Lease Option Folly for Bed & Breakfasts

During these difficult times of recession and the credit crisis, we have been thinking more about the use of Lease Options as a method of transferring Inns and Bed and Breakfasts. There clearly are some advantages for both Sellers and Buyers of Inns by allowing a faster closing period without the necessity of finding hard to secure financing. The universe of potential buyers is greater because the down payment (option price) and the closing costs are lower. Yet, I remain troubled about this method for both Sellers and Buyers. Here are the details.

First let’s describe the concept. The Lease Option is an alternative route to Innkeeping. It has been used over the years when financing gets tight or when the Inn in question is underperforming and cannot achieve normal financing. The way it works is that the Seller/Lessor leases the Inn property and business to the Buyer/Lessee for a five year term, keeping in place the existing financing on the Inn. The Buyer/Lessee pays an option price for the option which is less than a normal deposit for a purchase. The Lease is triple net, and the Lessee pays for all taxes, insurance, and maintenance costs. The rent is set at an amount sufficient for the Seller/Lessor to pay its mortgage on the Inn. In some cases the rent is lower at the beginning to enhance the ability of the Buyer/Lessee to improve the Inn’s business and make the Inn more capable of being financed in the future. In most cases a portion of the rent is also set aside as a credit against the ultimate option price, thus allowing the Buyer/Lessee to build up more “equity” in the Inn over the lease term. The Seller/Lessor retains title to the Inn and all tax incidences, including depreciation. Finally, the Option Price set by the Lease is received by the Seller/Lessee, but is not taxable until either the option is exercised or it expires by time or default.

From the Seller’s standpoint, they are able to get out of the active operation of the Inn and retain the tax benefits of ownership. They receive sufficient sums to continue to pay down their mortgage, and all operating costs are paid by the Buyer/Lessee. The Seller receives sufficient funds at the outset of the option to perhaps put a sufficient deposit on a new house or set aside funds for retirement without immediate tax consequences, but will not have a large payout to say buy a new business. One key point for the Sellers is that they still own the property, and thus, in the event of a default, can get back the Inn business faster than if they had to foreclose a mortgage. Overall, for a Seller that does not have immediate needs for the whole sales price, this looks on its face like a viable alternative, particularly where an outright sale is not possible.

From the buyer’s point of view, again, this looks attractive on its face for those Buyers who want to get into Innkeeping immediately, but lack the resources to make an outright purchase. It is clearly a cheaper route, with less of a down payment, and much lower closing costs (no appraisal or bank fees or transfer taxes). It gives the Buyer five years to develop and improve the business of the Inn, at the same time building up the equity under the lease and, hopefully, improving the overall value of the Inn while the option price remains fixed. However, for both Buyers and Sellers alike, this scheme is both illusory and full of risk.

Here is the main reason why this method is folly for both buying and selling Inns. The cash-strapped buyer is likely buying an underperforming Inn which usually requires an additional capital infusion of working capital in order to improve the business. Sweat equity is fine in a start-up situation, but does not necessarily work where real hospitality experience is needed to turn around a poorly performing Inn. Most of the Inns which are using lease options are full service Inns which are even more sensitive to needing qualified restaurant experience to improve the dining room parts of the Inn’s business. A new Innkeeper, even one with some restaurant or hospitality experience still has a huge learning curve just to run an Inn, let alone improve the restaurant business. The facts are clear that 50% of new restaurants in the United States fail after 3 years, with a whopping 90% failure rate after 5 years. This makes a lease option of a full service inn even more daunting when the new Innkeepers lack hands on restaurant experience.

