|By: Bruce Baltin, James R. Butler, Jr. and Peter Benudiz
Why are we buying this property?
A hotel is a business housed in real estate - it is dynamic - its market is dynamic. There are no major tenant leases. Every room has to be resold every night. Guests in the hotel’s dining and meeting rooms come and go on an hourly basis. Given these circumstances, it is imperative for investors deciding to include a hotel in their portfolio to understand why they are doing so, and then make broad assumptions about future market conditions and to devise a plan to deal with those conditions.
The first question a buyer should ask is, “Why are we buying this property?” Often, the reason vary from the pure economics of the deal to the purely emotional. The reality is that many acquisitions are driven, at least in part, by dreams of ownership and emotional incentives, including having a place to visit and/or entertain. Here, we are not trying to imply that there is anything wrong with decisions made for reasons other than economic ones. If one can afford to own a trophy hotel like a piece of art with little or no cash flow yield on his investment, more power to him or her. However, when such a purchase is made, it is important to understand that fact so that financing is not put in place with the expectation that the property will service the debt.
There are as many strategic reasons for buying a hotel as there are willing buyers. One may see the potential for success with a specific type of property - an all-suite hotel, a resort, a limited-service hotel - in a particular location - adjacent to a major demand generator like a theme park, and industrial park, or an airport. Another may find it advantageous to his long term strategy to have a property in a certain city or a certain part of town.
The acquisition process begins when investors identify an opportunity, formulate a vision for it, and then proceed to evaluate and possibly acquire the hotel. Caution dictates that many more purchased are started than are completed. A prudent buyer requires a thorough acquisition analysis and due diligence process which may reveal the need for a possible restructure or termination of a proposed transaction. And the prudent buyer keeps an open mind throughout the process.
The Acquisition Process
Given the complex nature of the interrelated business and real estate components of a hotel, the analysis and process of acquisition can be as complicated or as simple as the potential buyer wants to make it, recognizing that there are practical limitations to the human and financial resources that can be applied to a field of potential purchases. Conversely, there is a real benefit to added information and it is usually the most informed purchasers who get the best deals. The informed purchaser process through a series of steps designed to optimize the cost/benefit ratio of information. This phased acquisition process, each step of which is dealt with in the succeeding text, includes the following:
From the purely business standpoint, ownership rationale can vary from active to passive involvement. Some owners position strategically for the short term, while others take a longer view. In other instances, owners prefer to base their investment on yield or return requirements, which can vary, based on alternative investments available, strategic consideration, and other factors. Decision criteria are unique to each buyer. Among the criteria for deciding upon a hotel or group of properties to purchase are:
Identifying Potential Acquisition Targets
After the acquisition criteria have been decided upon, the buyer will typically get work into the market that he is interested in acquiring hotels that meet specified criteria. Brokers, asset managers, hotel companies and industry consultants are among those contacted. Often, press releases and advertisements in trade publication and the general business press are used to “get the word out”.
Once the request for properties has gone out, the buyer will then screen preliminary offerings submitted to him while continuing to network with industry professionals for hints of properties about to go on the market before they are “shopped around”. The screening process is crucial, as it allows the elimination of numerous properties early on and sets the stage for substantial effort be expended on other properties. Too often the buyer overlooks the screening step and misses good opportunities and expends unnecessary effort in the long run.
Lacking his own screening team, the buyer can call upon a team of outside due diligence/acquisition consultants. At his early stage in the process the buyer can “pick their brains” as to their general knowledge of potentially available properties. Using experience consultants with local market knowledge can materially help both in the screening and in the negotiation and acquisition phases.
The Acquisition Team
Given the hotel’s dual nature as both a business and real estate , an investor should be sure to have the advice of those familiar with the hotel industry. Typically, and investor will assemble a team of about six professionals who will assist in the overall evaluation of a hotel property. Such a team would include the following:
Broker The broker may represent either the buyer or seller of a lodging property. The broker typically helps market a property and bring the seller and buyer together. Often the broker helps negotiate and facilitate a sale. A broker’s fee is typically a percentage of the total sales price.
