Past Hotel Industry Problems Present Opportunities for Savvy Lenders
by: James R. Butler, Jr., Peter Benudiz and Bruce Baltin of the firm Jeffer, Mangels, Butler & Marmaro
As is the case with real estate in general, the hotel industry is cyclical. However, hotels are also operating businesses. Hotels are influenced by factor that often have little or no effect on other kinks of real estate, such as the health of the economy, business travel needs, and people’s recreational plans. These factors have a significant impact on the hotel industry, and the corresponding value of hotels.
Hotels also have fallen prey to many of the same factors that depressed commercial real-estate values in the 1990’s: a lack of debt available in the market, the oversupply of hotel product, the elimination of many tax benefits for owners, a depressed domestic and worldwide economy, and the “fire sale” of real estate owned (REO) hotel product held by the Resolution Trust Corporation (RTC) and institutional lenders, who have regulatory and financial constraints motivation them to “dump” their hotels and other real estate at a fraction of the original loans. These factor have combined to cause one of the biggest declines in hotel values since the Great Depression.
Hope for Recovery?
Many believe that the hotel industry is past the “crash of 1990” and that the industry will see a robust recover, with enhanced profitability and increasing values in the next two years. A given hotel’s profitability and value depend on many factor, however. In the 1980’s, more than half of U.S. hotels were built or refinanced at high values with corresponding high debt burdens. It may take some time for these hotel properties recover their 1988 or 1989 peak values and their ability to meet debt service on those high valuations may be strained.
Leading national hotel consulting and hotel appraisal firms such as PKF Consulting predict steady improvement in hotel occupancy and average daily rates, along with an improving market for the industry. Data on occupancy, average room rates, and operating expenses indicate that on a national level the industry passed the bottom of the cycle by 1993 and that it will see a continuing general recovery in 1994 and beyond.
Combined demand for hotel rooms from leisure, business and group meeting segments has grown every year over the past 10 years except in the deepest part of the recession (1991), thus showing the underlying strength of the industry. As in other segments of the real estate industry the primary problem in the hotel industry has been excessive supply.
However, with the growth in supply currently being slowed to a trickle and demand continuing to grow at healthy rates in comparison with the overall economy, occupancy is increasing nationally, room rates are beginning to show sigh of growth, managers are showing a renewed focus on operating efficiencies and operating profits are rising at healthy levels.
Of course, the recovery is not affecting all regions or all properties within regions in exactly the same manner: hotels are not commodities. Rather, the nature of the industry is that each hotel is somewhat unique as I each market. Thus the profitability and value of each property depends on a variety of factors that should be examined in accordance with one another to see how each factor can benefit from the general recovery.
The growing demand and operating profitability that the hospitality industry is currently experiencing combined with a more realistic capital structure indicate that much of the industry is on a far sounder financial footing today that it was during the down side of the cycle. Of course these general projections are tempered by the individual hotel’s characteristics, capital structure and other factors that may affect its cash flow and value.
Troubled Past May Mean Bright Future for Savvy Lenders and Buyers
The industry’s recent problems could spell tremendous opportunities fro the savvy, creative lender and buyer. An estimated 2,000 hotel properties have either been foreclosed on or otherwise liquidated in the last two years or are currently in that process.
Typically, liquidating lenders such as the RT., the FDIC and commercial banks have sold their hotel ROE properties for substantially less than the original construction cost or today’s replacement cost. Not infrequently buyers have acquired properties for less than half of the properties construction or replacement cost and sometimes as low as 20% of construction cost.
While seller financing has often been used for these “fire sale” liquidation’s many sales have included an unprecedented amount of equity, many with all cash deals. As the hotel industry recovers, subject to factors specific to different geographic markets, market segment and properties, lenders and buyers will find great opportunities, particularly for those who have bought properties at 20-year lows.
As 1994 begins, third-party financing for hotel properties is virtually nonexistent. This lack of financing occurs at a critical time for owners who bought their hotels in the 1980’s and managed to remain in business but are facing “bullet loans,” which must be repaid in the following 12 to 24 months.
Because of the virtual absence of any third-party financing in the last few years the hotel “fire-sale” purchases that have closed recently have been on an all-cash basis, creating tremendous equity in the newly traded hotels. This hold the potential to be a lender’s dream come true.
Lenders just beginning to test the waters now are finding opportunities to make solid, profitable loans with no competition and great pricing elasticity. Imagine loans at 50% loan-to-value and with 1.5 times debt service coverage at prime plus pricing, points and all cost paid by the borrower on properties that were bought for less than replacement cost. Isn’t this an opportunity worth exploring?