Another issue follows directly from the fact that the costs are lower because no financial institution is involved. Without a bank being utilized for financing, there also is no third-party looking at the historical cash flow and tax returns of the Inn business, no independent appraisal of the Inn, and, in some cases, no real due diligence of such things as the structural integrity of the building and systems of the Inn. The simplicity of the transaction belies the fact that protections for the buyer are sometimes overlooked. For example, since no title insurance is needed for a bank, often this basic protection in a sale is not present in a lease option deal. If a title problem is found later in the process, perhaps when the option is being exercised, the buyer may be at risk after it has paid the option price and all of the lease payments. Thus, in reality, almost all of the normal sale due diligence needs to be done for lease options as well, making the cost saving factors perhaps irrelevant. Finally, in our experience, with this relatively unusual form of Inn transfer, Buyers do not always receive the legal protections that they need. For example, since the lease is subordinate to the Owner’s original mortgage, at closing of the lease, the Buyer/Lessee needs to receive a Non-Disturbance Agreement from the Seller/Lessors’s bank in order to protect the lease and the option from a foreclosure which may occur due to other issues of the Seller/Lessor with that bank. This simple legal protection may not always be included in such a deal.

Let’s not forget about the Sellers as well. If the deal fails, they get the pleasure of taking back their Inn, perhaps a long time after they had stopped being Innkeepers. The failure of the option is a hard thing to keep private from the buying public, and the result may be that they have to take back an Inn at a time when it is worse off from a business standpoint. Also, if the markets are as tight as they are today, the seller may really have lost a part of the value of the Inn, and be unable to sell it after such a failure.

What we have really seen in practice in the last five lease option deals in the New England area is the ultimate inability of the Buyers to turn around the operations, and the failure to either continue to make the lease payments or to achieve financing of the option. In those cases, each Buyer lost their option payments and ultimately lost the Inn. In some of the cases the causes were due to unforeseen maintenance issues arising after the lease commenced which stripped the Inns of needed working capital. In others, the new Innkeepers had transition difficulties and basically had little inability to run complex Inn operations including restaurants. In other cases, the importance of increasing web-based internet marketing eluded the new Innkeepers, making profit margins even more difficult to achieve. In some cases, the new Innkeepers just realized after a few years that the Innkeeping life was not to their liking, and they were willing to just walk away with nothing since they had no basic personal liability like what they would have for a mortgage in a purchase scenario. The likelihood, in most cases, is that the failure was a combination of all of the above, plus the post 9/11 weakening of the hospitality market that did them in. While all of these things can affect new Innkeepers who purchased Inns the normal way through financed sales, the fact that the financial institution utilized some independent review of the transaction seems to have had a moderating impact on the risk of failure. Most Buyers when facing the failure of their business will fight hard, and perhaps use other resources (such as a part of retirement funds) to make the Inn successful. In practice, we just do not seem to see that willingness to sacrifice all in a lease option situation.

With today’s tight financing and really slow real estate markets, there will be a lot of pressure on Inn Sellers to utilize lease options to achieve their goals. Likewise, Buyers may be convinced to go forward using these methods where they cannot put down sufficient deposits to achieve normal financing or where such financing is totally unavailable due to the performance of the Inn or the credit crisis. In either case, for the reasons stated above, we feel that using this method is both folly and very risky for both sides. It is highly unlikely that we will be recommending its continued use in our consulting practice.

Buying a Bed and Breakfast in Uncertain Times

In several previous postings on our Blog, we have looked at various ways that Sellers can improve the performance of Country Inns and Bed and Breakfast Inns. All of this was done from the Sellers’ standpoint in order to add value to the sales price. In this Article, we are going to look at these issues from the Buyers’ standpoint. The central question is whether the economic meltdown of recent days provides real opportunities for Inn Buyers to obtain significant bargains? In other words, is the timing right for Buyers to buy Inns?

Here is the gloom: Clearly the Global Economic Crisis has been severely impacted by the lack of available credit. It is likewise certain that real estate prices will take a long period to recover. If banks are unable or unwilling to loan money to businesses, how can Inn purchases be financed in the near term? If Buyers are unable to sell their primary asset, their homes, they are just not going to be able to purchase an Inn.

Yet these are generalizations about the National and Global economy that are not always specifically true in every location in the Country. While we continually hear how much trouble the National and Regional Banks are in, many local banks which have been conservative in their lending practices seem to be weathering the storm. They continue to say that they have money to loan to creditworthy borrowers for good projects. This is especially true when Banks utilize the various SBA Programs which provide them with even greater security for lending to small businesses.

