Reprinted and/or posted with permission of the Daily Journal Corp. (2009).
Lynn K. Cadwalader is a Partner in our San Francisco office
The hospitality industry has been hard hit by the recession. This is particularly true in California, which is a major destination for domestic and foreign travelers, with travel and tourism accounting for a substantial share of government revenue in the way of transient occupancy, sales and use tax. Less travel and hotel stays have led to dramatic declines in hotel occupancy and ADR (average daily rate), significantly impacting the hotels' bottom line. Hotel owners have cut expenses to the bone and operators have cut hotel services in an attempt to stay afloat. However, these measures are often not enough, as the hotels financed at the height of the market are not providing enough income to service their inflated debt. It is estimated that there are now more than 250 troubled hotel loans in California, where hotel owners have either defaulted on their loan payments or have been taken back by the lender. More than 75 percent of these loans were financed or refinanced from 2005-2007, when there was an abundance of low-cost financing at 75 percent to 90 percent loan-to-value, some on interest-only terms.
Hotels are costly operating assets.
When the downturn first began in early 2008, the hardest hit hotels were independent, smaller hotels in tertiary markets. The downturn markedly worsened in the last quarter of 2008, and now all markets and hotel brands are affected – from smaller, limited-service hotels to full-service resorts. While all operators are suffering, the hardest hit are high-end business hotels and full-service luxury resorts, including high profile "trophy" assets. Many lenders have taken the stance "delay and forbear," not wanting (or being compelled) to mark their loan assets to market and take a write-down of their loans. Further, hotels are not like other forms of real estate. Hotels are operating assets that are extremely management intensive and expensive to run. In California, strong unions have further increased operating costs.
Understanding the management agreement is key.
Franchised or branded hotels now account for more than 60 percent of California's troubled loans, which typically operate under long-term management or franchise agreements requiring strict compliance with brand standards, significant repair, replacement and capital improvement reserves, as well as requirements for a high level of services. While the cost of operating a hotel under a brand flag can be substantial, the value brought to the table through brand recognition and marketing, a centralized reservation system and a well-organized management system, may well be worth the additional cost. What is clear – whether you represent the hotel owner, operator or lender in connection with a defaulted hotel loan – is that key to your ability to restructure the loan is understanding the hotel management agreement and all the parties' rights and remedies under that agreement.
Some key provisions and issues to consider under the hotel management agreement include the following:
Know Your Operator and the Market It is important to know the answers to the following questions: How leveraged is the operator in the particular market? What is the competition in the market and prospects for a comeback if the market is down? Is there any history on how the operator is dealing with its owners in this market?
Management Fee The management fee will be a combination of a base fee (percentage of gross operating revenue) and an incentive fee (a percentage of gross operating profit based on performance, and may be subordinate to the owner's return on equity). In a down market an incentive fee is unlikely. There may also be a minimum management fee, in which case there may be room to modify or negotiate a reduced minimum.
Term and Renewal Term Know current term and extension terms. Check for a termination penalty and its application. Certain types of sale of the company/project may be allowed without triggering termination. Term renewal is generally subject to a performance test.
"System" Charges: Advertising and Marketing Fees These fees are intended to approximate costs incurred by the brand associated with advertising, publicity and promotional activities for the resort. Brands are working to reduce these costs and may be willing to pass cost savings on to their owners. In a down market owners may be able to revisit these fees with the brand.
Cap-Ex and FF&E Reserve Agreed upon percentages as FF&E reserve (typical is 4 percent - 5 percent, often with ramp-up). Cap-Ex is part of the budget process and reserves are set to provide funds for maintenance of the brand standard. Subject to the lender requirements, the owner may be able to negotiate a temporary reduction in these reserves.
Brand Standard Compliance Requires maintenance of the hotel and related facilities at a specified "brand standard." This is the physical, operational and life safety standards established by the brand. When a project is facing financial difficulties, sufficient funding to maintain the brand standard is not available. It may be that certain capital expenditures and upgrades necessary to maintain or meet the brand standard can be postponed or amortized over a period of years when hotel revenue picks up.
Termination Typically, the owner has the right to terminate only for cause or non-performance during a "lock-out" period which is either (i) a set ramp-up period, or (ii) a period keyed to the performance test. Thereafter, the owner may terminate for any reason. Unless terminated for cause, the owner typically must pay the operator a negotiated termination fee. If keyed to the performance test, the owner may have an out if the operator is not meeting the test. Also, the termination fee may be less upon sale vs. other termination events.
Performance Test Review the performance test established in the management agreement. Failure to meet performance requirements for a set period will allow for termination prior to expiration of term or cure by the operator through cash makeup. The operator will have a reasonable period of time to cure any performance shortfalls and unforeseen conditions. Economic downturn may be considered an "adverse condition" which excuses the performance test for a period of time.
Sale of Property Review the circumstances which require the operator's consent to assignment of the management agreement. There should be standards for certain assignments which do not require operator consent. Also, consent may be required only during a specified number of years. Further, the termination fee may be less if it is based on a sale.
Employees If the management agreement is terminated and employees are employed by the operator, the owner may have the option to hire the employees. If not, employee transition may be more difficult.
Right of First Refusal ROFR can be a deal killer in a good market but not necessarily in a downturn, where the operator may be glad a new owner is coming in.
Territorial Restrictions Territorial restrictions are even more important in a down market as ADR and occupancy will decline.
Subordination and Non-Disturbance Provision The terms of the SNDA are critical, as they will set the stage for the operator's rights vis-à-vis the lender and what happens to the management agreement if the lender forecloses.
License: Conversion to Franchise There may be a right of the owner to convert to a franchise if the management agreement is terminated.
Focus on the Hotel Management Agreement
In short, the hotel management agreement is the lynchpin to a successful hotel loan restructuring. In California, where the majority of defaulted hotel loans are branded, this is particularly important. When weighing your options, and before considering termination, remember that the hotel operator views the hotel as a long-term relationship and is typically willing to work with owners on issues caused solely by an economic downturn. Further, having the hotel operator on your side may be a huge value-add in negotiating a workout with your lender.
This article is part one of three that was published in the San Francisco Daily Journal and the Los Angeles Daily Journal on October 23, 2009. Reprinted and posted with the permission of Daily Journal Corp. (2009).
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.
