Lynn K. Cadwalader is a Partner in our
San Francisco office.
James M. "Jim" Norman is a Partner in
our
Fort Lauderdale office.
In Part I of our July 30, 2009 Alert, Shutting Down the Hotel or Resort Until the Good Times Roll: Is It Really an Option?, we raised some practical and legal challenges to consider in assessing the option of "mothballing" (suspending) hotel operations for a period of time while awaiting economic recovery as a way of reducing hotel operational and carrying costs.
Who knew that our idea would provoke such discussion within the industry? Discussion is always good, when well thought out and backed by solid facts. We have taken the opportunity in Part II of our alert series to dig into the mothball concept in more detail and consider the interests of the primary stakeholders in a temporary (or partial) hotel shut-down and the key provisions to consider under the various operative agreements.
Common sense dictates that there is no single, "one size fits all" solution to the challenges of the current economy and the flow of largely negative economic statistics relating to the performance of hotel and resort properties.
Lender Considerations
The lender has a great ability to control what happens to a hotel property once the loan goes into default. Its options include foreclosure (judicial, non-judicial or deed-in-lieu), appointment of a receiver and sale of its loan at a deep discount. None of these are particularly attractive. Few lenders want to wind up as the owner of the hotel. In the absence of self-delusion, operating profits are hard to come by and the lender has few sale options that would not have been available to the owner, albeit with some help from the lender, in a short sale structure. Ownership means ongoing obligations and liability inherent in asset ownership, as well as the obligation to fund operating deficits. It may also mean the obligation to pay some or all of management, franchise and asset management fees.
What Does A Temporary Or Partial Hotel Shut-Down Mean For The Lender?
For starters, it means that the lender does not have to write-down the loan, as would be the case in a fire-sale liquidation. Hotel values have plummeted in many markets, and once a foreclosure or liquidating sale of the hotel takes place, the discounted value is booked – typically at a less-than present value price due to the nature of the sale. This may not be in the best interest of the lender. A 30 cents on the dollar sale of the loan gets it off the books, but this is an unattractive business model.
While hanging on to a hotel in trouble, which also has a history of poor operating performance, is not in anyone's best interest, hanging on to a hotel which, until the recent downturn was performing well and still continues to outperform its competitive set, typically is in the lender's best interest. Other indicators need to be considered as well, such as the likelihood for a rebound in any particular market (e.g., the Detroit, Michigan market is not likely to make a timely comeback), but it may be in the lender's best interest to forbear on exercising its loan remedies and work out a temporary standstill and closure agreement with the hotel owner.
Any full or partial shut-down of hotel operations would mean that there is little or no gross revenue to cover debt service, but in addition the lender's funding of operating shortfalls ceases or is minimized. Some self-professed "industry experts" think that temporarily shutting down hotel operations is the worst decision a lender can make, and that the lender is probably better off with a quick fire sale, citing that in most cases when a hotel closes it will be worth less than half the value it had the day before. There is not much evidence to support this proposition and waiting out the recession can avoid an unwarranted decrease in value when the market returns. Of course, during the temporary or partial shut-down someone has to pay for the costs of skeletal operation, so the borrower or lender must have some liquidity and be willing to fund minimal operation costs – but the payoff can be worth it when the market turns and the lender sees the value of its asset returning. Even in this instance the lender will likely have to restructure some portion of the loan, but that amount will likely be much smaller than the write-down which is taken on a liquidating fire sale of the hotel.
If a lender agrees to a temporary shut-down, a modification of the loan documents and a forbearance period will be required. In advance of any such agreement, the lender will require a well thought-out business plan for the short-term shut-down period, with an expected pre-opening and re-opening date, procedures and budgets. The loan forbearance agreement must provide appropriate protections to allow the forbearance period to terminate in the event that the benchmarks established in the agreement for pre- and re-opening do not occur, or the hotel owner is otherwise in default of its obligations under the agreement. In order to make the closure feasible, the lender will want the borrower to show that it has funds available to fund the pared-down or skeleton maintenance and operation expenses which will be incurred during the shut-down. In such an instance, the lender will likely require that the hotel owner establish an escrow for a portion of these costs in advance. A detailed budget of these expenses should be created prior to approaching the lender, as it will be critical to establish a baseline of ongoing costs during the closure period of negative cash flow.
The lender will want to establish requirements for maintenance of the property during the closure to make sure the asset is properly maintained and kept secure. A receiver (or, outside the litigation context, an asset manager) should be put in place to protect the lender's interests during the forbearance period. The subordination, non-disturbance and attornment agreement between the hotel operator and the lender must also be modified to take the forbearance into account.
