Hotel owners have many considerations when choosing between a franchise agreement or a management agreement with a hotel brand, most crucially factors such as how much control and flexibility an owner wishes to maintain versus the expertise and full suite of services brand managers can bring. While rarely the primary driver of the decision, this choice would also have material implications on financing the property. Mortgage lenders will, like owners, find increased control and flexibility in connection with the lenders' rights within a franchise arrangement. However, those same lenders generally see brand-managed properties as a lower-risk asset given the hotel brand's stability, oversight, and commitment.
Mortgage lenders' rights are established pursuant to comfort letters in franchise arrangements and subordination, non-disturbance, and attornment agreements (SNDAs) when hotels are brand managed. Franchisors and brand managers have drastically different responsibilities from one another. Thus, comfort letters and SNDAs provide lenders with correspondingly different rights and obligations. Similarly, they each reassure a lender that, upon foreclosure, the brand will allow continued operation under its name, provided certain noncompetitor and other conditions are met. Each document also, among other things, consents to the collateral assignment of the franchise or management agreement in connection with the loan. They each also govern what rights the mortgage lender has to cure defaults by the franchisee/hotel owner. On the other hand, they differ dramatically from one another in how much flexibility a foreclosing lender has to terminate the applicable agreement upon foreclosure. Franchise and management agreements also vary in how they treat cash management and, typically, how they determine who holds certain required accounts. Borrowers and lenders need to consider such differences early in the process of negotiating term sheets and throughout various points of the loan closing process.
Before considering how various loan features need to be structured, though, borrowers and lenders should consider, as a gating issue early in the process, whether the lender might be deemed a "competitor" of the franchisor or brand manager, as applicable, or otherwise be restricted from taking ownership to the property on foreclosure. Competitor restrictions can be broad. Particularly when a mortgage lender may be a division of a larger enterprise that may own hotel brands through affiliates, the parties should identify any such potential risks in advance and, as needed, to the extent possible, obtain preemptive determinations from the brand that the affiliation will not prohibit the lender from maintaining the flag after taking title to the property. Assuming the lender is comfortable, and it is not a competitor or otherwise restricted to own the property under the franchise or brand, then the parties should consider the differences between the nature of the franchise arrangement versus brand management and how those differences impact the credit and the loan structure.
The ability to terminate the agreement upon foreclosure is perhaps the most impactful difference and raises multiple issues for borrowers and lenders to consider. Whereas franchise agreements tend to be terminable on foreclosure pursuant to comfort letters, SNDAs executed with brand managers, like their lease SNDA counterparts, include non-disturbance rights. The hotel manager's non-disturbance right prohibits a foreclosing lender from terminating the management agreement as long as the hotel manager is performing and the management agreement has not expired by then. By contrast, under comfort letters, foreclosing lenders should be able to retain the flag post-foreclosure, but they do not typically have the obligation to do so, granting lenders much greater flexibility with comfort letters than with SNDAs.
Whether stability or flexibility is preferable to a mortgage lender is fact specific. Mortgage lenders are likely to prefer to maintain the brand post-foreclosure in order to avoid the costs and lost revenue of re-flagging a property and turning a property over to a different reservation and loyalty system. On the other hand, a foreclosing lender may want the option to terminate a flag if it deems the brand to be in any way responsible for the failures resulting in the foreclosure. As more of a blank slate, a hotel that is either unflagged or has the potential to be delivered unflagged could also attract a wider pool of potential purchasers at, or following, foreclosure.
Even once a lender (or its designee) takes title to the property subject to a flag, there are other economic factors still left to consider, and the lender should plan for them much earlier in the process than foreclosure if possible. Hotel brands often impose capital plans related to brand standards in the form of so-called "property improvement plans" when properties change ownership, and this can also mean changes of ownership occurring pursuant to or following foreclosures. The ability to terminate the flag at foreclosure pursuant to a comfort letter may provide mortgage lenders with better bargaining power to negotiate for moratoriums or similar restrictions when foreclosing. Thus, lenders should consider, to the extent possible, whether they can negotiate any such limitations or blackout periods before committing to maintaining the franchise. On the other hand, when there is a brand manager, lenders need to, if ever, consider this risk sooner in the process. Lenders may want to negotiate such limitations into SNDAs at the time of loan origination. In either case, it is likely that franchisors and brand managers will resist such restrictions or even refuse to engage, but lenders should consider the risks and, if deemed worthwhile, whether there might ever be a better time to engage with the brand.