Appraiser Since the work experience of potential appraisers can vary widely, it is advisable to select an appraiser who has appraised either similar properties or properties in the market in question.
Accountant An Accountant’s review of the property’s books and record will determine whether funds have been properly applied and whether financial controls and reporting systems are adequate.
Market & Financial Consultant A market and financial consultant is called upon to ascertain how a property might perform and what it would take to achieve desired profit or investment goals. Such consultants evaluate prevailing market conditions, prepare projections for both the market and the subject property. The market and financial consultant can also review revenues and expenses and assist in assembling the business plan.
Attorney/Legal Consultant Attorneys specializing in hotel work can help formulate the acquisition strategy or game plan, assist in identifying and coordinating acquisition team members, advise on terms and structure of transactions, assist in legal due diligence issues from the significance of litigation and regulatory matters, contracts, title issues, and document and close what is often not merely a “vanilla” real estate deal, but the purchase and sale of a complex real estate/business transaction. At a minimum, these are likely to include hospitality operation, management and franchise, labor, real estate, tax, corporate, and trademark. In other situations litigation bankruptcy, timeshare and other specialties may be critical.
Architects/Designers If the acquisition is to involve renovation or upgrading of the property, the architect will be responsible for reviewing the specifications set forth by the owner, as well as reviewing the applicable codes or regulations of the state or local municipalities. In addition, an architect can coordinate the activities of other members of the team who will be responsible for the physical property, such as the engineer and interior designer. He can review existing and potential compliance with all building codes as they apply to the existing property and as they will apply to any planned renovations.
Engineer A qualified engineer or team of engineers should review all the physical components of the property, including mechanical, electrical, plumbing, and structural elements.
Preliminary Evaluation of Potential Acquisitions
many properties will be weeded out during the initial screening process, based primarily on review of submitted offering packages, the buyer’s or consultant’s knowledge, and the acquisition criteria itself. For those properties that pass this initial screening, the next step is usually a site visit an property inspection at which point another “go/no-go” decision will be make. Properties that reach the inspection stage will require a preliminary property and market analysis. The next decision, based on the analysis, will be to develop a bid price and business plan or to eliminate the property from consideration.
Perhaps the most significant element in the buyer’s development of a purchase price is the analysis of the potential earnings to be derived from the hotel. In many purchases, it’s the only element. T develop the proposed acquisition price, the buyer must make assumptions as to future market conditions and the hotel’s performance within that market. These assumptions will be reflected in a discounted cash flow or stabilized operating projection. Thus, a preliminary business plan which reflects assumptions as to physical facilities and condition, management, affiliation and other factors must be developed in order to assess the potential acquisition realistically.
Understanding the Market
That markets will change is a given. Factors causing such a change include growth or decline in the supply of hotel rooms, shifts in market segmentation, and the renovation or repositioning of competitive hotels. The prudent hotel buyer understand the concept of property and market dynamics and does not purchase without a plan in place for receiving an expected return of his investment over time. This plan will reflect research and analysis on historical market performance, expectations for the growth in the supply of competitive hotel rooms, and the growth in demand for hotel by market segment (commercial, leisure, group etc.) by guest ability and willingness to pay at the projected rate level, and guest demands as to facilities, design concepts, amenities and services.
The following table sets forth an example of the results of analysis
of potential market performance. It presents a detailed picture of the
historical and projected performance. It presents a detailed picture of
the historical and projected performance of the competitive market for
our subject hotel and of the historical performance of the hotel within
the market. It further provides a framework for quantifying assumptions
as to the future performance of the property based on anticipated actions.
|Year||Average Daily Rooms||Occupancy Percentage||Average Daily Room Rate||Penetration||Yield|
|Market||Subject Property||Market||Subject Property||Market||Subject Property||Market||Subject Property|
|Penetration is defined as the share of demand received by a given property
relative to its share of supply; i.e., in 1993 the subject received 17.5%
of demand (165/945) relative to 20% of supply (300/1500). 17.5%/20.0% =
87.3% penetration. A shortcut is to calculate the subject’s occupancy relative
to the market’s (55%/63% = 87.3%).