Further complications may arise in the case of a CMBS loan. With a CMBS loan, the loan servicing duties are divided among the master servicer (who manages the flow of payments and ongoing interaction with the performing borrower), the sub-servicer (the loan originator or mortgage banker who sourced the loan), and the special servicer (to whom the administration of the loan is transferred upon default and who has approval authority over material servicing actions). If the hotel owner is considering a temporary shut-down of the hotel, the loan is likely in default and the parties will be dealing with the special servicer. In the rare case that a shut-down is being considered pre-default, it will be difficult, if not impossible, to get the attention of the special servicer, who is the only party with authority to restructure the loan. Further, even if you have the ear of the special servicer, a proposed loan forbearance and temporary closure may be beyond the scope of authority of even the special servicer to approve.
It is important to stress that any full or partial closure of the hotel must be consensual among the lender, hotel owner and hotel operator, or the plan won't work. Before approaching the lender, the hotel owner should already have secured the consent of the hotel operator and, in the franchise context, the licensor, who will each have their own concerns.
Hotel Operator And Brand Licensor Considerations
Operators provide their management expertise and efforts in a "fee for service" environment. Franchisors license their brands for a fee. Directly and indirectly, the amount of the fees earned by these stakeholders is dependent on the success of the hotel. Higher revenue means higher base management fees; higher profits mean higher incentive fees. The value of a hotel management or franchising company is largely dependent on its operations and the valuation of the income stream generated by their management and license agreements. A property that is not operating is a property that is not generating fees. The operator or franchisor has not signed on for the risks of ownership and asking them to forego or lower its fees or waive termination fees is asking them to devalue their company as a whole. Further, the perception of the hotel company's brand in the marketplace is critical to its success, and a property that is not being operated in accordance with the brand standard is damaging the brand. A poor guest experience at a branded property creates a "black eye" not only for that property, but for the brand generally. Black eyes add up.
Without the operator's consent, an owner's forced closure of the hotel would, in almost all cases, constitute a default under the management agreement and subject the owner to a significant damage claim or a termination fee.
So, Is It A Forgone Conclusion That No Operator Or Franchisor Would Ever Consider A Total Or Partial Temporary Shut-Down?
Absolutely not. What is required is a plan that makes sense to all the stakeholders. If the hotel will take, for example, half its rooms out of service for 12 to 18 months, then there must be agreement as to what portion of the hotel the operator will continue to manage under the operating agreement, and at what cost (fee). If the hotel is to cease operations for a period of time, certain maintenance will still be required, the details and cost of which must also be agreed to. An interim fixed fee might be acceptable, if coupled with some other concessions to the operator, such as suspension of the performance test, extension of the term of the management agreement or imposition of a more operator-friendly incentive fee which would not likely be earned until the economy is the subject of better news than it is today. This strategy is akin to treating the shut-down like an "economic casualty loss." As we mentioned in Part I of this series, we do expect to see future management agreements contemplate these occurrences in some fashion.
There are, as part of any partial or temporary shut-down process, related parties that may have to be involved in a "hiatus agreement." In some markets, hotel workers' unions must approve these arrangements by virtue of contracts, and the specific plan may trigger federal or state laws. There have been shut-downs for renovation and sale transactions that have been derailed because of costs associated with union contracts or compliance with legal requirements. Some vendor contracts and individual employment contracts may also necessitate special review and resolution. Careful evaluation of these issues is essential as part of the structuring of the "mothball" program.
Owner Considerations
Some on the owner side believe that the hotel operator and the licensor, because they have no "skin in the game" as investors, should significantly reduce their fees or permit a sale of the property free of a termination fee. Others believe that the lender should cut principal, interest and extend the loan term. Still others see owners being able (and entitled) to sell in a market that in reality and in many locations operates more like an auction with the owner selling to the highest bidder and ending up owing nothing to anyone. However, for these events to take place, all the stakeholders must go along with the program. A better solution may be a partial shut-down, which would have the effect of balancing expenses with available revenue for a period of time.
In seasonal resort markets which have been particularly impacted by the economic downturn, a partial or temporary shut-down during off-season may make a lot of sense. For example, this past August several hotels in the Caribbean announced temporary closures in response to low occupancy, citing plans to continue with scheduled upgrades and preventative maintenance during the closure in anticipation of reopening. Seasonal and regional hotel closures due to low occupancy have also been announced recently in several U.S. markets. Is temporary closure a growing trend?
The Key Is Something For Everyone
So, as the owner, you've run the cash flow analysis, assessed the ongoing costs of full or partial operation versus closure and analyzed how to provide some future upside to the other stakeholders, including the lender and operator. It's now time to sit down and negotiate a forbearance and standstill agreement with the lender and modification agreement with the hotel operator.
- Which do you approach first? That's a relationship question for you to evaluate.
- Who is most likely to be willing to consider the option? If a special servicer is involved, plan on tackling this part of the workout last.
- Is a temporary shut-down of all or part of the hotel better than a fire sale or the mutually assured destruction of foreclosure, bankruptcy and loss of the brand? The answer that makes the most economic sense will certainly be asset and market specific and, contrary to some industry naysayers, temporary closure may just be the right answer for all involved.
The bottom line is that this is a time for reasonable and creative parties to "give some to get some." It's far better than the alternative and it's the best option in an economy where there is no "one size fits all" solution.
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.
