When it comes to purchasing a hotel, there are some unique twists to financing its acquisition that every borrower should understand before making an offer or signing a term sheet.
For starters, whereas some larger REITs will buy for all cash and then find favorable financing at their own convenience (giving them them an advantage in bidding contests), many other buyers will want to seek out financing in advance to pay for their acquisition from the outset. Furthermore, while many lenders have traditionally treated hotel financing loans as real estate investments, other more savvy lenders do take the hotel’s operational and financial performance into account when negotiating financing terms.
The point is that there are many elements to financing the purchase of a hotel that many buyers may be unaware of. And that’s why we’ve put together this checklist of things that purchasers should understand before negotiating any type of financing.
1. Is there a Franchise Agreement?
Many hotel buyers (especially REITs) will purchase a hotel franchise. After all, franchised hotel locations offer the advantage of brand name recognition, integrated logistical networks, and pre-established marketing support.
Any Franchise Agreement, however, can have an impact on the financing terms that a lender offers a buyer.
For starters, many of the contracts that are valuable as collateral in real estate loans (such as leases and management agreements) are not assignable to hotel lenders under a Franchise Agreement. This means that the lender is required to take on a greater risk when providing that loan because, in the event of foreclosure, there are fewer assets to be liquidated, which affects the terms they are willing to offer on a loan — i.e. higher interest rates, etc.
It’s important, then, to fully understand any potential franchise agreement, and to take that into consideration when negotiating the terms of any financing package offered by any lender. If there is a franchise agreement, how will it impact those terms? And if there is not, how can you (the borrower) leverage that flexibility to negotiate more favorable terms?
2. Does the Lender Require a Comfort Letter?
In the event that a Franchise agreement is limiting the collateral available to the lender against the loan, the lender will likely require a Comfort Letter. Simply put, a Comfort Agreement is an additional contract between the borrower and the lender that provides the lender with wiggle-room or recourse in the case that the borrower defaults on their loan. As hotel lawyer Jeffrey E. Steiner explains:
The following are some typical terms of a comfort letter:
Franchisor default notice to the lender and lender cure rights, including time extensions (such as 120 days) for the lender to gain access to the hotel through a receiver or by completing a foreclosure before the franchise rights are terminated;
the lender’s right to obtain a new franchise agreement following foreclosure without having to pay a full franchise application fee or complete a PIP, or continue the existing franchise agreement for a limited period while the lender decides whether to continue it on a longer term basis or permit a purchaser from the lender to make that decision without the lender incurring franchise termination fees;
the lender’s right to transfer the franchise agreement post-foreclosure to a hotel purchaser and be relieved of future liability under the franchise agreement;
the lender’s rights to transfer the comfort letter benefits to its successor, if it sells the hotel loan.
These are all points of negotiation for the borrower. And the borrower, moreover, should negotiate for the right to make any modifications to their franchise agreement that are not detrimental to the lender’s risk — such as any reduction in franchising fees or changes in franchise terms.
3. Is there a Hotel Management Agreement?
Many hotel owners often choose to outsource the management of their property. In such cases, many lenders will require that any Hotel Management Agreement (HMA) is assigned to them as additional loan security.
Assigning an HMA to the lender, however, can restrict the borrower from amending or terminating that HMA without prior consent from the lender. So the borrower may want to potentially negotiate a few additional rights vis-a-vis the lender, including:
- The right to terminate an HMA for performance failure
- The right to pursue any revisions/modifications to the HMA that are not detrimental to the lender’s interests (such as management fee reductions or HMA term extensions)
Hotel lenders may also require the borrower to replace the hotel manager for failure to perform. Consequently, the borrower should negotiate with the lender under what circumstances the lender can require the termination of any HMA.
4. Are there any Subordination, Nondisturbance, and Attornment Agreements (SNDAs)?
Hotel owners are often bound by HMAs in ways that their lenders are not. Consequently, a lender’s decision to force the termination of an HMA can leave the borrower liable for termination (or other) penalties. Similarly, in the event that the borrower forecloses, the lender will not want to be liable for the remainder of the term of the HMA.
Consequently, many hotel management companies require that the borrower establish a Subordination, Nondisturbance and Attornment Agreement (SNDA) with the lender. Simply put, this is a separate agreement between the lender and the borrower stipulating that, in the event of foreclosure, the lender is bound by the HMA.
5. Is there a Cash Management Mechanism?
Almost all hotel financing loans require a Cash Management System. Essentially, this involves depositing hotel revenues into a bank account (often called a lock-box or clearing account) that the borrower is unable to make withdrawals from. This is the account that is used to collect payments from revenue sources (travel agencies, credit card companies, etc.), as well as pay suppliers and the tax man.
Consequently, any Cash Management Mechanism should ideally be negotiated to meet the operational needs of the borrower and their hotel property. For instance, many hotel management companies may want hotel revenues to flow through their own cash management system, giving the hotel management company the ability to pay hotel operating expenses, such as employee wages and benefits. If there is any conflict, then, between the lender’s cash management requirements and hotel manager’s cash management system, these can be appropriately addressed and negotiated prior to the borrower accepting any financing terms from the lender.
6. Are there any PIP Reserve Requirements?
Short for Property Improvement Plan, a PIP Reserve is simply a plan/fund for making renovations and upgrades to a property. For instance, most branded hotel franchise agreements require that there is a PIP Reserve in place. After all, hotel franchisers need to be able to ensure that each of their franchises meet certain standards and offer a consistent experience.
