As an asset class Australian hotels, particularly those in our capital cities, have been hot property in recent years and according to the expert commentators, 2016 is likely to see this trend continue(1). "Driving it all has been the growth in overseas and domestic tourism on the back of the weaker Australian dollar."(2)
For banks, financiers and other stakeholders keen to follow and support investment in Australian hotels in 2016, understanding the following will be beneficial:
- the identity and motives of the investors (which vary from recent Asian investor groups to the more traditional US and European investors);
- the issues facing the Australian hotel, tourism and hospitality sectors; and
- how to price, structure and deliver on an appropriate loan package
Set out below are a few key insights and some practical tips for financiers intending to bank on Australian hotels this year.
- The Hotel Market in Australia
The hotel and hospitality sector in Australia is attracting significant foreign investment interest, particularly from investors with an appetite for "whole of business" investments. Equally, there are some existing owners/investors looking to capitalise on often long held hotel properties in the face of:
- a lack of new supply; and
- a material uptick in demand
In the past few years, in New South Wales alone, we have seen acquisitions of the following properties– the Four Seasons Hotel, the Sheraton on the Park, the Westin and the Intercontinental (Double Bay), to name just a few. According to a recent article in the Australian Financial Review, a significant number of hotels are, or are likely to be, up for grabs in 2016, including:
- the country's biggest hotel, the Sheraton Four Points at Darling Harbour;
- the Swissotel Sydney;
- the five-star hotel component of Cbus Property's mixed-use development at 447 Collins Street; and
- potentially, the Hilton Melbourne South Wharf(3)
To date investment has primarily come from Asian and Middle Eastern investors (such as sovereign wealth funds, pension and other private funds). A characteristic of these investors has been their appetite for retaining all or part of the existing management and operating structures and continuing with relatively modest refurbishment in the near term. However, global competition appears to be heating up and there has been a "strong re-emergence of traditional older school investors from the US, UK and Europe who want to own hotels in Australia."(4)
It is well known that:
- revenue per available room (Revpar) has been rising steadily over the past few years;
- construction of new hotels has not kept pace with demand; and
- many older hotels have been converted to residential
To these factors potential investors can add:
- the declining value of the Australian dollar, after a prolonged period of strong value, which appears to be leading to an upturn in tourism;
- local and state governments that are supportive and encouraging of infrastructure investment, with the likes of new convention centres, transportation systems, casino/gambling and entertainment precincts on the horizon in many of Australia's capital cities;
- the availability of Australian debt at record low prices; and
- reasonable yields and certainty afforded by a "bricks and mortar" property investment
The economic conditions still appear to support the investment case for hotel acquisition/hospitality and tourism investment chasing a return in Australia.
- Typical Funding and Security Structures (and type of covenant packages)
Funding for hotel acquisitions is not dissimilar to most other corporate property finance transactions. Investors typically contribute somewhere between 35% and 45% of the equity and rely on debt providers, to provide the balance. Banks will apply their own financial models to the acquisition, the business and its funding requirements.
The banks will also have their own credit requirements for these types of acquisitions, typically a negative pledge limited recourse loan, coupled with security over the real property and all of the assets of the borrower entity (and possibly credit support or security from other associated entities). There may be other requirements depending on the nature of the loan, such as certain financial covenants (usually an LVR and an ICR covenant and some certainty around an ongoing capital expenditure budget) and particular consents and covenants from the hotel operators (which we will discuss in more detail later).
A very basic structure for a bank funding a hotel acquisition may be as set out in Figure A of Schedule 1.
A more complex structure may involve the inclusion of an additional entity at the borrower level. The reason for two entities at that level would be to separate out the property holding part of the business (the "propco" or "property company") and the operating part of the business (the "opco" or "operating company"). This is a strategy known as an "OpCo/Propco structure". The OpCo/PropCo structure allows the opco to keep the debt (and thus debt service obligations and associated issues, and if relevant credit ratings issues) off its books, which can be a considerable advantage and banks should be aware of the intent and likely effect of this strategy if it is presented by an investor/borrower.
- Legal DD
The legal due diligence required in connection with the acquisition of a hotel is not dissimilar to most other corporate property finance transactions. That is, a legal due diligence may consist of the obligatory:
- review of title and title issues;
- consideration of FIRB issues;
- review of the contract for sale of land;
- review of standard statutory property and building searches and reports; and tax issues such as thin cap if the investor is ultimately foreign owned
Typically a bank will seek to rely on the property due diligence prepared by the investors/borrower and their solicitors. Of course, due diligence reports of that nature have been prepared for a somewhat different purpose and so a further review of those materials and some of the underlying source materials should be carried out by the banks solicitors to confirm any further issues which may affect the bankability of the acquisition.