As part of the same enforcement and monitoring of brand standards by franchisors and brand managers that sometimes results in the imposition of property improvement plans, brand managers also typically require regular deposits into reserves for furniture, fixture, and equipment replacements and refurbishments. Under a brand management arrangement, these reserves would be held by the brand manager, who would also control the disbursement of such funds. In other management structures, hotel or otherwise, including those governed by a franchise agreement and a comfort letter, the mortgage lender generally has the right to hold and control the release of those or other reserve funds (even in situations where the third-party manager would otherwise be the one to reserve those funds). When the hotel is brand managed, borrowers should make sure that term sheets and loan documentation reflect (or at least do not contradict) this mechanism. Additionally, even when brand managers are maintaining furniture, fixture, and equipment reserves, mortgage lenders may require an incremental amount to be deposited in a lender-controlled account as a "top off" to what the brand manager requires. Thus, borrowers should be aware of the requirements set forth in the management agreement for reserve deposits when negotiating term sheets with potential lenders.
Lenders, on the other hand, need to be aware that they will not be holding the furniture, fixture, and equipment reserve (or at least some material portion of it) in the brand-managed context. Lenders should also keep in mind that occasionally, neither the franchise agreements nor third-party managers may require specific reserves. Accordingly, while furniture, fixture, and equipment reserve and similar requirements in brand-managed properties will appropriately include offsets or potentially tie to the requirements of the brand manager, lenders should independently size such reserves in hotels that are not brand managed, without necessarily relying on requirements pursuant to the franchise agreement or any other hotel brand document. Many lenders will require a fixed percentage (often something close to 4% of monthly revenues) that is inclusive of the amounts required by the franchisor, if any. Borrowers should ensure that the lenders' requirements are not duplicative of the minimum mandated franchisor deposits, if any.
In addition to holding various reserves, brand managers will tend to collect all revenues from the property and apply such revenues to property expenses, reserve deposits, and management fees prior to remitting anything into a lender's cash management regime. They would remit the balance to the lender's clearing account only after funding such other amounts first. This differentiates the cash management regimes available to lenders in brand-managed hotels from nearly every other asset class or hotel management structure, which may otherwise contain requirements for property revenues to be deposited directly into lender-controlled deposit or clearing accounts before property revenue is available to the (non-brand) manager to pay expenses and fees.
When negotiating term sheets and loan documentation for brand-managed hotels, borrowers should account for the foregoing distinction and ensure the loan documentation does not contradict what the manager will require. In management arrangements, lenders do not obtain the same security interest in (and control of) the accounts or property revenues as they would under most franchise agreements and comfort letters, and the debt service payments are only made after the brand manager has paid all other property expenses and fees. However, neither the borrower nor a third-party property manager has access to such funds either, and the mortgage lender has solace in knowing that the property revenues and funds on account are far less likely to leak to the borrower or other third parties in contravention of any loan or management agreement requirements. Such amounts are securely with the brand to be applied in manners intended by the brand manager to be accretive to the hotel.
Whether a hotel owner engages a hotel brand merely as a flag through a franchise agreement or as a brand manager has a variety of implications for a hotel owner. The choice of branding arrangement also has a meaningful impact on the structure of mortgage financing as franchise agreements and comfort letters provide greater flexibility for lenders, albeit less security, than brand management agreements and SNDAs. Borrowers and lenders should consider these differences in the term sheet stage. Such differences include, among other things, the size and control of various reserve accounts and cash management, and lenders should consider the credit and flexibility differences in these arrangements when evaluating the loans at the outset. While hotel brands are less and less open to negotiating many of the terms that are material to mortgage financings from their form positions, both borrowers and lenders should consider them early on when comparing potential structures to determine if any terms are worth attempting to negotiate.
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.