Advice to Lenders: Learn from Past Mistakes
In exploring the emerging opportunities in hotel lending it is critical to learn one key lesson from the past with a few corollaries: Hotels are not like other real estate. The lender invites disaster if it documents the loan or evaluates the collateral as it would traditional real estate.
Unfortunately a significant percentage of the hotel loans originated and documented in the 1980’s were analyzed, underwritten and documented with more of a real estate bent rather than taking the unique hotel considerations into account. This is an area in which lenders must obtain advice from hotel consultants, appraisers and hotel counsel. Real estate experience is not enough and the learning curve for advisor, lender or client will be painful with hotel-specific experience.
Hotel lending does not have to be wildly speculative, provided that the lender takes proper due diligence, conducts appropriate appraisal and market studies and conducts legal structuring and documentation.
Hotel-Specific Structuring, Documentation and Legal Issues
A few critical areas demand the attention and advice of hotel lawyers:
Mixed-Collateral Security Issues. Because hotels are going-concerns that are situated on real estate, the lender must encumber those aspects of the borrower’s property that are not typically covered by the mortgage or deed of trust. The prudent lender will obtain and perfect a security interest in the real and personal property as well as in all aspect in the operating businesses. This requires among other thins, a security agreement, UCC-1 Financing Statements and perfecting its security interests under Article 9 of the Uniform Commercial Code in all the personal property (including accounts), furniture, fixture and equipment (FF&E), software and other tangible and intangible personal property.
Although generic descriptions of the security property are often adequate there are some unique requirements for properly describing the typical hotel’s personal property collateral for the loan (such as the ‘rents’ versus ‘accounts’ issue discussed later).
In addition to properly describing the collateral lenders will often need to evaluate other liens on the collateral and their priority. If a first lien-holder on the FF&E were to remove all the beds, room furniture, televisions sets, kitchen equipment and meeting room furniture the impact on the lender’ collateral and additional expense to starting up again could be devastating.
As a result, the lender may need to get various third parties to subordinate their interest to that of the lender’s. The lender may also need to amend franchise agreements and management agreements to remove unduly burdensome terms that could affect the value of its collateral to give the lender specific rights of assignment and termination upon foreclosure (if it so elects) and to give the lender certain rights of approval, notice, reports and information.
The appropriate action depends on the circumstances and timing. Many management and franchise agreements are long term - 30 years or more. At one point in time their continuation may add millions of dollars of value to the hotel and provide a ready stream of valuable customers, and at a different time the same agreement may literally deprive the hotel millions of dollars of value and revenues that might be available with out the burden of the contract.
A hotel may have many other contracts or relationships that affect the hotel’s value, such as amenity agreements governing the rights of hotel guests to use certain parking, golf, tennis, swimming, marina or other facilities; there may also be airline, bus, tour group, rental car and other strategic partner or referral arrangements that may be burdensome or extremely beneficial.
The prudent lender will go down the check list of such contracts, examining the lender’s priority relative to the contracts and obtaining assignments and amendments as necessary with the ability to continue to benefit or have the right to terminate the burden when and if the lender becomes the owner of the hotel (or if certain events occur, such as loss of certain operating margins, profitability or debt service coverage).
To illustrate the importance of these concepts it may be helpful to take the management contract or franchise agreement as an example. In certain instances the franchise “flag” may be critical to the value of a property. Failure to obtain the necessary rights to an assignment of the flag (or conversely, the inability to terminate an inappropriate flag on default or foreclosure) may spell disaster for a lender or at least involve potentially significant reflagging costs such as new franchise and management fees, new signage, loss of software and operating systems, loss of reservation systems and replacement of any towels, glasses and other soft goods with the trade name of the franchisor or management company.
Working with consultants, hospitality lawyers must review management agreements, franchise agreements, leases, and other contracts that may have a significant impact on the lender’s collateral. They must also assist the lender in obtaining necessary amendments, assignments, and assurances to better protect the lender’s interests. They will help think through other issues that may be important to the value of a lender’s collateral - such as liquor licenses and ownership structure of the hotel as it affects security in hotel revenues (discussed in the following section).
Proper advice is also important when a lender seeks to foreclose on its collateral, particularly in cases where there are special rules on change in ownership (as with liquor licenses) or in the many jurisdictions that have one- form- of- action rules. Remember: the hotel has both real and personal property that present many procedural issues when foreclosing on mixed collateral.
