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Hotel Lending Lawyer: What Every Hotel Lender Needs To Know About Hotel Franchise Agreements

Hotel loan problems and hotel loan document issues are best dealt with at the loan origination. Do you know these fundamentals about your hotel loan documents dealing with hotel management agreements (HMAs) and hotel franchise agreements? There is a long list of things every hotel lender should take into account before making a loan so that it will be protected when a default occurs — much less a foreclosure. But few considerations are as important as dealing with issues raised by HMAs and hotel franchises. Lenders need hotel-specific experience not just real estate experience because, “You don’t know what you don’t know.” And what you don’t know can cost you a bundle. Because a hotel’s operating business is inextricably intertwined with single-purpose real estate, the borrower’s financial obligations are exceedingly complex.

Why hotel loans are different than other real estate loans

Hotel lending involves more lending to an operating business than lending to an owner of most types of commercial real property. Unlike typical real estate, hotel revenues are cyclical and not fixed. In fact, hotel revenues change daily. (That can be good news, as hotels can be a solid inflation hedge.) An experienced hotel lender will structure its loan with hotel-related loan covenants consistent with the hotel’s operating results, so that loan payments will more closely match the fluctuating and cyclical nature of hotel revenues. Further, because the hotel is an operating business, the hotel will succeed or fail by the actions and inactions of the hotel management team. Running a hotel is much more difficult than running a traditional real estate project. Because many lenders handle their hotel lending out of their real estate lending department, they often make the mistake of twisting their real estate secured loan documents to include hotel lending provisions. This is always a mistake. We have to remind these lenders that “You don’t know what you don’t know” when it comes to hotel lending. Hotel loans need to be in the hands of legal and business hotel specialists. Because the operating business of the hotel represents at least half the value of the hotel, the hotel lender has to be tuned into issues that arise in the running of the hotel.

Such issues include hotel projected revenues and expenses, marketing, trade credit, capital and operating costs, revenue enhancement and cost containment, employment and unions, ADA compliance, labor and employment, branding, back-end systems, and so forth. Any good commercial real estate lender will plan for an exit strategy in the event the borrower should default. For the hotel lender, this means it must be prepared to own and run a hotel. Hotel management and branding are keys to a successful hotel. The hotel lender has to understand thoroughly the hotel management and franchise arrangements. An experienced hotel lender will be well aware that the hotel and franchise agreements carry significant obligations, burdens and requirements on the hotel owner’s part. The hotel lender must confirm that the hotel owner has the financial resources and experience to comply with them. The hotel lender also needs to understand the other costs associated with the hotel management and franchise agreements, how these issues impact the value of its collateral, and how these agreements impact its rights and remedies as a hotel lender. For example, such arrangements will have a significant cost structure, including a requirement that the hotel owner pay a variety of fees beyond the base fee, such as incentive fees, marketing fees, centralized system fees, consulting fees, and so forth. This fee structure can often be three or four times the base fee amount. This is why the hotel lender needs to take a systematic approach to reviewing the hotel and the hotel operating documents.

Buying a Hotel and Financing Hotel Purchase

Buying hotels is in vogue right now. But financing hotel purchases has some twists every borrower should understand. The industry fundamentals continue to go from good to better, and values are increasingly favorable compared to alternative investments. Many think that this is the time to jump in, before it is too late. Most hotel buyers will want financing. Some of the big REITs or other cash rich players will buy for all cash and then find financing at their leisure. That gives them an advantage in bidding on hot properties. But most buyers will want financing to pay for their acquisition. Either way, there are some things your mother may not have told you, but as a buyer (and a borrower) in a hotel purchase, you really should know these 10 things that my partner, hotel lawyer Jeffrey Steiner, lays out for us in his article. The following are some special aspects of hotel lending for borrowers to be aware in negotiating hotel loans. Many of this matter are appropriately addressed at the term sheet or commitment stage, rather than leaving them to be negotiated in the loan documents.

Franchise Agreements; Comfort Letters.

A hotel franchise may be important in the lender’s underwriting of a hotel’s economic performance. Many contracts valuable to the real property collateral for a hotel loan, such as leases and management agreements, can be collaterally assigned to the lender and preserved after a mortgage foreclosure. However, major brand hotel franchise agreements typically are not assignable to hotel lenders and are not assumable by a foreclosure purchaser. Also, the hotel lender is exposed to the risk of a borrower default under the franchise agreement and its termination before the hotel lender is in a position to cure. In the absence of a separate agreement between the hotel lender and franchisor, the hotel lender faces the risk of franchise loss following a foreclosure or imposition of new franchise fees, property improvement requirements (known as a property improvement plan or program (PIP)), or more stringent franchise terms as a condition of franchise continuation.

