For most of 2008, the torrid performance the hotel industry has displayed for the past several years slowed significantly, but the industry was still doing quite well as it came off historic highs. Of course, since August 2007, those with larger hotel loans coming due worried about being unable to refinance them, and new financings grew increasingly more difficult. But in September 2008, the events surrounding the "Global Financial Crisis" have apparently broken the dam that was holding back a flood of loan defaults where the underlying assets are hotels or other special purpose real estate closely intertwined with an operating business. 

For almost a year, lenders have talked about a "flood" or "tidal wave" of troubled loans that were "coming." But until now, few loans defaulted and few bankruptcies were filed. It appears that all of a sudden, that has now changed. As lenders and investors deploy their special servicers, workout teams, and turnaround specialists to deal with the defaults on these assets, it is wise to remember that these loans are different. What is so different about TROUBLED HOTEL LOANS? Let's take a quick review.

Like falling off a cliff . . . 

We all read the headlines and we know the reasons the hospitality industry had to take a hit -- the economic crisis, cost of oil, cut back in airline seat capacity, collapsing of consumer confidence, job layoffs, and corporate cut backs. But the magnitude of the sudden downturn for the hotel industry was summed up well by Steve Van, President and CEO of REMIC Hotels, when he said, "Year to date performance in the hospitality industry for 2008 is irrelevant. In September, the hospitality industry fell off a cliff . . . and is still in free fall, with business dropping as much as 30% in some markets and market segments." 

With the CMBS markets and traditional lenders still frozen up , maturity defaults, and even payment defaults now loom on many hotel loans. And with cap rates increasing, LOI falling, few hotel loans are refinanceable today even before you take into account lower loan to value ratios and higher debt service coverage requirements.

In fact, the hotel lawyers at JMBM's Global Hospitality Group® have already seen a sudden change as our experts on workouts, receiverships, and bankruptcies have been called to action with hotel loans going into default and owners filing bankruptcies. So it seems timely to discuss some of the unique issues and problems lenders and owners encounter in dealing with troubled loans on special purpose real estate assets with operating businesses such as hotels. By the way, many of these same issues apply to franchised gasoline stations, convenience stores and restaurants.

What is so different about Troubled Hotel Loans? 

Special purpose real estate assets associated with operating businesses present unique problems. Examples include loans secured by hotels, casinos, franchised gasoline stations, convenience stores, restaurants, and the like. These assets involve an operating business that is integrally intertwined with special purpose real estate, and that operating business comprises a large component of the asset's value.

It is the operating business that raises some thorny problems. The operating business often needs management and franchise affiliations, licenses and permits, extensive vendor relationships, marketing efforts and a significant work force. Many of these aspects of the operating business are critical to the value and success of the asset and the recovery to be realized. They can evaporate very quickly during the handling of the troubled loan.

For example, what is the value of the underlying real property of a Marriott, Holiday Inn, Hilton, Hyatt or Four Seasons if it loses the brand and professional management? It becomes just a big box hotel with no name, no reservation system and no professionally run staff. What impact does it have on the lender's collateral if a breach of a management or franchise agreement exposes the owner to the expected profit of the brand or operator for a remaining 20 or 30 year term, or more? What damage is done to the public image of the asset if quality is not maintained, rumors of bankruptcy taint expectations of service, inventories fall below acceptable levels, and relations with critical vendors are damaged?

Or, to use another common example of loans secured by a gasoline station with franchised restaurants and convenience stores, it may be easy enough to renegotiate gasoline supply agreements, but what is the value of the underlying real property of a Burger King or Del Taco restaurant that loses its franchise, jeopardizes its ground lease, and faces defaults under its franchise agreement and other contracts?.

Understanding the "structure" of hotel ownership and operation 

Many lenders and servicers are unfamiliar with the business and legal "structure" of these special assets, so we will first use a hotel example to illustrate the franchise and management overlay that complicates working with many of these assets. The typical hotel is owned by an individual, institutional investor or investor group, and this owner is usually the borrower on the hotel loans. Complications grow geometrically when the operator also has a joint venture or other investment interest in the ownership, and such arrangements are common with many hotels. The hotel company -- Marriott, Starwood, Hilton, Hyatt, or whatever -- is a separate entity that will manage or franchise the owner's hotel.

Hotel franchise or management agreement. When you drive by a hotel and see a big red Marriott sign on top, the chances are great that an owner has entered into a franchise or management agreement with Marriott to brand the hotel and plug into Marriott's reservation system and expertise. But it is fairly unlikely that Marriott owns the property or has a significant interest in it. In many instances, the hotel is managed by the branded hotel company, but often the hotel will have a franchise from Marriott or one of the other branded hotel companies, and an independent management company -- unaffiliated with the brand -- will manage the hotel under a separate arrangement. 

Independent operators. In the jargon of the hotel industry, these independent management companies are often called independents or "third party managers" because they do not own a brand and are a third party to the owner-franchisor-operator relationship. In any event, these arrangements are governed by complex and critically important franchise agreements and management agreements that can add or subtract millions to the value of the hotel. 