Thus, the immediate answer is that we believe the times may be right for Buyers who are ready and able to purchase Inns, provided that they buy at the right price. While the bottom of the Inn market has not yet been reached, some Sellers have recognized that they either have to wait for a long time to sell or they need to make significant price reductions in order to attract Buyers. Sellers may also have to offer some degree of subordinated seller financing if they want to achieve the highest value for their Inns. The key answer for both Sellers and Buyers is to find a way to price Inns fairly based on reasonable and objective business standards in order to be able to attract lenders to provide reasonable financing.

Credit standards at most banks have tightened considerably. It is clear that borrowers need to have squeaky clean credit records and high personal credit scores in order just to get the banks to talk to them. Likewise, the availability of SBA loans is entirely dependant on the credit worthiness of the particular Inn business. This means that (1) the loan-to-value ratio will be more in the 70% to 75% range today (requiring more money down by Buyers), and (2) the historic Net Cash Flow (earnings before interest, taxes, depreciation, amortization and owners’ salaries) of the Inn must be able to cover the principle and interest payments of the new loan by at least 1.25 to 1.30 times (the “Debt Coverage Ratio”).

With those very conservative lending criteria in mind, we are basically talking about Buyers buying only Inns that are performing well in today’s business climate as opposed to those Inns that have struggled in the past to achieve profitability. While many Buyers fall in love with the beautiful Country Inn or Bed and Breakfast which could be turned around to reach profitability by their hard efforts, most banks today are not going to lend on potential earnings. The banks only want to look at the past profitability, and what are the risks that, if the economy continues to slow even more than at present, how will the Buyers be able to keep the loans current?

Whether the economic slow-down will impact tourism in the long run is a key factor in all of this decision-making as to timing. It is clear that it will have an impact in the short-term, but what will next summer bring? Predicting flat or somewhat decreased sales seems too optimistic in today’s economy. We believe that sales may decrease next year by a factor of 5% to 10% as against the current year. This must be factored into the Buyers’ pricing and business plan.

In conclusion, ready and able Buyers may find this is an opportune time to buy historically well performing Inns and Bed and Breakfasts at realistic prices. The need is to search out the good opportunities from the very many non-performing Inns on the market today, negotiate the right price along with credit enhancements such as Seller financing, and take advantage of local banks with help from the SBA programs.

Best Methods for Finding the Ideal Inn

Written by: Howard J. Levitan, Oates & Bredfeldt, LLC

This is one of the most asked questions at every one of Oates & Bredfeldt’s Innkeeping Seminars. How can I find my ideal Inn? The answer is very easy, but counterintuitive. We say simply to “Stop looking at Inns for sale!” Here is why:

Location, location, location is still the golden rule. Searching for an Inn is not like buying a home (it is a business first!). We often hear, “Well, I have moved all over the United States during my business career, I can live anywhere.” Better yet, we often hear prospective innkeepers say “I will know my ideal Inn when I find it.” In order to take control of the process, every prospective Innkeeper needs to first decide clearly what they are looking for in an Inn, and, most importantly, where that Inn is located. Location will dictate the one clear factor in the Inn’s business model, the occupancy rate. While the occupancy rate at Inns will vary depending on the rate charged, or the amenities, or the size and furnishing of the rooms, or especially the hospitality provided, the key factor is location.