Comfort Letters. To improve the lender’s position, typically it will require the franchisor to enter into a separate agreement addressing lender cure and franchisor termination rights upon a borrower franchise agreement default and lender rights to continue the franchise after a foreclosure. This agreement is known as a “comfort letter.”

Typical terms of a comfort letter. The following are some typical terms of a comfort letter:

• Franchisor default notice to the lender and lender cure rights, including time extensions (such as 120 days) for the lender to gain access to the hotel through a receiver or by completing a foreclosure before the franchise rights are terminated;

• the lender’s right to obtain a new franchise agreement following foreclosure without having to pay a full franchise application fee or complete a PIP, or continue the existing franchise agreement for a limited period while the lender decides whether to continue it on a longer term basis or permit a purchaser from the lender to make that decision without the lender incurring franchise termination fees;

• the lender’s right to transfer the franchise agreement post-foreclosure to a hotel purchaser and be relieved of future liability under the franchise agreement;

• the lender’s rights to transfer the comfort letter benefits to its successor, if it sells the hotel loan.

The hotel lender will require a borrower covenant to perform its obligations under the franchise agreement and not amend or terminate the franchise agreement without the lender’s consent. The borrower should negotiate for exceptions to the restrictions on amendments for minor changes and modifications not detrimental to the lender’s interests, such as a franchise fee reduction or term extension. Also, the loan documents should detail the time the lender has to respond as to whether proposed amendments are approved and what happens if the lender does not respond on a timely basis.

Hotel Management Agreement; SNDAs

The hotel lender will typically also require the assignment of any hotel management agreement to it as additional loan security. If the hotel manager is a borrower affiliate, the hotel management agreement, or at least the manager’s right to fee payments, will have to be subordinated to the hotel loan payments. The borrower will be restricted from amending or terminating the hotel management agreement without the lender’s consent. The borrower may want to negotiate for rights to terminate for a manager default or performance test failure, or to make modifications that are minor or not detrimental to the lender’s interests without having to obtain the lender’s consent, such as management fee reductions, or a term extension if the manager is not in default.

Do’s and Don’ts for Distressed Hotels

The hotel lender may require the borrower to replace the hotel manager if there is a failure of financial covenants in the loan documents. The borrower should determine at the loan commitment stage what rights the lender will require to force the hotel manager termination. That way the borrower can evaluate whether it has those rights under the hotel management agreement or if the manager will modify the borrower rights to terminate to conform to the loan documents. Even if the borrower can terminate the hotel manager, the logistics of doing so while remaining in compliance with the loan document covenants may be difficult, unless the covenant terms are carefully negotiated in the loan documents. The loan documents will generally require that the hotel continuously be managed by a qualified hotel manager, while any new hotel manager and new hotel management agreement must be approved by the lender, which can take time. The borrower may be able to negotiate in the loan document a standard for new hotel manager qualification and permitted new hotel management agreement terms, so that the selecting an replacement manager selection process can be streamlined.

For instance, if the hotel is branded, the franchisor may maintain a pre-approved management company list, and the lender may allow any franchisor-approved management company to be the manager. A hotel management agreement is a contract for services that binds the hotel owner, but not the hotel real property, as distinguished from a lease of hotel space, for instance, that creates a real property interest to which a future hotel owner’s rights will ordinarily be subject. A successor hotel owner, including a lender acquiring by foreclosure, is not typically bound by the hotel management agreement and may terminate the existing hotel manager without liability to it. Major hotel management companies entering into long term hotel management agreements may require that as a condition of the hotel owner obtaining a hotel loan, the general legal principles regarding hotel management agreement survival be reversed. This change is accomplished through a separate agreement of the lender to be bound by the hotel management agreement following a foreclosure, which is commonly known as a Subordination, Non-disturbance and Attornment Agreement (SNDA), a name taken from the real estate leasing world. Lenders also may have want an SNDA with the hotel manager confirming the subordination principle, providing for the lender to receive notices of default and cure rights before the hotel management agreement can be terminated, and imposing restrictions on amendments and terminations without lender consent.

Hotel Cash Management

A cash management mechanism is required in almost all major hotel loans, particularly for loans to be securitized. The cash management system ordinarily requires that hotel revenues be deposited directly into a bank deposit account sometimes referred to as a clearing account or lock box that is blocked to borrower withdrawals. The borrower is required to send payment direction letters to credit card processors and other major hotel revenue sources, such as travel agencies, group travel organizers, airlines, and retail tenants, requiring them to make payments into the clearing account. The next stage of the cash management system is more critical to the borrower in terms of its practical effects on day to day hotel operations. In the more restrictive version (sometimes known as a hard lock box or cash management arrangement), the clearing account receipts are swept periodically into a lender-controlled account for distribution to subaccounts, such as for debt service, property taxes, insurance premiums, capital reserves, and operating expenses or excess cash flow subaccount. The subaccounts are filled from the available cash in the clearing account in the priority set forth in the loan documents known as a “cash flow water fall.”

