A Guide to Buying a Leasehold Motel
There are essentially two ways in which to purchase a motel. You can either buy the business and the freehold, or the business and the leasehold. This article will focus on buying a leasehold motel.
If you intend to purchase the leasehold, you are buying the right to occupy and conduct the business on the land. Generally speaking, the entry costs can be much lower than buying the freehold and the net return (at least initially) can be higher.
A prospective purchaser should undertake a thorough financial due diligence (with their accountant or business advisor), and a legal due diligence (with their lawyer). From a legal point of view, a review and analysis of the lease is generally a good starting point.
The leasehold interest can be purchased from either the current owner of the business (being the current tenant), or from the freehold owner (who has decided to sell only the business).
It’s important to appreciate that a tenant’s right to occupy the premises is controlled through the lease. As such, it is necessary to understand how the lease operates, and what factors need to be considered when undertaking a due diligence.
(a) Term of Lease
Motel leases typically run for a term of 10 years and provide the right to 2 or 3 option terms of 5 years.
In evaluating a business, it is critical to determine if there are a good number of years remaining on the lease. To say the least, it would be an ambitious tenant who assumes that they will be able to easily negotiate a lease extension if there are few or no options.
Typically, an additional term will only be offered to a tenant if a premium is offered to the landlord. This may be by way of a cash payment, or some agreement involving the tenant paying for capital improvements.
In order to comply with the Retail Leases Act 2003 (Act), it is necessary to ensure that any payment is proportionate to the benefit which is received by the tenant. If there is no real or true consideration given for the payment or the benefit, then it will be “key money” and cannot be accepted by a landlord.
The commencing rent is typically calculated as a percentage of the turnover and/or the net profit of the business.
One method to calculate the rent is to take 20 – 25% of annual accommodation and sundries turnover, plus no more than 8% of annual turnover for food and beverage. Another method of calculation involves estimating rental as approximately 45% of the net profit of the business.
(c) Rent Reviews
During the term, rent is typically reviewed annually by reference to a fixed amount or percentage or to CPI.
If an option is exercised, then the rent will be reviewed to “market”. This means that the landlord will propose a new rent based on current market conditions.
If the parties are unable to agree on the renewed market rent, then it is usually referred to an independent valuer for determination. The parties will be required to share the costs. Given this, a purchaser should be wary of leases which require the rent to be reviewed to market annually.
A purchaser should also be wary of leases which have underpinning or “ratchet” clauses. These are clauses which seek to prevent the reduction of rent, or limit the extent to which the rent may be reduced. These are prohibited under the Act.
(d) Outgoings and Service Charge
A tenant will typically be required to pay any costs incurred by the Landlord in owning the motel. This includes council and water rates, insurance, and levies payable to any authority (under the Act, there are limitations on the right of the landlord to recover any land tax).
The purchaser should refer to the lease disclosure statement to better understand what outgoings are payable in connection with the premises. A tenant will also be required to pay all service charges like electricity, telephone and gas.
(e) Maintenance and Repairs
A motel lease should clearly set out the obligations of the tenant and the landlord in relation to the repair and maintenance of the motel. It is a feature of most well drawn modern leases that responsibility for maintenance and upkeep of the motel is largely left to the tenant.
However, under the Act, a landlord is required to maintain the structure, the plant and equipment, and the landlord’s fixtures in a condition consistent with the condition of the premises when the lease was entered into. This means that if the place is a dump at the commencement date of the lease, the landlord will not be obliged to keep it in a better condition.
The most difficult task is often determining who owns what in the motel and who is responsible for the replacement of an item when it falls into disrepair. The general rule is that each party replaces their own property; however, it is all maintained by the tenant.
The type of pre-contract searches that are undertaken will vary depending upon the particular motel in question. However, the following searches are often sought:-
(a) Health and Wellbeing Act and Food Act Inspection
All food premises must be registered with the Council under the Food Act. A motel is also a “prescribed premises” and must be registered under the Health and Wellbeing Act. This is a separate registration.
It is strongly advised to arrange a Transfer Inspection with council to determine if any work is required on the premises. This can be extremely important when you consider the cost of compliance with any council orders or recommendations.
(b) Title Search
A title search should be undertaken to determine if the entity offering the lease actually owns the premises. The title search will also disclose if there are any registered encumbrances on title which may affect the leasehold.
(c) Planning Search
A planning search should be undertaken to ensure that the underlying zoning supports the use of the premises as a motel. If a planning permit has been issued, it is important to determine if the motel is being conducted in accordance with the plans and permits.
(d) Country Fire Authority / Metropolitan Fire Brigade
An inspection should be arranged with a CFA / MFB representative to undertake an inspection/evaluation of the premises in regard to fire and life safety matters and to obtain a copy of any relevant reports or recommendations.
(c) Liquor Licence
If applicable, a search should be made through liquor licensing to obtain copies of the relevant licence, the red-line plan, and details of any notices or orders which might affect the licence.
(d) AAA Tourism
A copy of the most recent AAA Tourism Inspection Report and details of any outstanding orders should be obtained.
It is typical that a purchaser will be required to enter into a (non-binding) heads of agreement prior to entering into a contract of sale.
It is important that a prospective purchaser ensures that it has either completed its financial due diligence before entering into the contract, or that a due diligence period is negotiated as a part of the special conditions.
If the purchaser intends to obtain finance to fund the purchase, it is essential that any offer is made subject to finance being approved on conditions which are satisfactory to the purchaser. This protects the purchaser where finance may be approved subject to onerous and unreasonable conditions.
The role of the lawyer is to assist the purchaser with the legal due diligence, and to provide advice in terms of the lease, any key contracts, the liquor licence, the way that the deal is structured, and the terms in the sale document.
The sale contract should be carefully negotiated in conjunction with the business broker, the purchaser’s solicitor and the vendor’s solicitor. A lawyer’s role is to ensure that the sale document accurately reflects the agreement reached by the parties.
The issues which frequently need careful consideration by a lawyer relate to the warranties and indemnities to be provided by the vendor, the vendor’s post completion restraints, and ensuring that the lease and any key contracts (management agreements, franchise agreements, supply agreements etc.) can be validly assigned.
About the Author
Matthew is an experienced commercial lawyer who regularly advises parties in relation to rent roll transactions. He is a member of the Law Institute of Victoria (LIV).
The information contained in this article is intended to provide general information only and is not legal advice or a substitute for it. You should always consult your own legal advisors to discuss your particular circumstances.