If the Inn is in a destination location (each state has only a few true historical destination locations), the occupancy rate will be significantly higher on average than if it is located in the countryside. Thus, occupancy rates at Inns located in destination areas like Stowe, Manchester, and Woodstock, Vermont, or North Conway, NH, or Bar Harbor, Camden, and Kennebunkport, ME can be almost twice the occupancy rates of their counterparts in non-destination areas of the same states. This is a historical factor. People have been vacationing at these locations since travel was made easy by the Industrial Age. They have a recognition factor, and Inns in these types of locations do not need to sell coming there, only how their Inn is differentiated from the other Inns. The Internet and particularly the Search Engines have heightened this effect. People may enter “Boothbay Harbor bed and breakfast” into Google, but few are going to enter “Newcastle bed and breakfast” (where our Inn was located) even though it is only a few miles away. Thus, Inns in non-destination locations need to be at the very top of their electronic marketing game just to hold their own against the destinations. Location is a critical factor, but what about price? The other side of the equation is that with higher occupancy rates, and, potentially, more net cash flow, the Inns in destination locations tend to be very expensive. You need to decide what factors are your ideals!

Creating Your Model Inn. This is the key to success. Take control of the process by clearly defining what you want in an Inn; your ideal “model.” What does it look like (style of architecture), is it full service or bed and breakfast, what kind of food service will you serve, how many rooms (dictates the need for and number of staff), is it a mature business or a start-up, and, most of all, where is the location? The model needs to be as detailed as possible; it is not something that you can just dash off in a few minutes. For couples, one of the most interesting exercises is to do this separately and then compare models. Often, there are clear differences that need to be ironed out before commencing to search. Start the process with a very exhaustive list of exactly what you want in an Inn. You may never find your “ideal” Inn, but at least you now have an objective list of what you are looking for. Put it down in a spreadsheet, so that you can compare all of these factors against each of the Inns that you look at.

Inns for Sale? Looking at Inns for sale all over any region, like New England or the Southeast, or any broad location can be an exercise in frustration. Again, it is not like buying a house. The more you see does not necessarily expand your knowledge of Inns, only of Inns that may be overpriced or have problems. The simple answer is that most very good Inns sell without the general buying public ever being aware that they are for sale. This is a confidential process. Most Innkeepers understand that being for sale may be a “four letter” word. It has an impact on the staff and clearly on the guests coming to visit. If the average life of an innkeeper is about 8 to 10 years, this means that about 10-12 percent of all Inns are for sale at any one time. Not all of these are publicly on the “market” with a broker.

Another very important factor in Inns for Sale is how the offering price may be set. What is the justification for the high asking prices we now routinely see in Inns? Does the Innkeeper decide the price based on anecdotal evidence of what other Inns in the area have sold for, or is it based on some kind of simple rule of thumb like a gross revenue multiplier? Can the Inn support normal commercial financing or does it require more equity in order to cash flow? Does the Inn’s business model have potential for growth, or is it stagnant or are revenues/occupancy falling? All of these are important questions in the process of setting the right price. Searching for an Inn which is ready to be sold, but not yet on the open market, may be the real answer to finding your ideal Inn.

The Tell-tale Signs. The Inn is for sale, but only the Innkeepers may know it. There are always clues. Perhaps it is the chipped paint on the stair treads, or the landscaping that just is not as manicured as it should be. The website has not been updated for a while. The Innkeepers are a bit tired, or you only see them occasionally; the staff is running the Inn. They have been keepers of the Inn for 8 or 9 years, and perhaps they are ready to move on. If the Inn meets your ideal model, or is close to it, why isn’t this situation the perfect solution to your Inn search? Approach them before the Inn goes on the market, and you may be able to get a much more reasonable price. The worst thing that can happen is that you are told that the Inn is not for sale. But even then, you may be able to get a first bite when they are ready to sell.

Create a Search Plan. Take your model, and visit your location. You should have a back-up location which you are keeping an eye on, but not actively searching. Visit your location as often as possible, in different seasons, staying at Inns which are high on your list as meeting your model. Network with the Innkeepers, tell them that you are searching and what is your model. Even if they are not really for sale, they can help you with knowledge of who might be thinking about selling. This is the best way to get first hand facts of what is going on in that location. The Innkeepers may not tell you financial information about their Inns (occupancy rate or average daily rate), but most are quite free with giving you everything they may know about other Inns in town. This networking is really the key to success.