In this arrangement, the amount payable for operating expenses may be based upon a lender approved annual operating budget, or the amount in the excess cash flow subaccount will be distributed to the borrower’s operating account for use to pay operating expenses instead of there being a specific allocation to an operating expense subaccount. The borrower’s right to the excess cash flow or operating expense payments may be suspended in the case of loan default. In the less restrictive system more favorable to the borrower (sometimes known as a soft lock box or cash management arrangement), the funds in the clearing account will automatically be distributed or swept to a borrower operating account for use by the borrower in its discretion, until the lender notifies the clearing account bank to cease the sweeps to the borrower operating account. The lender may terminate the sweeps to the borrowing operating account upon a loan default or other triggering events identified in the loan documents, such as a debt yield or debt service ratio test failure. When those sweeps terminate, the funds will be redirected to the cash collateral account and handled in a similar fashion as in the hard cash management system. In negotiating the cash management system details, the hotel owner should take into account the requirements of its hotel manager, which may want hotel revenues to flow through its cash management system, so it has control over the funds to pay hotel operating expenses for which the manager may have personal liability, such as employee wages and benefits. It is advisable for the hotel owner to build in flexibility to meet lender cash management requirements when it negotiates its hotel management agreement.

PIP Reserve And Capital Reserves

PIP Reserve. If the hotel financing is funding a branded hotel purchase, the franchisor may require a PIP to be completed following the closing the purchase and finance closing. A hotel lender will typically require that the borrower deposit funds needed to pay for the PIP (plus a contingency) in a pledged reserve account or in a “hold back” from the loan proceeds to be disbursed to pay costs as the work progresses or upon completion. Alternatively, the borrower may be able to negotiate to substitute a letter of credit for the reserve account. The lender may also require a completion guaranty from the borrower’s principals, or if the borrower has strong enough sponsorship, the lender may accept a parent completion guaranty in place of the reserve. The borrower should make sure the loan document terms for reserve disbursements are consistent with its cash flow requirements for funding the work, and the time schedule for progress payments to the borrower’s contractor. To allow the borrower to complete the PIP work in an orderly manner and in accordance with the franchisor’s time schedule, the borrower should negotiate for the Approval Mechanism to apply to lender approvals of plans, design changes, contractors, and applications for payment.

Capital Reserve: The hotel lender will typically require that a capital reserve be funded periodically from hotel gross revenues, usually 4% of gross revenues, and deposited in a lender controlled account. The loan documents will address the permitted capital reserve uses, and the conditions upon reserve disbursements. If lender budget approval is required, the capital reserve use may be limited to projects identified in the budget, or else, the capital reserve funds may be available for any projects necessary to keep the hotel in the condition required by the loan agreement, franchise agreement, and hotel management agreement. The conditions upon disbursement may include lender approval of the contractors, plans for major projects, bonding requirements, invoices and lien releases in applications for payment, and title insurance endorsements. Borrower compliance with these requirements may be burdensome and expensive. Through negotiation, certain requirements may be eliminated or restricted only to projects costing above a minimum threshold. Exceptions to the requirement that capital expenses be on the approved budget may also be qualified for improvements to meet brand standards, improvements costing less than an agreed upon maximum, code-required improvements, and tenant improvements. The Approval Mechanism should also be applicable to lender decisions concerning capital reserve use.

Motel Annual Operating Budgets

The degree to which a hotel lender will require control over the hotel’s annual operating budget will depend in part upon the level of cash management control imposed. In those cases, whether at the loan inception or following a triggering event, where the disbursements to the borrower to pay operating expenses are subject to lender control, it follows that the lender will have to approve the annual operating budget. Where the cash management controls are not as strict, the hotel lender may be willing to forego budget approval, particularly for lower loan-to-value ratio loans. Also, if the annual operating budgets are being prepared by a major hotel management company, the hotel lender may be willing to eliminate budget approval as long as that management company operates the hotel. In any case where lender approval is required, the borrower should negotiate for coordination of the lender approval process with the time schedule for budget delivery and approval in the hotel management agreement. Provisions addressing the temporary budget to be used if the final annual operating budget has not been approved in time, and dispute resolution provisions in the hotel management agreement, also need to be consistent with the loan documents. Finally, having the Approval Mechanism apply to the lender-budget approval is an important part of the coordination effort.