Yield is a property’s REVPAR divided by that of the market, reflecting a property’s relative position both as to occupancy and room rate. REVPAR is derived by multiplying Average Room Rate by the Occupancy Percentage; e.g., In 1993, Market REVPAR was $51.03 (($81 X’s .63) and Subject REVPAR was $40.70 ($74 X’s .55). $40.70 divided by $51.03 results in a yield of 79.8%.
In this example, relatively strong growth in demand has occurred over the past several years, as is typical of a market emerging from recession. Demand is projected to grow at more modest levels over the next several years, with the exception of the year in which a new hotel is added to the market. (New hotels in a strong market often create induced demand or accommodate otherwise unsatisfied demand). Average rate has grown modestly and is projected to continue to do so, except while new supply is being absorbed.
The subject property’s occupancy and rate have both grown at below-market levels, resulting in the declining penetration and yield. The challenge for the buyer’s team is to determine the specific causes of the declines in yield and penetration and devise and test a plan to reverse them, if possible, so as to realistically project future penetration, yield and cash flow.
Given market dynamics, the buyer’s analysis and plan will consider the quality and condition of the following, which are the basic components of any hotel prepay:
The management company or organization will be the one best suited to the needs of the property vis a vis quality, operating culture, cost control and marketing strengths
Capital Structure and Financing Costs
After reviewing historical and projected market performance, along with the historical performance of the subject property relative to that market, the potential buyer will evaluate and plan for each of the foregoing issues. The result will be a set of assumptions as to future market performance, a plan of action for the property, and a set of cash flow projections resulting from that plan. The Cash flow projections, including assumptions as to capital expenditures and reserves, financing costs, an exit strategy and disposition price, will then be discounted back to a present values at a discount rate that meets the buyer’s return requirement. In this way, the buyer establishes the price he is willing to pay for the subject property.
Taken as a whole, the analysis outlined above, will help the buyer determine how next to proceed: whether an appropriately priced buy represents a turnaround opportunity with great upside potential, or whether the hotel as already reached its maximum earnings level, thus posing a significant downside risk to the investment.
In determining an offering price for the subject property, the prudent buyer will consider the foregoing discounted cash flow analysis, the historical earnings of the property, and the sales prices per room being achieved for comparable hotel sales in the marketplace. The relationship of the offering price to the discounted cash flow analysis is often dependent upon the strength of the market, the buyer’s and seller’s relative positions, and other market factor. The stronger the seller’s market, the higher the offer price, and vice versa.
Once the potential buyer makes the initial offer, negotiations begin. The resulting process will either wind up with the buyer and seller coming to a meeting of the minds on the purchase price and continuing into more refined discussions or the negotiations will be broken off.
Once an agreement to purchase has been reached, the buyer will often summarize for internal approval or other purposes the analysis which led to the decision. The resulting investment memorandum may include the following:
The Purchase and Sale Agreement Process
After a tentative agreement to buy and sell has been reached, the process of negotiating the major terms of the purchase and sale agreement can begin. Successfully negotiating and preparing a contract for the purchase or sale of real estate requires a thorough understanding of the objectives of the buyer or seller, the legal and tax situation, the character of the property and the interest of third parties, including lenders, brokers, union etc., who may require contractual provisions for their protection even though they are not parties to the contract.
The basic terms of sale, along with a property inspection, enable the purchaser to determine if the price and terms are reasonable and if the property is worth purchasing and make an initial offer.
Because the purchase and sale of real estate involves the investment of a substantial sum of money and the transfer of valuable assets, the parties and their professional advisors should negotiate the terms of the transaction with great care and precision.
