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Hotel Brand Management Agreements* and the Economic Downturn:
Lessons Learned or Lessons Forgotten?

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By:  Rob Nicholas, Esq

If the global recession of 2008 was an earthquake, its aftershocks are still being felt throughout the hotel industry.  The recession has caused occupancy and rates to plummet, sending hotel values into a downward spiral.  HVS recently reported that the average value of hotels across the United States is expected to drop to $50,000 per key in 2010, down 50% from the high water mark of $100,000 per key in 2006.  In light of the high prices paid by many hotel buyers during the period 2005 through 2007 (and the highly leveraged loans they were able to get), you can understand why many owners owe more than their hotels are worth today.  Additionally, since the gross operating income generated by many of these hotels is not sufficient to cover all or some portion of debt service, operating expenses, taxes, insurance and compliance with “brand” standards, many owners are having to fund operating shortfalls from their own funds, while others are defaulting in paying their monthly debt service or in paying their loan balance at maturity.     
 
In an effort to stave off foreclosure, the owners of these distressed hotels are turning to their lenders hoping to restructure their loans.  In order to have meaningful “work-out” discussions with their lenders, they soon learn that they must provide their lenders with a detailed plan for turning around their hotel’s performance.  This, of course, requires the involvement of the party who has the most knowledge about the hotel’s operations and performance…the hotel manager.  
 
As will be discussed in this article, unless the interests of the major hotel companies under their brand management agreements are aligned with the interests of the owners and their lenders, the hotel manager will have little or no incentive to cooperate in the workout discussions.  For owners, this may mean that they will not be able to modify their loans and will not be able to improve their cash flow by restructuring their hotel brand management agreements.  For lenders, this may mean that they will be unable to find a buyer willing to pay top dollar for the hotel after acquiring the hotel by foreclosure or deed in lieu of foreclosure.    
   
While the proliferation of hotel construction leading up to the recession and the recession itself have wreaked havoc on hotels, the seeds for this destruction were sown when many of the major brands opted to manage hotels rather than to own them.  The hotel companies found that they could avoid the risks of ownership and operation while securing a constant stream of income by entering into long term, non-terminable management agreements.  The more stable and uninterrupted the stream of income, the greater the value Wall Street placed on these companies.  Consequently, hotel company management agreements became more and more favorable to the hotel companies, as evidenced by the following:
  • The term of the management agreements were extended from 10 years to 20 to 30 years or more;
  • Performance based termination rights were watered down;
  • Lenders were required to execute SNDAs that prevented them from terminating the management agreements, even after taking back a hotel by foreclosure or deed in lieu of foreclosure;
  • Owners were denied or given limited approval rights over operating and capital budgets;
  • Management companies sought to override the now well established common law right of owners to terminate management agreements based on principles of fiduciary and agency law by including new contract provisions that purport to waive the fiduciary and agency relationships and, in an amazing display of commercial chutzpah, a few hotel companies lobbied for laws that nullify the common law right of a principal to terminate an agency agreement (see, for example, Title 23 of the Commercial Law of Maryland).  Of course, these companies also required the application of Maryland law to their management agreements;
  • Owners were required to comply with vague “brand standards”, pay for undefined and/or non-quantified chain services and refurbish their hotels pursuant to a fixed and accelerated time schedule, frequently bearing little or no relationship to the owner’s return on investment;
  • Hotel companies either refused to provide for liquidated damages or they set the amount so high that termination by the owner without cause was no longer an economically viable option; and
  • Owners were required to defend and indemnify the manager for employment related liabilities, even if resulting from the manager’s gross negligence or willful misconduct.
The aggregate affect of these and other changes helped to create a “heads I win, tales you lose” situation for the hotel companies -- owners could lose their hotels to foreclosure and lenders could end up holding an asset worth less than the amount of their loans, while the hotel companies are allowed to stay in place and collect their fees. 
 