Liquor Licenses: The liquor license may have a critical affect on the business of certain resort or convention properties and should produce significant revenues in almost any property. Many hotel guests do not want to have their wedding reception or annual convention at a hotel with out a bar; moreover, food and beverage operations can be significant profit centers and the hotel may suffer if it can’t serve beer, wine or other alcoholic beverages.
Loss of a hotel’s liquor license could cause cancellation of critical business for the hotel. Obtaining new licenses may be expensive, time consuming, and uncertain because of political considerations or limited license availability. Lenders may also want to have the directors and officers of every entity up through the parent holding company fingerprinted, investigated and qualified as principals on a liquor license application.
As important as a liquor license may be to a lender’s collateral most jurisdictions will not permit a security interest to be granted in a liquor license. And a blanket security agreement and UCC-1 are completely ineffectual unless properly used. Depending on the particular facts of a given situation and the provisions of local law, the problems of securing the economic benefits of a security interest in the liquor license can normally be resolved by knowledgeable hotel counsel.
In some instances the license may be transferred to a separate management company independent from the borrower. In other situations the lender may require the borrower owning the liquor license to pledge its stock or other ownership interests or place the license in a corporation whose stock is pledged as part of the collateral for the loan. The appropriate structure varies widely by local regulation, but can generally accomplish a lender’s objectives.
“Rents” versus “Accounts”: This issue is a persuasive example of how hotel lending is different than traditional real estate lending. For lending on a commercial office building, the lender typically gets a mortgage and an assignment of rents. The applicable jurisdiction’s real estate law controls the drafting of these documents, the perfection of the security interest and the foreclosure of the collateral.
When commencing foreclosure proceedings the lender relies on the assignment of rents provision to provide a perfected security interest that should withstand the borrower’s filing of a petition in bankruptcy, leaving the lender with a secured interest in the real property and revenue stream.
In the case of hotel lending, the overwhelming number of jurisdictions that have considered the matter have rendered decisions that seem counter-intuitive. The majority of decisions hold that under the typical hotel ownership structure, most of the revenues earned by the hotel (from guest rooms, food and beverage, banquets, telephones, movies, meetings and other such activities) are not rents from real property, but are accounts or income derived from the operation of a business. As such, these revenues are derived from personal property and are considered personal property.
This legal ruling can have a profound effect on the lender. First, a security interest in such revenues cannot be created by a mortgage and assignment of rents under real property laws: a security interest can only be created by a security agreement and financing statement under the Uniform Commercial Code. Failure to recognize this leave the lender unsecured as to the income stream from the hotel.
In addition, the failure to comply with some important technicalities of description and perfection may also cause the lender to forfeit a security interest in the revenues. For example, courts have held that the phrase “all personal property, whether tangible or intangible” does not properly describe the various types of revenues that a hotel may generate.
Even more significant for the unprepared lender is the fact that the filing of petition in bankruptcy by the borrower will cut off even a properly perfected security interest in hotel revenues if they are considered accounts and not rents. This result does not seem strange to commercial lenders who take a security interest in a manufacturing business and its assets. Such lenders understand that if the manufacturing company files bankruptcy, Section 552(a) of the bankruptcy Code will cut off the lender security interest in postpetition revenues from the business. The Bankruptcy Code treats postpetition revenues as derived from services rendered after the bankruptcy and deprives a secured lender of any interest in such revenues.
In contrast, this result often baffles traditional real estate lenders because Section 552(b) of the Code exempts rents and certain other income from the operation of 552(a). The traditional real estate lender therefore continues to have a postpetition security interest in the rents from its real property collateral.
Lenders believing that lending on a hotel is just dealing with a special kind of real estate may be dismayed by the prevailing characterization of revenues from typical hotel ownership as accounts.
Sale-Leaseback Could Solve “Rents” Versus “Accounts” Problems: A number of workable solutions are available to the lender and borrower in this area. For example, prior to the 1980’s hotels were usually owned by professional hotel management companies that ran them. For many years, the most favored for of financing by the hotel companies was the sale leaseback.
The sale-leaseback technique permitted the management company to free up invested capital and shed other burdens of property ownership but it also ensured the hotel company of the ability to manage and operate the hotel for long periods of time. This format was largely abandoned because hotel companies developed the long term management contracts that now predominate in the industry.
