Selling one of Newport Beach’s largest resort properties wasn’t an easy choice for Sunstone Hotel Investors Inc. Chief Executive John Arabia.
The transaction was “very bittersweet,” he said of the July sale of the Hyatt Regency Newport Beach, a 408-room property on 26 acres next to the Back Bay area.
Woodridge Capital Partners LLC, a Los Angeles-based real estate investment and development firm, bought the property for $95 million, or nearly $233,000 per room, according to Sunstone, which confirmed the deal on July 29, about a week after the Business Journal was first to report the sale.
It’s the priciest Orange County hotel transaction in over a year.
‘Aggressively Pursued’ Land
The Hyatt Regency was the only Orange County asset of Aliso Viejo-based Sunstone, which has 24 hotel and resort properties and a market value of about $3.6 billion.
Arabia, speaking to analysts on his company’s quarterly earnings call on July 31, said he understood the obvious value of owning a Newport Beach property.
The Hyatt is “a very short walk to Balboa Island, [and] is by its own definition long-term relevant real estate.”
The problem was that the Hyatt was on leased land whose owner didn’t want to sell, according to Arabia.
That gave Sunstone less financial flexibility and long-term security to consider a redevelopment of the 55-year-old hotel, which “eventually will need to be changed,” Arabia said.
“This was a piece of dirt that we aggressively pursued with the owners, the family that owned it, for the better portion of five years,” he told analysts.
Records show the land is owned by a family entity with ties to Santa Ana-based ACP Management, which has also invested in the Capri Laguna hotel in Laguna Beach.
Clock Ticking
Sunstone bought the Hyatt in 2005, when the property had about 43 years left on its ground lease. But the clock was ticking on a depreciating asset, and a relatively short ground lease limited the potential pool of buyers, company executives said.
Sunstone ultimately decided that, “we now have a 30-year lease left on this asset, and it has certain requirements,” according to Arabia. “We thought if we could not buy the dirt, that we would have to effectively cut ways with the asset.”
“Clearly, 30 years is shorter than most [would like left on a lease],” Arabia said on the conference call. At “a certain point, it starts to become more and more difficult to finance shorter-term ground leases.
“Maybe [Woodridge Capital Partners] will have better luck” in terms of future redevelopment options, and buying out the ground lease.
Higher Cap Rates
Sunstone’s issues in Newport Beach aren’t uncommon in the hotel industry, where many properties sit on leased land.
A few years ago, nearly half of Sunstone’s properties involved similar types of ground leases that required the real estate investment trust to pay rent to the parcels’ owners.
News reports on a hotel industry conference in London last month noted that one executive in attendance called ground leases “the biggest cancer in the industry,” an opinion other participants felt was too strong a statement.
Pricing is clearly affected when hotels don’t come with the land, according to Alan Reay, president of Irvine-based hospitality consultancy and brokerage Atlas Hospitality Group. Values can be impacted from 0.5 to 1.5 basis points on the cap rate when a ground lease is involved, he said.
Sunstone reported that its Newport Beach hotel sold at an 8.6% cap rate. Cap rates for comparable properties without ground lease issues tend to be closer to 7.5%, according to recent data from Westbury, N.Y.-based HVS Consulting & Valuation.
And ground lease-impacted properties “are typically harder to sell; a number of buyers simply will not touch them,” Reay said.
Others aren’t as down on the practice.
“We prefer not to have them, but the big issue is the length of the lease,” said Bob Olson, chief executive of Newport Beach-based R.D. Olson Development, which has been California’s most active hotel developer over the past decade.
Long-term deals have little impact on a hotel’s operations or value. But the shorter the remaining length of the ground lease, “the value of the [property] transfers to the lease holder,” and financing or refinancing a property becomes harder, Olson said.
In some instances, the hotel is required to be torn down at the conclusion of the ground lease.
Once a ground lease approaches 30 or fewer years, “lenders will start to ask, ‘What’s my exit,’” Olson said.
Lido Lease
R.D. Olson operates a couple of properties on leased land, most notably the recently built Lido House hotel on city-owned land in Newport Beach that was once home to City Hall.
The ground lease for the 135-room Marriott Autograph property is 66 years with a 14-year extension option, giving his company and investors plenty of financial flexibility, Olson said.
Government agencies that control underlying land have different goals than private landowners, said Olson, whose firm spent months this year negotiating with county supervisors over terms of a hotel development on county-owned property at Dana Point Harbor that would be subject to a long-term ground lease.
The developer has had informal meetings with the city of Newport Beach about buying the ground lease for Lido House, discussions that haven’t yet led to formal talks. “We have a good lease that allows the city to sell it to us when they’re ready,” Olson said.
Little Management
It’s a solid investment for a ground lease owner, said Russ Fluter, owner of Newport Beach-based Fluter Industries.
“If you are a real estate owner, you oftentimes want to own the real estate that takes the least amount of management,” said Fluter, whose real estate investment and management firm owns the ground lease on the land next to the Hyatt Regency that’s home to Palisades Tennis Club.
Sometimes, it’s just a matter “of holding the property and getting checks.”
There’s often little motivation for them to sell, factoring in taxes and the lack of other adequate properties to reinvest in, Fluter said.
“Unless you’re getting [offered] more money than it’s worth, I don’t think I’d want to sell.”
Sunstone Shift
Sunstone’s experience with the Hyatt Newport Beach has proven a bit of an anomaly for the firm during its operations under Arabia, who took the top spot in 2015.
Near the start of his tenure, nearly half of the company’s portfolio properties were subject to ground or air-rights leases. That’s down to about 18%, he said.
Along with the disposition of the Newport Beach property, Sunstone recently paid $15 million for the leased-fee interest in the land under JW Marriott New Orleans, a 494-room property it bought in 2011.
“With the consolidated ownership of the fee and leasehold [in New Orleans], we now truly control the asset, which we believe is an important component in determining what long-term relevant real estate is and what it is not,” Arabia said.