Hopefully, owners and lenders will learn a few lessons from the downturn and won’t forget them once the market turns around.  Some of these lessons should include the following:
  • Owners should limit the length of the term of the management agreement unless they are given a viable termination right.
  • Owners should seek a termination right upon sale of the hotel.
  • Too many performance based termination clauses offered by hotel companies are illusory.  They usually provide for two-prong test, where the manager must (a) fail to provide the owner with some percentage of budgeted net operating income and (b) fail to achieve 90% of the revenue per available room for the competitive set.  Experience has taught us that hotel companies rarely fail the latter prong.  Owners, therefore, should seek a more realistic performance termination right.
  • Area protection or non-competition clauses must be carefully reviewed to make sure the management company cannot circumvent them by owning, franchising or managing another “brand” or category of the same brand offered by the hotel company.
  • Owners should resist mandatory refurbishment of the hotel tied to a fixed and/or accelerated time schedule.
  • Brand related loyalty programs must be carefully negotiated to prevent the hotel company from profiting at the expense of the owner.
  • Chain costs must be carefully vetted to make sure the owner will not be charged for categories not contained in the annual budget or otherwise approved by the owner.
  • Owners must have approval rights over operating and capital budgets.  
 
The items listed above are just some of the ways an owner can try to align its own interests with those of its management company.  They all share a common denominator: to incentivize the hotel companies to participate in and to contribute to turning around a hotel’s performance.  Alignment is necessary to insure the profitability of the hotel for the owner in good times, and to enable the owner to cause the management company to cooperate in bad times.  Without alignment, owners and lenders will remain at risk.   While some owners have tried to negotiate for provisions that encourage alignment, the bargaining power of the hotel companies has been too great and owners, anxious to make a deal, have been too quick to give in.  In order to reverse this trend, owners and lenders will need to identify the provisions that are of importance to them and to aggressively negotiate to have them included in the management agreement.  Otherwise, history will surely repeat itself.

 
*    Hotel brand or company management agreement is meant to refer to those agreements with any number of the major hotel companies who manage and lend their brand to the hotel, in contrast to an independent third party management agreement, under which the hotel is managed by a manager who is not associated with any particular brand.


ABOUT THE AUTHOR:  Rob Nicholas, a partner at Haas & Najarian LLP, specializes in representing owners, developers and managers in the acquisition, financing, management, leasing, construction and disposition of commercial real property, with an emphasis on hotels.  He also has extensive experience in the negotiation and drafting of hotel management agreements (on behalf of owners and managers) and in the review and negotiation of hotel license agreements, subordination and non-disturbance agreements and comfort letters.  Mr. Nicholas is an allied member of the Asian American Hotel Owners Association, the Academy of Hospitality Industry Attorneys, the American Hotel & Lodging Association, and is a member of the Real Property Section of the American Bar Association (Hotels and Hospitality Subsection) and the California State Bar and San Francisco Bar Association. Mr. Nicholas enjoys an “AV” rating in Martindale-Hubbell. 


ABOUT HAAS & NAJARIAN:  Since its inception in 1973, Haas & Najarian LLP has provided legal counsel to a diverse client base in the areas of real estate, entity structuring and formation, taxation, estate planning and trust administration, employment law and litigation/alternative dispute resolution.    The Firm’s Hotel Real Estate Practice Group represents owners and developers locally and nationally in the acquisition, disposition, financing, leasing, construction and management of hotels and other hospitality properties.  Many of the Firm’s attorneys have significant experience in negotiating hotel management, license and operating agreements.  In order to better serve its hotel and restaurant clients, the Firm recently hired Baxter Rice, a past director of the California Department of Alcoholic Beverage Control, as an in-house consultant to advise clients on and to facilitate the acquisition and transfer of liquor licenses in California.  Mr. Rice works with Dan Kramer, Esq. in providing legal representation and counsel regarding all aspects of liquor licensing, including working with lenders and receivers in making sure a troubled hotel will be able to continue to provide alcoholic beverages to its guests.

To learn more about Haas & Najarian, visit its website at www.hnattorneys.com.


 
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Contact:

Rob Nicholas
Haas & Najarian
58 Maiden Lane
Second Floor
San Francisco, CA 94108
415) 788-6330
rnicholas@hnattorneys.com
www.hnattorneys.com

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Also See:
Taking Back Hotels by Foreclosure or by Deed in Lieu of Foreclosure: Lenders Beware / October 2009

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