November 22, 2010

Foreclosures of Hotels: Branding and Management Issues to Consider

Holland & Knight Alert
Allison McCarthy | Jerald S. Cohn

The current inconsistent performance of the U.S. hotel industry and the resulting rising defaults in loans secured by hotel projects has caused many lenders to find themselves, reluctantly, in the hotel business. A hotel property is an operating business with diverse issues unique to this type of asset, in addition to the issues associated with other real estate assets, that need to be considered by the lender in determining the most effective way to control, operate and market the asset.

In addition to the operational issues to be considered in connection with the service aspect of this asset, the legal structure of a hotel is generally more complex than other real estate assets and may involve:

  • branding and management relationships
  • extensive equity structures
  • interrelationships with residential, retail, office and condominium components in a mixed-use setting

This alert is limited to a discussion of the branding and management issues the lender must contemplate when considering its alternatives with respect to a hotel loan in default.

Hotels are either branded, meaning they are affiliated with a hotel company’s brand (i.e., Marriott, Starwood, Hilton), or independent, meaning they are not affiliated with a hotel company’s brand. Hotels may be managed by a brand manager, independent manager, or self-managed by the owner.

Franchise Relationship

If a hotel is branded, it gains the right to affiliate itself with the brand by entering into a franchise agreement or a management agreement with the hotel company.

A hotel franchise agreement grants a right or license to the franchisee to operate the hotel under the hotel company’s brand and use other specified intellectual property; it may also provide the hotel certain rights to use the hotel company’s reservation systems and other centralized services. The franchise agreement allows the hotel company to exert certain operational and quality control over the hotel in connection with the hotel’s use of the brand, but the hotel company does not manage the day-to-day operations of the hotel under the franchise agreement.

When a hotel franchise agreement exists in a loan transaction, a lender will seek to preserve the brand value of the hotel created by the franchise agreement by requiring that the hotel company provide certain assurances. Typically, these assurances are in the form of a “comfort letter” which states that the hotel company will not terminate the franchise agreement in the event that the lender enforces its loan default remedies, including taking title of the hotel property through a foreclosure or deed-in-lieu of foreclosure. In most instances, the hotel franchise agreement provides for a termination of the agreement if the property is transferred without the hotel company’s consent. Additionally, the comfort letter sets forth the conditions that must be met for the continuation of the franchise relations if a change in ownership results from the lender’s exercise of its default remedies. These conditions may require the lender to:

  • cure the hotel owner’s defaults under the franchise agreement
  • enter into a new form of franchise agreement
  • pay fees in connection with the transfer
  • upgrade the hotel to the current standards of the brand

The lender must be familiar with the terms and conditions of the comfort letter prior to the lender initiating foreclosure proceedings or taking steps to acquire title to the hotel and consider the effects of such terms and conditions on the lender’s plans for the property. For example, if the lender’s intent is to sell the hotel in the short term, the lender should consider whether it will be able to assign the franchise agreement to its buyer. If the lender intends to foreclose the property in the name of an affiliate, the lender should confirm that the terms of the comfort letter extend to the affiliate. There may be additional issues that the lender will also need to directly address with the hotel company, including negotiating a right to terminate the franchise agreement if the lender decides that the brand is not the correct brand for the property and desires to re-position the hotel.

Management Relationship

A hotel owner may elect to self-manage the hotel, if it is qualified and was approved by the lender (and where applicable, the franchisor), or engage a third-party manager to operate the hotel. A hotel owner engages a third-party manager to operate the hotel by entering into a management agreement with the manager. This management agreement generally gives possession and control of the operations of the hotel to the manager subject to limited approval rights of the hotel owner over certain critical ownership matters, such as the budget process. The manager may be a brand manager, meaning that it is a hotel company that agrees to operate the hotel under the hotel company’s brand as an obligation of the management agreement, or an independent manager, meaning that the manager’s obligations under the management agreement does not include branding the hotel. A hotel operated by an independent manager may be associated with a brand pursuant to a franchise agreement or may not be branded at all.

The lender needs to consider the terms of the management agreement in place in determining whether to retain the management company and whether the lender would be able to renegotiate some of the existing terms. The terms of management agreements are more likely to vary from project to project than franchise agreements, and there are also differences found between the typical brand-managed management agreement and the typical independent-managed management agreement that would affect the lender’s approach concerning the management of the hotel, including, for instance, brand-managed management agreements generally have longer terms with provisions that make termination of the agreement more difficult and expensive than independent-managed management agreements.

When a hotel management agreement exists in a loan transaction, a lender will generally require a subordination, non-disturbance and attornment agreement (referred to herein as an “SNDA”) to be entered into by the parties to address the rights and obligations of the lender, borrower and hotel manager. The lender should carefully review the terms of the SNDA for the transaction. As the terms of management agreements may be negotiated and vary from project to project, the terms of the SNDA tend to also vary as well in response to the specifics of the project and the lender’s concerns when the loan was made. Some SNDAs may contain provisions for rights of first refusal or cure rights under mortgage documents, which can cause problems in attempting a foreclosure sale. Additionally, SNDAs for brand-managed properties typically support the hotel company’s goal of brand continuity and distribution by requiring the lender or any transferee of the lender to retain the brand-management agreement, recognize the hotel company and not permitting the termination of the management agreement. In such instances, the lender may not have much leverage to renegotiate the brand-management agreement. There tends to be more flexibility under the SNDAs for independent-managed properties.

Unique Asset

When a lender understands the differences between hotels and other real estate assets, including the legal structure of the branding and management of the hotel, it is better able to anticipate and address the unique problems that arise to ensure the uninterrupted operation of the asset upon taking title. For example, the operation of a hotel requires employees, and depending on how the operation of the hotel is structured, the employees may be employed by the borrower or by the manager (or affiliates of either parties). The lender needs to understand the identity of the employer, the lender’s possible exposure to employee-related liabilities and the process required to replace or transfer the employees prior to taking the property back.

The operation of a hotel also requires a number of contracts, licenses and permits, which the lender needs to carefully assess as part of this process as well, and confirm that any essential contracts, licenses and permits will be in place upon the transfer of the property. If the hotel property requires a liquor license in its operations, the lender needs to give special consideration to the requirements for the lender or its transferees to sell liquor upon the transfer of the property as these requirements vary from jurisdiction to jurisdiction and may require a temporary license to be obtained for the food and beverage operations to continue uninterrupted. The transition of these contracts, licenses and permits will also be affected by whether the borrower or manager holds such items and whether the manager will continue following the transfer of the property.

Receiverships may also provide the lender with an alternative to divest the control of the hotel from the borrower while enforcing its other remedies, but as with the exercise of its other property remedies, the lender should create a strategy to effectively use this alternative that takes into account the operational and legal structure of the hotel property and the laws governing receiverships in the applicable jurisdiction, and the lender should ensure that the receiver selected has experience in operating hotels. Many hotel management companies are willing to serve as a receiver.

When considering whether to enforce its property remedies in connection with a hotel asset, a lender needs to conduct its due diligence of the property in a fashion similar to a purchaser in purchasing a hotel. The challenge in transactions where the lender is considering taking back the property is that the borrower in default might not be as cooperative as a willing seller. In fact, becoming the hotel owner responsible for funding operating shortfalls may create greater problems than it solves. Given the unique and complex aspects of hotel collateral, before initiating remedies a lender should seek the assistance of a team with experience in the hotel industry to assist it in formulating and implementing the best strategy for the hotel asset.

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