Detailed discussion should include the following crucial business elements of the deal:
As a general rule, hotel assets include the following:
Non-financial assets are also a consideration in a hotel acquisition. Accounting books and records, operating statistics, employee records, sales and marketing files, licenses and permits and numerous other items are required to keep a hotel going. The hotel buyer should be certain to have his attorney and operational advisors assist in making sure that the purchase terms will ensure a smooth operation transition form seller to buyer.
Final sales price is often affected by negotiations involving other terms in the purchase and sale contract,. For example, the purchaser will at times pay a higher price if the seller is willing to take back purchase money financing. Other factors that can influence final sales price are the amount of the earnest money deposit, the amount of time over which cash payments can be spread, and whether or not an existing mortgage can be assumed. Other considerations that may affect final sales price include the track record and financial strength of the purchaser and the speed with which the transaction can be completed and what is being purchased (e.g., receivable, claims, etc.).
Existing Management or Franchise Affiliation
When a hotel is subject to a hotel management contract, the contract should be examined by counsel to determine ability to assign, terminate or otherwise deal with it. When the purchaser desires a new operator, the parties must resolve the ability to terminate and related issues of canceling the management contract. In some instances, the contract can be terminated by paying a cancellation fee. Generally, when a hotel is sold without the requirement that the existing management be retained, the sale price will be higher than it would be if the operator were to remain.
in situations where the seller is the present management company operating the property, and the purchaser wants the management company to remain in place, the seller may offer cash flow guarantees or take-back purchase money financing, which essentially pays out the purchase price over time. Such arrangements generally create a higher selling price and make it easier for the purchase to put together the overall financing.
When a buyer enters into a purchase and sale contract, a sizable money deposit is usually made to demonstrate the purchaser’s commitment to closing the transaction. If the deal is not completed, the buyer may forfeit all or a portion of the deposit. To reduce the risk of losing the deposit, the purchaser usually negotiates a set of key terms involving various contingencies that allow the purchaser to back out of the transaction and still have all or a portion of the deposit returned.
Some of the more frequently used contingencies include any inability of the purchaser to:
One school of thought holds that a letter of intent is the best way to start the process of buying or selling a property.
Most parties do not intend a letter of intent to be a binding contract; nevertheless, the letter on intent can be a binding contract if that intention is indicated and sufficient terms are specified. It lays out the basic terms of the agreement; it also serves as an obligation on the part of both the buyer and seller to make an effort in good faith to complete the transaction. After the letter of intent has been accepted by both parties, the buyer must perform tasks of due diligence and must obtain financing. Negotiations regarding the final form of the purchase and sale contract should be ongoing throughout the entire process. When the content, structure and schedule of the transition are agreed upon the closing takes place.
Unless the letter of intent provides otherwise (and the provision is stated to be binding) the seller can negotiate with other interested investors. The investor has to make a good faith effort to conclude the transaction. Ethically, this restricts the seller to a limited extent. Nevertheless, letters of intent may serve a legitimate purpose in the following situations:
Property Description A description of the property being sold or leased. This is not a legal description, but is detailed so that both parties understand the nature of the transaction.
Selling Price A description of the price and terms of the transaction and the financing structure.
Due Diligence The purchaser is allowed to perform a certain amount of review, documentation, and analysis of the property.
Contingencies Specific circumstances that allow one or both of the parties to void the deal.
Seller’s Representations Representations that are made regarding the owner’s legal ability to complete the transaction.
