Over the last 5 to 7 years in the Vacation Ownership Industry, a new buzz phrase, “Asset Light” or “Capital Light” strategies has been gaining traction. While relatively new to the vacation ownership (“VO”) industry, these strategies are hardly new or inventive. Rather, they were refined decades ago by traditional hotel companies in a quest to differentiate holdings or ownership of cash flow streams to different classes of investors. This article will take a look at exactly what are these strategies and what are the causes behind its emergence as an industry-wide focal point.
A Historic Perspective
The vacation ownership industry, or as it sometimes is referred to as “shared ownership”, refers to resorts or hospitality developments that are sold as timeshare, fractionals, private residence clubs or variations of “right to use” the facilities for an up-front payment for a term of years, or in perpetuity.
Historically, all of the vacation ownership companies were independent non-branded companies. In many ways, they developed real estate for hospitality-based uses highly similar to that of their more well-known transient hotel developers. These early vacation ownership developers followed the same development process as traditional hotels and resorts. Namely, they acquired a piece of real estate generally in a resort destination, then entitled, financed, constructed and sold the real estate. As such, this process was very “capital or asset intensive”.
However, in the mid-1980s, the vacation ownership companies began to “cross over” into mainstream hospitality when the major lodging brands began to enter the industry. However, there were major differences between the “hotel divisions” and the new “vacation ownership divisions”. Since 1993, when Marriott Hotels and Resorts split their company into two separate entities–Host Marriott, which owned the real estate, and Marriott International which was the management or operating company. Most of the major hotel chains eventually followed suit in strategically decreasing their ownership of the underlying properties that they operated and adapting their business models into providing management services and brand affiliations to third party owners.
Most, if not all of the major brands in entering the vacation ownership (“VO”) industry acquired existing timeshare companies that operated as owner, developer, marketer and manager of their existing vacation ownership resorts. In short, the hotel companies were now re-leveraging up their balance sheets with hard assets and significant amounts of debt, essentially reversing three decades of moving to “asset light” companies.
An Economic Awakening
During the last 20 years, the traditional hotel companies were very satisfied with their timeshare divisions and related profitability. However, the “Great Recession” of 2007-2009 awoken most of the brands to the attendant risks of their vacation ownership divisions.
The Great Recession was accompanied with not only an economic slowdown in corporate profits and high unemployment, but was coupled with a devastating almost complete and total evaporation of liquidity in both the private lending and asset-backed securitization markets. The VO companies relied on these credit markets much more then their hotel counterparts. Why? Vacation ownership is traditionally a cash-flow-negative business model in the early years of the development and sales cycles, due to high product, sales and marketing costs, coupled with the fact that most buyers financed the purchase of the vacation ownership interest. In order to bridge the gap, the hotel companies had to “monetize” the purchase mortgages through hypothecation or securitization.
With these “lending markets” shutting down, the major hotel companies found that they had to literally stop sales of vacation ownership interests to stem the accompanying negative cash flow. This has been mitigated to a degree with the emergence of Club based systems. In Club based systems, the Club and not the location is sold. Additional inventory allows the Club to sell more points, which is the currency of “use” rights of a Club’s resorts. It was then, that almost all the major brands realized that they had re-entered the asset-intensive environment (in their VO divisions) that they had been exiting over the last 20+ years in their hospitality divisions. The solution was to move back to “capital light” or “asset light” strategies. But what exactly does this mean in the context of vacation ownership resorts?
The Capital Light/Asset Light Continuum
Mistakenly, many people in and around the vacation ownership industry see “capital light” or “asset light” as a singular strategy, typically akin to the “pure fee for service” or “PFS” operations of their hospitality sister divisions. In reality, capital/asset light is part of a continuum of potential development or product acquisition strategies which we refer to as the Capital/Asset Continuum.
There are four major strategies of inventory acquisition/development along the Capital/Asset Continuum. Most of the major vacation ownership companies use two or more of these strategies, described as follows:
Full-Scale Development – This represents the historical paradigm and is situated on the capital-intensive (left) side of the continuum. Traditionally, all of the major VO companies developed product for sale. This required substantial capital to acquire the land, take the assets through the permitting and entitlement process, take on construction debt, and hold the assets through sale. Capital intensive, full-scale development is the most stable of the supply platforms, and provides the greatest continuity to “brand standards” in terms of the quality of the final product.
