Investors know the importance of conducting thorough due diligence in the acquisition of real estate assets. Generally speaking, the due diligence tasks for completed and stabilized projects are the same regardless of the type of assets to be acquired. For those evaluating hotel assets, however, the due diligence tasks are greater, and these expanded investigations are crucial to understanding not only the real estate being acquired, but the business that comes with it. For hotel assets, apart from the due diligence associated with tax structuring issues that arise if tax-exempt entities or REITs are involved, there are four main categories of additional due diligence required to evaluate both the real estate and the business: (i) branding; (ii) hotel management; (iii) employment matters; and (iv) operating licenses and permits. Each area must be evaluated for financial as well as legal consequences.

What's Your Brand?

While many consumers may be under the impression that every Hilton, Marriott, and Hyatt is owned by the chains bearing the same name, in reality most hotels are not owned by the "flag" associated with the hotels. Rather, institutional investors, REITs, and other third parties usually own the hotels and enter into licenses to associate the hotels with a particular hotel brand or chain. Like any brand driven business, the brand associated with a hotel can enhance the value of the real estate asset. Brands known for luxury accommodations or a hip lifestyle can command higher room rates, but such luxury and lifestyle bring higher operating expenses and more frequent capital improvement projects to remain associated with the brand.

In addition to brand value, real estate investors should evaluate the following:

  • Brand reputation and consumer demand

  • Licensing, marketing, reservations system, technical services, and other fees due to the licensor

  • Assignment rights

  • Required periodic property improvement plans (so-called "PIPs"), costs associated with PIPs, and the frequency with which the licensor may "re-PIP" the hotel and require the owner to make capital improvements to rooms, furnishings, and common areas

  • Termination rights and associated fees (characterized as liquidated damages)

  • The right of the licensor to grant additional licenses to other hotel owners and the right of the owners to own other hotels in geographic proximity to the hotel

  • The services that the licensor will provide (e.g., national advertising, centralized reservation systems, award programs)

  • If the brand will change in connection with the sale (in some cases, a hotel guest will go to sleep in a Hyatt and wake up in a Hilton), who is responsible for removing signage, branded inventory, etc., and what is the time period for doing so?

Can I See The Manager?

Sometimes the management company affiliated with the brand will manage the hotel, but often the manager will be an affiliate of the owner or a third-party management company. Changes in management of a hotel in connection with an acquisition can present unique challenges. The transition is not always seamless and can be quite rocky if the existing manager is reluctant or unwilling to cooperate with the transition, which is often the case, especially where the prior management is affiliated with a brand that is exiting the hotel. Hotel management contracts almost never adequately address transition issues, and so they are subject to negotiation, often right up to the closing. Transition issues include employment matters (discussed below), electronic transfer of guest room and function bookings, marketing proposals and other information, and final accounting matters.

With respect to the existing management, the management agreement should be reviewed to assess whether it can be terminated (if the new owners desire to install their own managers) or assigned (if the new owners want to retain the managers). In either case, there may be certain fees and costs that are due to the managers. Whether the buyers or the sellers pay these fees is highly negotiable. In some instances, the hotel buyers will not have any choice as the hotel is subject to a long-term management agreement, especially where management is affiliated with the brand. Such a management agreement may be viewed as an asset or a hindrance to prospective buyers, depending on whether the buyers believe that they can better drive revenues with a different brand or management.

In any case, careful due diligence will help minimize the costs of the transition, avoid delays in closing, and maximize the return to the investor from the revenue-producing asset.

Fired And Rehired

The third issue to assess in connection with a hotel asset is employment matters. If the hotel manager is to be terminated at closing, the hotel employees will also be terminated as the employer cannot assign its rights to the employees to the buyers. While the hotel employees will be terminated simultaneously with the termination of the manager, for a host of practical and economic reasons, buyers (or their managers) typically rehire most of the existing employees. Subtlety is required, as there often is an exodus of employees and a general reduction in service quality once word gets out that the hotel is being sold. The termination of the employees often will subject the transaction to the Work Adjustment and Retraining Notification Act (the "WARN Act") and any equivalent state laws. The WARN Act sets forth certain notification requirements in connection with any mass layoff and imposes penalties for failure to comply with these requirements. However, there are limited exceptions to the notification requirements, and, in many instances, the notification requirement may be waived if the buyers make offers of employment to a certain minimum number of existing employees on comparable terms and conditions as the employees' prior arrangements. Transitioning vacation and sick time can also present thorny issues.

As a preliminary matter, buyers should inquire as to whether the hotel employees are union employees subject to a collective bargaining agreement or if there are union-organizing activities ongoing. If there are, the union may have certain approval rights with regard to the sale of the hotel or the rehire of the employees. A union hotel may also be more expensive to operate than a non-union hotel and the financial underwriting for the future performance of the hotel will need to take into account these factors.

Permits, Licenses, & Revenues

The final additional category of due diligence in connection with a hotel acquisition involves operating permits and licenses. Room revenue is only one profit center for hotel assets; hotels often have other revenue sources that have unique licensing and permitting requirements. A typical example is a liquor license for hotel bars and restaurants, catering functions, room service, and in-room mini-bars. There are also spa or health club licenses, banquet and conference licenses, and pool or recreational facility permits. Obtaining copies of these permits and licenses is a key due diligence exercise to ensure the hotel is properly authorized to generate revenue from these services. It is essential to retain competent liquor licensing counsel or other expertise to run the gauntlet of state and local requirements to ensure uninterrupted liquor service at the hotel.

Diligence Is The Difference

Acquiring operating hotel assets requires additional due diligence that goes beyond an evaluation of the real property and the improvements. Failure to spend the required time, energy, and money on such additional tasks could result in unexpected and disappointing surprises following the closing. The purchase of existing hotel assets requires an evaluation of both the real estate and the operation of the hotel. The additional diligence could be the difference between a hotel that puts a mint on the pillow and a hotel that is itself a mint.

Goodwin Procter LLP is one of the nation's leading law firms, with a team of 700 attorneys and offices in Boston, Los Angeles, New York, San Diego, San Francisco and Washington, D.C. The firm combines in-depth legal knowledge with practical business experience to deliver innovative solutions to complex legal problems. We provide litigation, corporate law and real estate services to clients ranging from start-up companies to Fortune 500 multinationals, with a focus on matters involving private equity, technology companies, real estate capital markets, financial services, intellectual property and products liability.

This article, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. © 2008 Goodwin Procter LLP. All rights reserved.