Depending upon the language used and legal doctrines that may apply, this document can be (1) binding, (2) non-binding, or (3) partly binding and partly non-binding. The typical letter of intent attempts to detail only the most important deal points to be sure the parties have fundamental agreement of the “big issues” before they proceed with due diligence and definitive contract negotiation. When a letter of intent is intended to be non-binding in its entirety, it is usually just a preliminary step used to confirm a meeting of the minds on key terms before expending more time and money on due diligence and documentation. A binding letter of intent can be dangerous, because any party may be able to compel the other party to perform without agreement on the details that are usually worked out in the final definitive agreement. However, a letter of intent is often intended to be binding only in certain regards and otherwise non-binding. This is the case where the parties want to postpone negotiations of the details to a later time, but want certain provisions to be binding, such as a forfeitable deposit by buyer, confidentiality provisions, a “no shop” provision (preventing the seller from negotiating with others while the buyer completes due diligence, and the parties negotiate the definitive agreement). [Sometimes a buyer will get the seller’s binding agreement to “stand still” (and not sell to anyone else) during a limited period of time (say 30 days) while the buyer conducts due diligence. If due diligence is satisfactorily concluded, the letter of intent may provide some additional period within which the parties must negotiate and execute a definitive purchase and sale agreement.]
The language of the letter of intent is very important in determining what provisions, if any, are binding and what provisions are non-binding. Parties should be advised by counsel whether they want a letter of intent to be binding in whole or in part, or to be non-binding in whole or in part. For a letter of intent to form a binding contract, it should expressly state that intention and it must also specify sufficiently the material terms of agreement such as parties, subject matter, price, and terms. If the parties want a letter of intent to be non-binding, that intention should also be clear. But in many states, the law will imply conditions on the parties that they may not have intended or understood. For example, a buyer or seller may believe a letter of intent is non-binding, but may not be free to walk away from the deal without negotiating in good faith with the other party to consummate the transaction. If the parties want to be able to terminate at any time without damages, then a clause should be added to that specific effect. Similarly, since a buyer may expend substantial money in due diligence, he should understand what rights, if any, he has to force the seller to proceed with the sale.
Another school of though hold that a letter of intent just wastes time that could be better spent in negotiation a binding definitive agreement with appropriate “outs” or conditions such as satisfactory due diligence, obtaining financing, obtaining necessary regulatory approvals, compliance with the pre-acquisition requirement of the Hart-Scott-Rodino Act and other such matters. Under this approach, the parties execute a binding agreement of purchase and sale and simply provide that the agreement may be terminated (with or without payment of certain sums) in specified events prior to the expiration of the due diligence period. Once under binding contract, a buyer may have greater comfort in spending the money required to complete due diligence, obtain financing, and take the other steps necessary to buy the property. The down-side of this approach is the time and money required to negotiate the agreement without the certainty that the diligence results will be satisfactory or that other condition will be satisfied.
The parties may seek to insure that the letter of intent is not legally binding by expressly providing that no legal obligation will be incurred by either party unless evidenced by a formal written contract. Despite this, it is possible that one party may end up liable in damages to the other on the basis that the obligation to negotiate in good faith was breached. If the parties wish to avoid any such interpretation the letter of intent should include a specific provision that neither party has a duty to continue negotiating and that either prorate may withdraw from negotiations for any reason.
Purchase and Sale Contract
The final purchase and sale contract negotiations should establish the complete terms and condition of the transaction. The issues covered in the purchase and sale contract include all those in the letter of intent and many other details that typically not included in a letter of intent, particularly representations and warranties, indemnifications, and closing conditions and terms. With any contract, the actual document should be reviewed and approved by an attorney and an accountant familiar with hotel and real estate transactions to ensure that none of the terms conflict with federal, state or local laws.
The basic clauses usually found in a purchase and sale contract are as follows:
Real and Personal Property Being Sold A description of the real and personal property being transferred.
Business Assets Being Sold A listing of the various licenses, contracts, franchises, and other miscellaneous and intangible personal property that are being transferred with the real property.
Closing The date, time and place of closing.
Purchase Price The purchase price and its composition (relative to equity and debt)
Earnest Money or Deposit The amount of the deposit and circumstances under which it would be defaulted or returned.
Due Diligence The review of the property and other aspects of the transaction made by the purchaser and the conditions and limits imposed upon the transaction. The contract should detail the period of time during which this should occur and the rights and obligations of each party.
Terms of Purchase Financing The terms of the mortgage involved in transactions in which the seller takes back purchase money.