Just In Time Inventory – As one moves to the right to a less capital-intensive strategy, the “Just in Time” or “JIT” inventory model emerges. A relatively new model for the VO industry, it is less capital-intensive, but only marginally so. In a JIT business model, a third party such as a fee developer or a financial entity becomes the development division of the VO Company. The VO Company enters into a forward purchase contract to purchase the inventory at specified points in time in the future, and designs the product to meet their brand standards. The forward purchases are guaranteed by the VO company’s balance sheet. In terms of benefits, it allows the VO company to out-source the development process, relieving them of the needs to carry large development staffs and land held for future development. Further, the transactions are scheduled to reduce the hold time of the completed inventory on the balance sheet. Today, one of the pioneers of this strategy is Madison54 Partners, led by Henry Silverman. Madison genreally will only take on these projects for a public VO company do to the strength of their balance sheet. Theoretically, the goal is to have the acquisition of the VO interest and subsequent sale to the consumer as close as possible. The public VO company, with its strong balance sheet provides the “take-out” money to the fee developer, at a specified point in time, with a great deal of certainty. However, in any case, the VO company commits to a scheduled take down of the entire project whether their sale estimates are met or not.
Owner Buy-Back Programs and Maintenance & Financial Defaults – Moving further to the right on the continuum, the cost of inventory is reduced through the acquisition of re-sales or defaulted inventory sometimes referred to as “churn”. Traditionally, re-sales of inventory by existing owners yielded only a small percentage of the original purchase price. Historically, such owners would either consign their interest to re-sellers or simply “walk away” from their interest as they no longer wanted to pay the ever increasing maintenance fees or special assessments. Buy back programs allow the owner to surrender their interest and not impact their credit.
Today, some of the VO companies are approaching these consumers and offering to purchase the inventory at discounted pricing. Such is reflected on their balance sheet as substantially lower “cost of sales” of the underlying interval or points. Most of the major brands have instituted some form of inventory buy backs to re-load inventory at a low financial basis. In projects that are managed by the VO company, the inventory of defaulted interests is purchased or resold by the VO company to monetize the defaulted inventory and to set up a new owner, who is committed to paying associated maintenance fees of a resort or Club.
Pure Fee For Service – To the far right of the continuum, we encounter “Pure Fee for Service” or “PFS” strategies. Fee for Service today is often confused as the singularity of what capital/asset light strategies entail. In fact, when taken to their extreme, they do represent the lightest capital structures available, and often entail little direct capital commitment on the part of the VO company. However, in a number of cases, the VO company “advances” sales and marketing expenses to the project. From each sale, the developer gets a recoupment of his costs, hopefully with a built in profit and the VO company keeps the rest of sales proceeds to recoup advanced sales and marketing expenses and a “fee” for marketing the resort.
The PFS model is largely an outgrowth the “Great Recession”, where VO companies began to gravitate away from development and its attendant capital requirements. Emerging from the recession, there were numerous leisure based developments which either had failed to open or sell product or others which were dramatically underperforming their original economic projections. Thus owners of these projects turned to PFS to convert their projects to timeshare on select basis. PFS, has some definitive drawbacks. Primarily, the developer is required to get a hypothecation line to finance the receivables sold by the VO company. The VO company intern loses the profit from the spread of the VO receivable, generally originated with a 12%-15% coupon and the underlying hypothecation line which is generally priced at 300-600 basis points over LIBOR. This financing profit can further be enhanced by securitizing a pool of receivables in an off-balance sheet transaction where the cost of the securitization falls to 1.75%-3.0% depending of the quality of the underlying paper. Additionally, by their very nature, PFS deals are opportunistic. In times of economic stress, there are more opportunities and in boom times there are less opportunities. Hence the model is not a stable supply platform and must be used in combination with the other strategies presented herein.
Summary
Capital and asset light strategies in the VO industry are among the most talked about and often most misunderstood in their breadth of application. While often looked at mistakenly, as binary (either the strategy is asset light or not), they are in fact part of a continuum in which the capital required changes based on the services and activities provided. While pure PFS will continue to grow on an industry-wide basis, it is unlikely to ever constitute the majority of revenue for any company in the foreseeable future, that seeks to grow its revenue base. Rather, combinations involving full-scale development, JIT inventory transactions, inventory “churn” from existing owners will need to be combined in order to constitute a reliable supply chain that can grow revenue and earnings over time. This is especially true for the public VO companies, who require steady earnings growth to substantiate increasing share prices.