In this article series, Richard Vaughton shines a light on the emergence of the master lease business model in urban short-term rentals and how this growth compares with the traditional vacation rental market.

Where exactly is the short-term rental industry now?

Rentals are not new. The concept of staying in someone’s home and sharing space has been around for years. The only difference in 2020, is that we label this as short-term rental accommodation and customers are presented with a greater variety of booking options.  

Do we choose an Airbnb, an Aparthotel, a vacation rental or a serviced apartment? Should we go with our favourite brand, or is our budget tight? Should we book on VRBO, Expedia or or one of the thousands of other websites? Can we book last minute or further in advance?

The likely answer today is a combination of these options. Our decisions will often be driven by how frictionless our previous booking experience was.

As a result of progression, the lines are blurring around accommodation choice but polarising in terms of booking channels. Below the guest’s observable accommodation universe – the inventory managers, developers and finance businesses are beavering away to be part of this rapidly growing sector. The market is dividing into many short-term rentals (STRs) subsets. 

This is where, in my view, the industry stands at the start of the new decade.

What is fuelling the STR fire?

How a person chooses to both plan and stay overnight in an accommodation is rapidly changing. This is largely driven by technology, the Internet and our habits and trends. Mobile devices, and more latterly machine learning and AI have further accelerated both the market and the power players.

The result has been a significant rise in the residential and STR space.

In order to understand the growth, firstly, let’s reflect on the economics involved. In our capitalist society, the capacity to increase building income from STRs rather than residential lettings is very apparent. Airbnb is one of the companies which took advantage of the growing trend and benefitted from underutilized assets in homes and adjacent markets. A perfect storm analogy is appropriate here when all factors are considered, but as with all storms, there is damage and danger involved…

Airbnb has been a big influence on the equity investment sector, even more so than the US sub-prime fuelled property crash of 2007 to 2010. Coupled with this, EU interest rates are looking stable, but may rise slightly due to Brexit in the UK. The US looks set to stay put too

On top of this, baby boomers of the 50s are now close to or in retirement. They are seeking income from their capital and the affordability of homes is also changing dramatically at a global level. This is emphasised in cities such as San Francisco. This in turn affects the attitudes of the next generation. Millenials are resigning themselves to a lifetime of renting in many parts of the world.

A booming residential renting market

The net result is that more people need to rent homes, which has led to a property development boom in cities, now tempered with a growing suburban interest. The latter is where we could expect to see individual Airbnb growth as the markets mature and spread from downtown to ‘just out of town’. However many residential planned buildings are now being served up as STR accommodation despite the need for permanent living spaces. Why? ROI of course. 

This takeover of accommodation planned for residential living is coming from urban STRs (often now known as Airbnbs) as well as regional vacation rentals; such as cottages and villas generally in traditional holiday destinations.

The vacation rental model – the maths

The maths is simple for this model, with properties typically owned and managed by individuals or small to mid-size property managers. The more bookings made at a high value, the more money the management company earns. As does the owner. 

There are many variations in the way commissions are approached, but the net effect is that income for both owner and manager is dependent on performance, and if both contribute – then it can make for a great partnership.

And now the master leasing model….

Master leasing can be used as an umbrella term for a raft of companies who rent all available space (or a large section of it) in a building from the landlord and for a predetermined price. This lease allows for subleasing to third parties. The term ‘arbitrage’ is often used in the context of master leases and this has both upsides and downsides depending on who is arguing the case and what the lease terms actually include.

The brands who occupy these spaces can be aparthotels, serviced accommodation providers or the new breed of STR operators who have recognised the potential to offer accommodation which is bigger and better than hotel standards and to strip out the overheads associated with hotels such as redundant communal spaces and staff, replacing them with technology. Guests pay less than hotels per sqm, especially when sharing, and have more space in downtown locations.

Master leasing is not to be confused with the abundant Airbnb city management companies which represent individual owners who often ‘buy to rent’ real estate in downtown locations. There is a fine dividing line and little to demonstrate to a guest that other economics are in play. And generally they will not care. Value for money and good service is all that is required.

Are the recent massive investments warranted?

In the latter half of 2019, the question on everyone’s lips was, ‘are the sums of money being invested in these tech or real estate companies justifiable?’ The WeWork debacle may have negatively affected the investment market as a whole and may have influenced real estate prices too, as shown in New York

With IPOs on hold or recent shares dipping (Uber and Peloton for example) and local regulations on rapidly scaling companies (such as scooters), the investment climate is questionable and investors will want to see more controls and granular financial details. No doubt companies will be looking at their bank and cash reserves too.