Other licenses and agreements. Depending upon the nature of the property, there are also likely to be a host of important agreements, licenses and permits. Resort properties often have "use agreements" or leases that provide access to hotel guests for golf, tennis, marina, spa or other facilities. Licenses may include cabaret and business licenses, liquor licenses, and many other permits such as FCC licenses for base-to-shuttle or ship-to-shore communications for shuttle buses, marina and similar operations. The ability of a foreclosing lender or buyer to continue to enjoy rights under these agreements and licenses can be critical. One can imagine the impact on value when a resort hotel loses its golf, tennis, beach club or other amenities, or can't serve liquor at large group meetings, banquets, weddings and events. And, of course, it is almost certain that there will be a significant work force that may be technically employed by either the owner or the operator, but for which the owner will have full legal responsibility and extensive indemnity obligations. There may even be union contracts and potential labor claims and liabilities.

Complications. The lender's choice of options in dealing with a troubled loan on a hotel is complicated by the typical hotel management or franchise agreement. It tends to give tremendous control and many exclusive rights and powers to the operator and franchisor. The owner's (and thus the lender's) access to information, the work force, and the asset itself may be greatly limited. It is also common for the lender's position on the loan to be subordinated to the hotel management and franchise agreements so that upon a foreclosure, the lender or its successor will continue to be bound by the old management or franchise agreement. Alternatively, and sometimes worse, the lender may lose the benefit of the franchise or management agreement and find itself with an unbranded and unmanaged asset.

Hotel loans present at least four categories of issues that lenders don't usually encounter with traditional real estate loans such as their loans on office buildings or apartment houses. These special issues should all have been addressed in initial loan underwriting, but need to be reconsidered as a loan gets into trouble. They include:

1. Subordination and SNDA. Subordination agreements and SNDAs are frequently encountered with branded hotel management agreements. The lender's rights are often vitally affected by the terms of a subordination agreement or a common variation called the SNDA which the owner, lender and operator may have executed. Such agreements typically provide comfort to lenders that upon a foreclosure, deed-in-lieu or sale in bankruptcy, the lender or its successor in interest will continue to enjoy the benefits of the management agreement. (See "Hotel Management Agreements: SNDAs or Subordination Agreements" on www.HotelLawBlog.com.) 
This may be of great value in some circumstances. However, as many surprised lenders learned in the last downturns, approximately 80% of the buyers for properties selling for $10 million or more were either other hotel companies or joint ventures of capital sources and hotel companies. In either event, these buyers would only purchase assets they could brand and manage, so the ability to terminate existing management and franchise agreements could make the asset attractive to a larger universe of buyers and could add tens of millions of dollars to the hotel's value.

But the typical SNDA contractually obligates the lender to the terms of the management agreement, by providing that if the lender or anyone succeeding to the property by foreclosure, deed-in-lieu or otherwise ever comes into possession of the hotel, the lender or its successor shall immediately be bound by the agreement or is obligated to execute a new one on identical terms to the original for the remaining term of the original agreement. The lender faces liability for breach of contract if it does not fulfill its obligations and ensure that successors are similarly bound.

While this would seem to suggest that long-term, no cut management contracts and franchise agreements cannot ever be terminated, the use of a court appointed receiver will generally not constitute a breach of an SNDA by the lender, and certain sales pursuant to a plan of reorganization in bankruptcy will also likely avoid breach of a lender's obligations under even the most stringent SNDA. Long-term management agreements will generally be viewed as executory contracts that can generally be rejected in bankruptcy, and the operator then becomes an unsecured creditor in the bankruptcy to the extent of damages sustained for rejection of the contract. Thus, where the lender is properly secured and there is no equity, the rejected operator will take nothing for its damages.

An industry rule of thumb is that the right brand and operator can easily raise or lower the nominal value of a hotel by 25% or more. 

2. Management and Franchise Agreements. Most hotels in the United States operate under a brand name. They acquire the right to use that brand name in one of two ways: (a) as part of a "bundled" deal with a branded management company (like Marriott, Hilton, Starwood or InterContinental) where the management agreement typically provided the operator will manage the hotel and include branding rights for free as long as the operator runs the hotel, or (b) in a separate franchise or license agreement with the brand, and not including management. Where a hotel has a franchise agreement, it will also likely have a "third party" management agreement with an independent (i.e. unbranded) operator. An industry rule of thumb is that the right brand and operator can easily raise or lower the nominal value of a hotel by 25% or more. In other words, a hotel nominally worth $10 million might be worth only $7.5 million or as much as $12.5 million, depending on the management and franchise agreements -- and these numbers are "scaleable" so add as many zeroes as you want. Dealing with the management and franchise agreements can be very technical and tricky. 

3. Need for access to more information. Because hotels and other special assets have operating businesses, there is a vast amount of information that can and should be provided by the operator on a monthly or other regular basis that will greatly assist a lender in monitoring developments with the asset-events that may happen months before the effect is seen on the income statement or balance sheet. The prudent lender will assure access to such vital information, and may provide that a default occurs if there is deterioration in certain operations or procedures reflected in such reports. 

4. Lender liability. There is a much better balance today than 10 or 15 years ago between the lenders' needs to protect their collateral and realize its value and aggrieved borrowers to obtain redress for excesses and abuses of over-zealous lenders. But lender liability should still be a significant concern or focus for the careful lender, and these concerns are likely to be aggravated by dealing with a more active operating business such as a hotel than a passive real estate asset like an office building. Binding arbitration and jury trial waivers continue to be important elements in the lender's defensive arsenal.

Jim Butler
Chairman, Global Hospitality Group
Jeffer, Mangels, Butler & Marmaro LLP
1900 Avenue of the Stars, 7th Floor
Los Angeles, CA 90067-4308
(310) 201-3526 direct
[email protected]
www.HotelLawBlog.com