Confidentiality. Remember one thing. If an Inn is not actively on the market, whether it is for sale or not, telling other Innkeepers or people in the community that you are trying to buy a particular Inn is the fastest way to lose a deal. You need to get knowledge, but not by breaching the confidentiality of the Innkeepers. Word spreads quickly in small communities and this can impact the business of the Inn that you may be trying to buy. There will be plenty of time to accomplish the due diligence that you need between the time an offer is accepted and the dates set in the purchase and sales agreement. You need to respect this!

Final Thoughts. This is all about taking control of the process. We have taught hundreds of prospective Innkeepers these lessons, and they work. Create a model, create a search plan, and then find your Ideal Inn.

2007 New Year's Resolutions

It is the start of the New Year and this is it! You have decided to finally quit your job in the corporate world and take the plunge into Innkeeping! You are serious, but what to do first? Let’s outline the seven steps to successful Inn ownership in 2007!

1. It is time for a reality check
2. Evaluate your financial situation
3. Define your Inn model and the needs of your family
4. Conduct your search
5. Evaluate the numbers
6. Make an offer
7. Quit the job and close on the Inn!

It is time for a reality check. First, ask yourself if you really want to do it? What impact will it have on the family? Do you really want to work with your significant other 24 hours a day? Can you give up the weekend activities with your friends? Can you adjust to a different lifestyle? Income will be adjusted, can you adapt or will you need a defibrillator? It is okay if you say Innkeeping isn’t for you, but if you are still saying you can deal with these changes, let’s go forward.

Evaluate your financial situation. How much money is in your savings account? What is the capital in your home? How long will it take to liquidate your home? How much money is in your 401K (we don’t really encourage using it, but it is good to have as a back- up plan)? Are there investments that can be liquidated? Will your family be able to assist you in the investment? Finally, look under the mattress and make sure that all monies are accounted for. When this is all tallied, keep in mind that a bank will be asking for about a 25% investment from you when purchasing an Inn. Now you know the price point that you can realistically afford to purchase.

Define your Inn model and the needs of your family. In the Fall, 2005 newsletter (available on our website in newsletter archives), we had an in-depth discussion on building a model. In addition to building a model that works for you, your individual family needs have to be considered as well. Do you have children at home? Are they old enough to be part of the Inn or do you need to have private space away from the Inn? Can you live in a conservative owner’s quarters to begin with and then expand into larger quarters as the time passes? All of these considerations should be incorporated into your model.

Conduct your search. Visit Inns, stay at Inns, speak with Innkeepers, and find an area where you will truly enjoy living. Join Innkeeping associations, network with other people who want to become Innkeepers, and be open to new ideas. This will be a rewarding journey if you approach it with your “eyes wide open”.

Evaluate the numbers! You have found an Inn that meets your needs. The emotions are running high and you need to make an offer before someone else buys it! STOP!! Rein in the emotions and make a logical evaluation of the numbers. Make sure that it all makes sense and hire professionals to assist you. We have been involved with too many Innkeepers who now need assistance because of financial hardships. This could have been avoided if only they had evaluated the Inn prior to purchasing it. SLOW DOWN!

Make an offer. You have poured through the numbers and everything seems to make sense. Make an offer and move forward. This is a stressful time and it is important to have a good working relationship with the Innkeeper who owns the Inn of your dreams. Howard has a saying, “there is a lot between the cup and the lip”, meaning that the offer is only the beginning. There will still be many negotiations as you work through the purchase and sale agreement.

Quit the job and close on The Inn! The offer has been accepted, you have completed the purchase and sale agreement, and the bank has approved your financing. You have waited a long time to do this and have had a good time doing it! Quit the job and don’t look back. It is time for a long overdue lifestyle change. The Inn is in your hands now. Our words of wisdom are to have a good sense of humor, remember that decorating is tax deductible, take at least one full day a week off to enjoy with your partner, and enjoy the new lifestyle. You worked hard to get here and now we want you to enjoy it!

P.S. Burn the suits now because you won't be needing them again! Have Fun!