Title Commitment and Survey/Search The specifications for the type and quality of title the purchaser is willing to accept.
Seller’s Deliveries The data and information that must be given to the purchaser by the seller.
Seller’s Representation, Warranties and Covenants The various facts and statements made by the seller relative to the transaction which are used to induce the purchaser to buy the property.
Representations and Warranties of Purchaser The various facts and statements made by the purchaser relative to the transaction which are used to induce the seller to sell the property.
Prorations and Adjustments The specific prorations of the current revenues and expenses between the purchaser and seller.
Closing Documents and Procedures The various documents needed to close the transaction as agreed to by both parties. The closing procedure must also be approved by both parties.
Closing Expense The agreement reached on the allocation of closing expenses between the purchaser and seller.
Eminent Domain and Risk of Loss The details of what occurs if the property is taken by eminent domain or a casualty loss while the hotel is under contract.
General Clauses General housekeeping contract clauses.
Employee Issues Since much of a hotel’s success is based on the expertise and cordiality of its employees, compassionate treatment of employees during the often stressful sale period can go along way toward protecting the business being purchased. Unfortunately, however, the liability for past employment practices for the seller and/or future employment practices of the buyer usually motivate both parties to make the separation as dramatic as possible.
It is usually preferable for the buyer to have previous ownership officially terminate all employees on the day of takeover and for the new entity to re-hire them on a probationary basis. At the same time, an analysis can be made of medical and health benefits, pension and retirement plans, vacation and sick day entitlements, etc. If appropriate, the buyer may choose to allow all employees to carry their benefits forward as if no sale had taken place, with an accounting between buyer and seller for the accrued liabilities for vacation, sick days and retirement assumed by the buyer. Legal counsel can help a buyer avoid unintended “successor liability” for employment practices of the seller or its predecessors. Legal guidance is particularly important where a hotel is the subject of union contracts, union organization activity or some unique plant closing laws ( such as can be found in Hawaii).
Due Diligence A thorough analysis of the financial condition of the hotel is usually termed a Due Diligence Review, or simply, “due diligence.” Any letter of intent or purchase and sale agreement should provide that purchaser’s obligation are subject to satisfactory results from the due diligence investigation. A Due Diligence Review would typically deal with the following items.
Financial Audit - an independent audit performed by accountant or firm with experience in the hospitality industry.
Engineering Inspection - a detailed study of all physical components of the property, including mechanical, electrical, plumbing, structural elements, telephone systems, computer systems and items of decor.
Environmental Inspection - a detailed inspection made by a qualified environmental engineer to disclose any potential environmental hazards that may exist on or within the property site.
Legal Verification - an investigation by a skilled local attorney into all the property’s contracts, licenses, permits, franchises and other documents to determine any potential adverse provisions and whether they can be transferred from the seller to the buyer.
Title Search - a review of the various factors that could affect the title to a property. The title search should be performed by either an attorney or title company.
Property Tax Verification - a search into the current status of the tax assessment imposed on the property. When a hotel property is sold, the local taxing jurisdiction is likely to investigate the terms of the sale and possible adjust the property’s assessed value upward to reflect the sale price. A new assessed value could adversely affect the property’s future cash flow. A property tax verification performed by a knowledgeable property tax consultant will provide an accurate estimate of future tax liabilities. The property tax consultant can also assist in minimizing an upward adjustment made by the assessor.
The closing of a hotel transaction involves the actual transfer of title of the hotel from the seller to the buyer. Generally, when the buyer assumes management, the closing coincides with the takeover by the new operator. The parties that are normally present at a closing include:
After the necessary allocations and prorations are calculated, the mortgages and notes are signed and the requisite moneys are transferred among the parties. Once this process is concluded, the buyer holds title to the hotel.
For more information:
Visit Jeffer, Mangels, Butler & Marmaro LLP’s web site.
Email Jim Butler at [email protected]
Jim Butler 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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