Is It Time the Short Term Rental Industry Abandon the Master Lease Model?
By David Phillips Co-Founder & President, Jurny Inc. | November 08, 2020
In 2019, WeWork was touted as one of the most valuable startups in the world with a $47 billion valuation. The company emerged shortly after the Great Recession in 2010 and transformed the appeal of co-working spaces into a solution for businesses looking for flexibility and affordable office space.
Many of the short-term rental industry's key disruptors were inspired by WeWork and operate using a master lease model, but many are finding out the hard way the model is not meant for longevity.
Its model is simple. For example, WeWork takes out long term leases on huge properties in prime locations and sub-leases it by the workstation. However, in taking on long-term leases, the company takes on massive debt. Regardless of occupancy rates, the company is always on the hook to pay rent.
While long-term leases enable the company to offer lower rents to tenants, it's also trapping the company in debt obligations.
According to Forbes, 71 percent, or $24.1 billion, of WeWork (The We Company) operating lease obligations are due in 2024 and beyond. These issues were front and center during the company's failed IPO attempt, causing the company valuation to fall by $44 billion to $2.9 billion, far less than the company owes in operating lease obligations. And its building leases are typically locked at 15 years on average, while its members have the option to sign month-to-month leases.
After watching the rise and fall of WeWork, the question becomes why is this same model still used in the hospitality industry?
Why Are Master Leases Used in the First Place?
In real estate, a master lease is an agreement where an individual or company leases an income-producing property and then subleases it to occupant tenants for rental income. In the short term rental industry, companies like Sonder and Lyric use master leases, or long-term leases, for properties, generally multi-family buildings, before listing them on short term rental platforms like Airbnb. However, it leaves the company on the hook to pay rent to a landlord regardless of occupancy, leading to a potential "WeWork situation."
There are many reasons a property owner with multiple assets would want to utilize a master lease to rent their commercial or residential properties. First of all, it creates an efficient way to consolidate assets and transfer liability of the day-to-day management from the property owner to the tenant. Additionally, master lease agreements are an excellent way for sellers to avoid a massive capital gains liability that would be payable upon sale. The benefits are endless for the owner.
For many short-term rental companies, much like WeWork, a master lease enables these companies to take almost complete ownership of a building, inserting their own design and branding. And in many cases, the tenant is able to lock in a prime location for a competitive price that may have been otherwise a long shot. Short-term rental startups initially saw, and some still do see, the master lease as a huge revenue opportunity to combine apartment-style amenities with hotel-quality services in desirable locations that blend seamlessly into a city, driving revenue per available room (RevPAR).
It seems very appealing, especially when startups like Lyric close a $160 million financing round. However, Stay Alfred, another company that operated with a master lease model, raised $62 million but wasn't structured to sustain the financial strain of the pandemic. In 2019, the company reported $100 million in revenue from short term rentals, operating 2,500 units across 33 cities. In May 2020, following a failed raise and inability to sell off assets, the company was forced to close permanently. Under the master lease model, when bookings decrease, capital quickly evaporates.
Master Leases Only Work if the Space is Occupied
The hospitality industry is notoriously vulnerable to market fluctuations caused by seasonal downturns, staff turnover and price competition. Even before the pandemic, profit margins were slim. Between travel restrictions and social distancing measures, the pandemic's impact on the industry is catastrophic.
Experts are predicting a "tsunami" of hotel closures in the near future following the recent closures of New York City's iconic Hilton Times Square and Los Angeles' Luxe Rodeo Drive hotels. The steep decline in tourism and business travel has resulted in temporary closures turning into permanent shutdowns as hotels stack up past due mortgage payments.
While short-term rentals are poised more favorably for their ability to reduce touchpoints and interactions, they are still at risk in this current climate, especially companies holding master leases, who are likely piling on debt from low occupancy rates. The master lease model can bolster revenue under the right conditions and magnify losses during downtimes if not diversified.
Unfortunately, even when travel resumes, consumer behavior and mindset have shifted. It's even evident in the trends emerging throughout the pandemic, and nearly every day introduces a new travel trend. Travelers are steering away from major cities and traditional vacation locations for the outdoors and more rural areas. Most travelers are choosing to stay closer to home. For example, booking site Travelocity noticed that most hotel bookings were within 100 miles of where travelers live.
The hospitality industry is being forced to adapt to new traveler requirements to accommodate guests. The customer service-oriented industry is being tasked with removing the human interaction that played a massive role in the guest experience. Rather than rely on staff to deliver flawless customer service, hotels are turning to automated services to reduce potential interactions. And these upgrades aren't always affordable for many hotels and short-term rental owners, but they are necessary to stay competitive in the current climate. The hospitality industry is being forced to evolve, and it only adds further expenses to an industry already pushed to the edge. One thing is certain, it is not an ideal time to be locked into a long-term lease agreement.
In many cases, like WeWork, the short-term rental industry is taking on long-term expenses and hoping for a consistent flow of bookings. WeWork accrued massive debt by committing to a debt stream that is hyper dependent on "potential" future payments from tenants. Not to mention, master leases put operators at the mercy of external factors like a global crisis to constantly-changing travel trends and inevitable industry shifts.
There is no denying the master lease has proven short-term success, but its longevity is definitely in question.
The Future of the Short Term Rentals Industry Post-Pandemic
The pandemic has left an undeniable imprint on the hospitality industry. It magnified both the industry's weaknesses and strengths. The collapse of legacy hotels and high profile startups like Stay Alfred will cause the whole industry, especially the short term rental industry, to reassess the risk involved in business. While bookings have begun to increase gradually, it will still be a while before tourism and business travel resume as usual, meaning more pressure on short-term rental margins and the master lease model. It's highly likely we will see more short-term rentals owners and operators seek financial security through long-term tenants.
Many startups and companies in the space have prioritized growth over sustainability, and that mindset will definitely shift as the industry looks to rebound. WeWork was considered one of the fastest-growing startups. Prior to its failed IPO, the company noted several potential risks, including a warning that it had increased spending to grow its business, and it might not be unable to achieve profitability.
At the time, the company was planning to expand aggressively in its existing cities and launch in up to 169 additional cities. In the first half of 2019, the company generated $1.54 billion in revenue, while losing $689.7 million in the same period. And these figures weren't impacted by a global pandemic and economic downturn.
The pandemic has pushed the industry to a breaking point and its opening the door for new solutions to emerge. Hospitality tech startups are introducing innovative solutions and alternatives to traditional models to adapt. The industry as a whole is finally embracing technology as a means for property owners to automate and streamline operations. As the industry continues to evolve, master leases will become archaic with management agreements combined with technology becoming the standard. Technology and automation could be a long-term solution to the short-term rental industry's longevity problems.
No one could have predicted the downturn this year. The companies that are able to restructure and shift to accommodate the new needs of travelers will rebound swiftly with simple changes like adjusted cleaning protocols or new technologies to streamline operations. Companies that can evolve with change will gain a competitive edge and sustainability.
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