder of the Regency Group, James Canavan always dreamt of owning a hotel although he started small and learning from his mistakes, he was able to establish several shopping centers and building both residential and commercial. He purchased a land which was just 10 minutes away from CBD 30 years ago at $350,000. Rothbury evolved over the years to become a hip and happening suburb which increased the value of land and soon the mortgage on the land was lifted. The increase in warehousing in the area fetched James $25,000 per month from the warehouse and the land associated.
Over the years, due to the rust and general wear and tear of the steel warehouse valued at $1,200 only. The surrounding area near the land redeveloped leaving James with many opportunities for development of the land. Argon Developments made an offer to purchase the land from James at $5 million but James envisaged developing a hotel on that property. He set his team to research about the same and the following options were narrowed down and each of the independent scenarios is analyzed as under.
One of the simplest scenarios is to just sell off the land to Argon Developments and take up the $5 million as offered by Argon. This way he will be able to generate cash flow and can invest the same in the present business of Regency group or some new diversification of business. As said it was the simplest option but creating business opportunities should be analyzed before selling the land. The opinion given by Sophie Lonsdale, who is a hospitality consultant and hotel development specialist, was that the hotel business was a good opportunity and in the CBD area, two new hotels were to establish in 2020 and 2021. She was also of the opinion that the hotel was slightly far from the CBD. The Regency Group concluded that they could build a service apartment-style hotel and the target customers would be corporate clientele for longer durations and this will also be different from the two hotels that were going to be established in the future.
The Regency group wanted to build a 110 room, 4-star hotel which would cost $180,000 per room totaling to $19,800,000. The initial intention of James was to operate and brand the hotel by him but he was not aware of the work involved in it. The first and foremost option available to the Regency group was to get the amount financed from a financial institution in the form of a loan. There were two different banks which offered two different loans as follows:
Generally, the Regency group could borrow at 5% Cost of Capital but the hotel business is a new line of business and the absence of affiliation with a known brand by the Regency Group increased the interest rate and reduced the loan to valuation ratio. Both the banks required the company to maintain the Debt coverage ratio of at least 1.5 times of EBITDA which was very difficult to maintain at an initial level because of the higher cost of construction and lower-income. Therefore these offers were not lucrative and more so the requirement of personal guarantee by the Allstar Bank had the risk to the involvement of James' other business and personally owned assets. Herein James Canavan will be the owner of the hotel but the extra interest cost of 2% - 2.5% will be a huge burden.
James could afford an amount up to $4,000,000 and raise the balance through equity issues but the cost of the same was between 15-20% which was very high. He could also enter in a joint venture partnership which may provide him with a known brand and could also help in the operation of the hotel. The financial feasibility of issuing equity is least cost-effective. The issue of equity will dilute the ownership of James. Although James was reluctant in entering into a joint venture as well but a partnership will be better for the group as that would help the company not only in the financing in the construction of a hotel but also in the management and operation of the hotel being constructed. James will be a partial owner in the same.
James approached Oliver Thumb from Cest Apartment Hotels and they showed interest in the project as proposed by James. They gave the following options to James regarding the hotel:
In the offer made by Cest, the capital funding will be provided at a lower cost which will be financially feasible but the ownership will be of the Cest Apartments Hotels. Both the options were beneficial from the other offers made to James. But as he wanted to own and run a hotel business, James would not want to work under this model. Selling the property after the development of the hotel would not be a feasible option but working under the franchise of the Cest Apartment Hotels which currently owns 20 hotels will give a boost to the already settled brand.
The last option was proposed by the Allwood Hotel Group which will manage the property using one of the subsidiary brands of Allwood. They offered a lease and buy-back agreement wherein James would initially sell the property as developed to Allwood and again take the same on lease. Allwood was also under construction of another hotel which was due in 2020 which has 120 rooms. This would give superiority to the Allwood as a brand in the area and will also benefit both the hotels in economies in scale. This will be classified under a finance lease. James was concerned about the appropriate amount of capital funding from the Allwood group.
James could also use the pre-sale method to raise the funds and can sell a portion of the property to some investors who will have a guaranteed return. He could sell the management rights of the hotel and can fetch up to $2 million. Given that James has a sum of $4,000,000 available with him, and to raise $19,800,000, he will have to sell more than 87 units which will make the operations very clumsy. In selling the management rights will fetch $2 million but he will lose control over the operations of the hotel but he will remain the owner of the hotel.
The offer that was made by the Allwood Hotel group was the most feasible as the hotel developed by James would get the brand name of Allwood who already has experience in running hotels and the hotel is starting in 2020 would empower the superiority in the area. They could get the benefit of the economies of scale and having two different types of hotels under the same brand name will give the customers more options as per the requirements of the customer.
The other options available are not cost-effective or not feasible. By selling the management rights James will lose control over the operations of the hotel bit he will remain the owner of the hotel. In the case of a loan, the average cost of capital will be very high and the operations of the hotel will become very difficult as James does not has an experience, and also there will be no brand associated with the hotel.
The option from Cest Apartment Hotel is also associated with the brand but the franchising model will involve more control from James and less involvement from the Cest group which in the future may create problems for the companies.
Therefore, the best option will be the Sale and leaseback transaction which will also be cost-effective and efficient working. The finance lease will also provide the ownership to James in the future and the operations could be worked out together by both the hotels in the area. The management would become easier for both the hotels.
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