Margin is the simple lifeblood of these businesses.

Why such a huge STR investment?

This is a million dollar question. In fact a several billion dollar question with all the current investments. In the traditional space we have witnessed Vacasa become the first VR Unicorn and we have seen Sykes Cottages purchased for about $480m recently. Sykes makes money and the results are published, so we can see what multiples are being achieved at exit. We are still awaiting outcomes from the urban startups.

In the STR space, which includes master lease and other income structured models we have seen Sonder, Lyric, Domio and Stay Alfred raise substantial amounts of money. Oyo has now entered the STR industry with the acquisition of @leisure adding a sizable portfolio to its budget hotel chain operation (note the word operation – not ownership). In January, we saw The Guild raise $25m for business travelers – so money is still flowing.

The levels of interest and investment should signify that these market sectors are going to grow exponentially and there is no reason to doubt this. 

Comparing the two models:

If we look at the current status of these models and their strengths and weaknesses then we can see why they are not blended into one homogenised global business.

Traditional VR vs urban master leasing STR:

Seasonality of destinations reduces occupancy vs Urban location increases  year-round occupancy.

Single owner per property means increased ‘relationship management’   and reduced occupancy (owner use); less quality control of property vs Multi-unit, single landlord: control over pricing and property quality; no owner usage.

Hard to standardise brand; seasonal destinations rely on tourism mainly, with less business travel vs Standardising brand by control; urban destinations see high levels of business travel and tourism.

Holiday properties can be distributed over large distances which makes management more difficult; staff are often seasonal and hard to recruit out of season vs Urban, multi-unit blocks can have local, fully employed staff and cities have greater populations to pull from.

Owners like local office representation in these seasonal destinations vs Urban businesses are more financially attuned.

Owners may not want 100% occupancy and can have a ‘wash its face only’ approach and rules on what is and what is not allowed vs The urban STR market is more focused on maximising returns.

Does master leasing win out?

Looking at the above from a commercial perspective, master leasing wins hands down. A single contract with full control over all aspects of the business and the capacity for the manager to build a brand and make more income. Or does it?

There are challenges to master leasing which are not insignificant:

Airbnb & Hotel Lobbies: Despite years of Airbnb’s influence on hotels being denounced, the company has had a dramatic effect across the globe and is seen as a threat. Airbnbs are now predominantly complete properties. The master lease companies are compounding this issue in urban centres, through little fault of their own.

The master lease businesses are modelling along the lines of hotels trying to develop brands, but removing the cost structures and investing in technology.

This has led to a kickback from the hotel lobbies, published as a ‘$5m War’ in the New York Times last year, amongst many others reports. All accommodation that is not a hotel, also falls foul of these influences. The world’s major destinations are now under attack or are implementing or considering regulations.

Traditional areas of vacation rentals are not immune and many regional holiday destinations across the globe are now under fire after many years of peaceful renting and income generation for destinations that rely solely on tourism. The residential neighbourhood complaints are easy to understand, especially as the guest demographic has changed and the lack of guest auditing has resulted in many disruptive problems. 

Increased Real Estate Competition: The significant investment in master lease businesses has made developers and building owners aware of the potential income and has made them more analytical and demanding. There are also numerous new models such as pop-up hotels like WhyHotel or YotelPad and co-living companies, or retirement accommodation to add to the rental pot.

Limited Inventory: The potential to increase residential rents through an individual’s reduced buying capacity and in some areas, lack of supply, means that residential rents can be very high, particularly in major cities. This reduces margins for the STR companies when negotiating leases.

Licensing: As mentioned above, regulations, zoning and licensing are increasingly apparent. Look at all the properties in London that have only residential use, but book more than the allowed 90 days. It’s a Barcelona waiting to happen, investors beware.

Hotel standards: Unlike many vacation rentals, city location multi-unit models often come under much more diligent safety procedures but not the same as hotels.

Government Income: Local and national governments have realised that there are unrealised income streams to be taken advantage of: licensing, inspections, higher taxes, quality standards and more.

All of a sudden this perfect business model seems to be fraught with challenges, which are not encountered by the multitude of Airbnb-style management companies or traditional vacation rentals, who in turn are also being significantly challenged, but in other ways.

The burning question is, can these threats be overcome and which model and company will win out in the end or are there new ways to look at this?

To be continued...

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