There are some unique features of the legal due diligence required in connection with the acquisition of a hotel such as a review required of the existing hotel management arrangements and liquor or gaming licenses (if any liquor or gaming licenses are attached to the hotel). These will be discussed in more detail below.
As ever the issue of an appropriately skilled and qualified valuer cannot be under stated. Hotels, being a specialised asset class require a level of expertise not always available from even some of the more reputable valuers.
- Intercreditor Issues
It is not the purpose of this note to describe the types of capital structuring that may be adopted in connection with the acquisition of a hotel, nor the terms of any resulting intercreditor agreements. Suffice to say, the capital structuring is not dissimilar to other corporate property finance transactions – albeit, in our experience:
- it has not been common or a requirement of the investor/borrower's to obtain mezzanine finance in connection with the hotel acquisitions in recent years; and
- it is typical for shareholder or unitholder investment to be made via the subscription for shares or units in a parent entity as identified in Figure A in Schedule 1 with the proceeds from such funds to be on-loaned, on an unsecured basis, from the parent to the borrower for funding the equity contribution (and such loans will be subordinated in all respects to any bank loan made to the borrower)
- Hotel Side Deeds
It appears to be a characteristic of recent investor activity that they retain, existing hotel management arrangements. In fact, the ability for the investors to continue to trade the acquired hotels under the same brand has been a critical investment feature in many cases.
Operators and managers of CBD and national hotels are sophisticated business operators and as such, for the certainty of their own businesses, hotel management agreements are often keenly drafted and negotiated between the parties, which may lead to intended (and sometimes unintended) consequences for a bank in connection with a hotel acquisition. In our experience, hotel operating/management agreements need to be carefully reviewed as part of the legal due diligence phase and consideration should be given to any consents and concessions required for the purposes of the banking arrangements and to deal with specific issues such as change in control. These consents and concessions are often dealt with in a side deed (or non-disturbance deed) between the borrower, the bank and the relevant hotel operator (or counterparties to the hotel management agreements) (Hotel Side Deed).
There are benefits to a Hotel Side Deed for the borrower, the bank and the hotel operator. From the point of view of the bank, the Hotel Side Deed forms an essential part of its security package and the benefits include obtaining:
- the hotel operators consent to it security;
- step in/step out and cure rights in the case of a borrower payment (or non-performance) default under the hotel management agreement; and
- direct rights to critical financial and property information
Often the banks rights under Hotel Side Deed will be negotiated to mirror the rights of the borrower under its agreement with the hotel manager.
From the point of view of the hotel operator, the side deed gives it a direct contractual covenant with the bank which:
- in the case of a borrower which has defaulted, is likely to mean continued performance of material obligations under the hotel management agreement until a "restructure" or sale of the hotel has occurred; and
- should ensure the rights of the borrower and bank are managed in a way so the operator's conduct of its business from the premises is least likely to be impacted or disturbed
- Hotel Specific Issues
Other commercial and legal issues for the banks to consider and manage in the acquisition finance process will include the setting of covenants regarding:
- capex spending (growth and maintenance);
- development requests and changes to use;
- businesses/operations (including consents to leases or licensing of site);
- environmental and heritage issues; and
- tax structuring
The banks and the investors/borrower will need to strike a balance on these covenants which meets each of their needs to effectively run the business, maintain profitability and the property.
At Kemp Strang, we have considerable and recent experience acting on significant whole of business hotel acquisitions and divestments in Sydney and up and down the east coast of Australia, having acted for:
- banks in providing syndicated or bilateral secured finance;
- investors/purchasers (both from Australia and abroad) in navigating the purchase process and where applicable, preparing foreign investment applications; and
- vendors preparing for and executing on the sale of their hotels
Known as experienced, trusted and practical commercial legal advisers, we are well placed with banking, property and finance experts and offices in Sydney, Melbourne and Brisbane to assist you with such an opportunity and we look forward to being able to share our further insights and experiences with you.
For further information please contact Matthew Wilson, Executive Counsel.
1 "Tourism boom to drive record
Australian hotel investment in 2016" by Larry Schlesinger,
Australian Financial Review, Fairfax Media, published on 8 January
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.