A return to the old sale-leaseback structure should solve the rents versus accounts problem for lenders: it is also now more feasible than at any time the past 20 years. The opportunity for the sale-leaseback structure is created by the dearth of financing and the need to attract lenders to the industry and provide them with the security interest they need; however, competitive and economic conditions (in the hotel industry and the nearly 1,000 hotel management companies in the country) make the current form of management agreement less viable than it has been since its inception.
Here’s how the lease structure works: just as in the 1950’s, 1960’s and even into the 1970’s, the hotel owner/investor has legal title to the hotel and gives the lender all the normal real and personal property security interests in the hotel. The owner however, leases the hotel property to a separate legal entity that manages and operates the hotel and pays the owner rent (calculated as a specified percentage of specified types of income).
For example, there would be a fixed amount of base rent, plus a specified percentage of other types of revenues. In addition to its typical mortgage, assignment of rents and UCC security interest, the lender would record a real property security interest in the owner/borrower’s rental income under the lease with the separate management company.
It seems to be clearly established law that such an arrangement converts the revenues of the hotel into rents in the hands of the owner/borrower, thereby avoiding the problems that lenders have had with the rents versus accounts issue. In fact, cases that declare hotel revenues from rooms, conferences, and food and beverage operation to be accounts characterize the same revenues as rents when they are derived by the hotel owner/borrower under a lease to concessionaires, gift shops or even turn-key food and beverage operators (who pay fixed rent plus 20% of food revenues and 40% of beverage revenues). This is exactly what a return to the old lease format would represent and it should be treated no differently.
Other Important Issues
Of course there are a number of other considerations to be taken into account in making hotel loans. Many of these considerations are applicable to any commercial real estate loan. For example, the lender should consider strong affirmative and negative covenants and balancing provisions requiring the borrower to maintain certain loan to value ratios over the life of the loan, as measured at annual or other specified intervals (and as determined by appraisals paid for by the borrower to be made by appraisers selected by the lender)
The lender may also wish to consider arbitration or judicial reference of any disputes arising under the loan - provisions which will effectively avoid jury trials and give the lender the prospect of a final binding decision in a matter of months rather years.
Loan participations have additional considerations, particularly for the lead lender. Unlike traditional real estate loans, the lead lender will have to make more decisions that are associated with the operating business of the hotel if the lender is forced to take the property back. For example, will the lender/owner terminate the franchise flag or management agreement or reposition the hotel?
Negotiations with the borrower for a deed-in-lieu may be more important than in traditional real estate loans. It is likely that participations will require votes of participants that are majority or plurality, but unanimity is probably unworkable. Deemed consent provisions may be critical if participant response is not obtained within a short period of time after notice of intended action.
Not All Consultants or Appraisers are Alike: Hotel Experience is a Requisite
The value of a hotel’s operating business and its ability to consistently produce revenue to service its debt depends on factors that only hotel appraisers and consultants should evaluate.
In evaluating the hotel as collateral, the operating business and the revenue stream it produces are critical aspects of collateral value. Traditional real estate concepts are important: however, the value of the operating business often accounts for more than half the value of a hotel.
Factors to be considered include the physical plant and its suitability for the geographic location, as well as the hotel’s positioning within the selected market segment (e.g., economy, mid-level, luxury, resort or long-term and whether it caters to recreational, business travelers or meeting-oriented or other customers) Does a business and meetings oriented hotel have sufficient meeting rooms, proper layout and design and other amenities to market its product? Is it well located for its intended market? Is the layout and design consistent with the market position?
For example, a large luxury resort in a beautiful location may not be able to attract business travelers who need to be in a downtown location. Such a resort with a sprawling estate will not lend itself to the economic staffing required for an economy or mid-level product. A property with too much meeting space or too many amenities may be unable to attract economy-oriented customers and the reverse is true as well.
Other factors include the hotel’s operating strategies, marketing program and budget, management, franchise affiliation, amenities for product type (e.g., golf, tennis, fishing, harbor slips or fishing), competition and national and local market conditions and economic trends.
These factors, which are unique to hotels are fundamentals routinely examined and evaluated by hotel consultants and appraisers. Lenders are will advised to seek these experts to help evaluate the collateral. The costs of such evaluations and appraisals are routinely borne by the borrower.
For more information:
Visit Jeffer, Mangels, Butler & Marmaro LLP’s web site.
Email Jim Butler at [email protected]
Jim Butler or Peter Benudiz at the Firm
Jeffer, Mangels, Butler & Marmaro LLP
2121 Avenue of the Stars
Los Angeles, CA 90067
Phone: (310) 203-8080
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