Insofar as a PIP Reserve amounts to a considerable financial asset, being required to maintain one can have considerable implications for hotel owners when negotiating with lenders. As Hotel Online explains:
To minimize their risk, most lenders will either require the PIP to be current during the purchase/refinance of the property or escrow the funds into a reserve account. There are alternate options that can be negotiated including a hold back from loan proceeds, letter of credit, or even a completion guarantee. In addition, lenders will typically require a capital reserve equal to 4% of revenue. This accounts for future PIP renovations, unplanned projects, and the repair/replacement of furniture, fixtures, and equipment (FF&E). The lender will almost always underwrite the 4% for loan sizing, but can be flexible with the capital reserve requirement.
In other words, just as franchised properties offer the advantage of brand name recognition, an integrated logistical network, and pre-established marketing support – the relationship goes both ways. Meaning the hotel owners/franchisees are professionally required to meet certain standards. This has a direct impact on the hotel’s financials and, therefore, should be taken into account when negotiating with lenders.
7. Are there any Annual Operating Budget Considerations?
Operating budgets are a considerable variable when acquiring a hotel. Indeed, they impact financial forecasts, hotel management agreements, and the very level of cash flow itself.
Consequently, the extent to which a hotel lender requires control over a hotel’s annual operating budget depends (at least in part) upon the cash management system outlined in their financing terms. Similarly, if annual operating budgets are managed by a hotel management company (as part of the HMA), the lender might be willing to forego budget approval. The point is that whether or not the lender requires approval on a hotel’s operating budget as part of its financing terms should be addressed during the negotiation stages of the financing process.
Operational Energy Costs
For instance, consider how “electricity is the largest utility expense comprising 60 percent of total expenditures. Water/service is the next largest utility cost (23.8%) followed by gas/fuel (10.6%), and steam (2.3%).”
Fortunately for hotel owners, there are a variety of energy management technologies that make it possible to not only monitor energy consumption with the utmost accuracy, but also to adjust and optimize it in response to real-time patterns. Indeed, borrowers should be asking (1) whether the property they are eying leverages energy management systems, or (2) whether their PIP Reserve will allow them to upgrade to technology that is (essentially) standard across all successful hotels.
Specifically, IoT energy management devices now allow hotels to both use their HVAC systems more efficiently as well as save significantly on their energy consumption and costs. Which means, while smart thermostats and occupancy sensors monitor and respond to fluctuations in occupancy, smart energy management systems (like Verdant EI) employ sophisticated machine learning algorithms to continuously analyze historical thermodynamics, local weather patterns, and peak demand loads to optimize energy consumption all year round.
Indeed, using smart energy management systems to monitor and optimize energy consumption can reduce hotel energy costs by up to 20%, and generate some of the fastest payback periods in the industry (between 12-24 months). The ROI is so significant, in fact, that it can potentially increase the entire resale value of a hotel.
However, if this is the kind of upgrade that a hotel owner want to invest in, they should determine during the negotiation stages of their financing whether (1) it will be covered by a PIP Reserve, and if not (2) the lender will require approval on such an expenditure.
8. Are there Limits on Other Indebtedness?
As a lender, part of protecting your investment is ensuring that you’re not financing a project that is going to incur other debts above and beyond what you are owed by the borrower. After all, the more debt from other sources that a borrower incurs, the less likely the lender will be to recoup their investment (or maximize their ROI).
Consequently, the terms of any financing plan may restrict the borrower from incurring additional debt (other than the initial mortgage loan or, possibly, a limited amount of accounts payable that may be outstanding upon upon acquisition or for a short time). This is why it’s imperative that the borrower (i.e. you) review historical levels of accounts payable and payment cycles to make sure you have the ability to comply with the ‘other indebtedness’ terms of your financing.
9. What is the Timing for Lender Remedies?
Every jurisdiction has its own laws and procedures regarding acceptable remedial processes. So the location of the hotel property/franchise will determine what laws and remedies that a borrower is susceptible to beyond their financing terms.
Specifically, depending on where your desired hotel property is located, the collateral assignment of your HMA may provide for the immediate exercise of lender remedies respecting the agreement following a loan default. For instance, as hotel lawyer Jeffrey E. Steiner also explains:
[…] under California law, in the case of periodic payment defaults, the borrower has reinstatement rights that give it an extended cure period by law before the lender may complete a real property foreclosure. This law does not restrict the lender’s remedies against personal property collateral, even though the borrower’s reinstatement period is still pending.
Although the hotel lender will ordinarily conduct a unified foreclosure sale of real and personal property and not have an incentive to exercise its remedies against the personal property or hotel management agreement before completing the real property foreclosure, it might do so to place maximum pressure on the borrower. Consequently, the borrower may want to negotiate a requirement that the lender use the unified sale procedure to foreclose on real and personal property collateral concurrently.
In other words, as a borrower, make sure you’re aware of what jurisdictional remedies you are susceptible to vis-a-vis your lender. And if there are any jurisdictional remedies that might make your investment less viable, make a point of trying to renegotiate them with the lender prior to accepting any financing terms.
Preparation Meets Opportunity
Purchasing a hotel is no trivial undertaking. And when it comes to financing such an acquisition, the nuances abound. Consequently, there are no shortage of points that require due diligence and negotiation prior to agreeing to financing terms.
So whether you’re a REIT or an individual entrepreneur looking to make a solo investment, you’ll likely require both legal and operational assessments from a third-party to ensure that that due diligence is properly conducted. Indeed, failure to do so can result in some rather unsavory consequences down the line, within the first few years of your property’s operation.
Our intention, here, has been to provide you with some context on what some of the more pertinent financing points of negotiation might be so that you’re in a better position to work with either your legal or operational counsel toward a fair or advantageous outcome. After all, buying a hotel is a considerable investment, and the success of that undertaking will lie heavily with your success in enlisting the appropriate third-party expertise to guide you through that nebulous process.