The economic crisis has spread globally to an unprecedented height – no industry or country remains unaffected. The Dow is having its worst period since 1931. Real estate values seemingly evaporated overnight. Consumer confidence is at or near an all time low. Mixed-use projects have been particularly hard hit by these events through decreased hotel occupancy, revenue and a virtual stand-still on residential sales. These factors and more are causing hotel owners and operators to review their rights, obligations and restructuring options under the hotel management agreement and other operative documents.
The structures of mixed-use projects are particularly complex, given the number of parties involved, their differing interests and the many agreements which will need to be renegotiated as part of a restructuring. Interested parties may include the developer, equity investors, lenders, the hotel operator, amenity owners and operators, retail and commercial tenants, unit purchasers, local governmental agencies, state and federal governmental agencies including the department of real estate and HUD under the Interstate Land Sales Act, and the SEC relating to sales and marketing programs. Numerous operative agreements must be reviewed and analyzed in order to fully to assess relative rights, obligations, liabilities and remedies, including the hotel operating agreement, residential association management agreement, residential sales and marketing license agreements, affiliation agreement, technical services agreement, loan and investment agreements, purchase and escrow agreements, lease agreements, project governing documents (CC&Rs, articles and bylaws) and amenity membership program agreements.
The Hotel Brand Perspective
Guilt by Association
Hospitality brands are particularly concerned in a restructuring scenario with the potential liability of a well recognized brand name by virtue of mere association with the project independent from any action of the brand. Typically, the developer, hotel owner and owners' association indemnifies the brand from all but the brand's own bad acts; generally only intentional misconduct and sometimes gross negligence are carved out of the indemnity. Nevertheless, mere association of a brand with a failed project, or the filing of a law suit against the brand, however undeserving the claim might be, denigrates the brand. Accordingly, brands are very concerned about the affects of a failed project. Further, if a project is debranded, the brand also loses the location and future long-term fees.
Maintenance of the Brand Standard
Hotel management agreements, license agreements and often association documents such as CC&Rs provide for the maintenance of the project, its common elements and shared facilities at a specified "Brand Standard." This is the physical, operational and life safety standards established by the brand. When a project is facing financial difficulties, sufficient funding to maintain the Brand Standard is not available. This is particularly true when funding is derived from developer subsidies or hotel revenue. In this situation, maintaining financial transparency and a good working relationship with the hotel brand is important. It may be that certain capital expenditures and upgrades necessary to maintain or meet the Brand Standard can be postponed or amortized over a period of years when hotel revenue and unit sales improve.
Know Your Hotel Operating Agreement: Key Provisions to Consider
The key to a workable restructuring of a mixed-use hotel project is knowing and understanding the rights and obligations of each party under the hotel management agreement, which is the main agreement establishing the relationship between the hotel operator and the hotel owner. If the hotel management agreement is in default or is terminated, typically all of the other brand agreements will cross-default or cross-terminate, resulting in a debranding of the project. Some key provisions and issues to consider under the hotel management agreement include the following:
- Know Your Operator and the Market
How leveraged is the operator in the particular market? What is the competition in the market and prospects for recovery if the market is down? Is there any history on how the operator is dealing with its owners in this market?
- Management Fee
The management fee will be a combination of a base fee (a percentage of gross operating revenue) and an incentive fee (a percentage of gross operating profit based on performance; it may be subordinate to the owner's return on equity). In a down market, an incentive fee is unlikely. There may also be a minimum management fee. If there is a minimum, there may be room to modify or negotiate a reduced minimum.
- Term and Renewal Term
Know the current term and extension terms. Check for a termination penalty and its application. Certain types of sale of the company/project may be allowed without triggering termination. Term renewal is generally subject to a performance test.
- "System" Charges – Advertising/Marketing Fees
These fees are intended to approximate costs incurred by the brand associated with advertising, publicity and promotional activities for the resort. Brands are working to reduce these costs and may be willing to pass cost savings on to their owners. In a down market, owners may be able to revisit these fees with the brand.
- Cap-Ex and FF&E Reserve
Agreed upon percentages as FF&E reserve (typical is 4-5 percent, often with ramp-up). CapEx is part of the budget process and reserves are set to provide funds for maintenance of the brand standard. Subject to lender requirements, the owner may be able to negotiate a temporary reduction in these reserves.
- Termination
Typically, the owner has the right to terminate only for cause or non-performance during a "lock-out" period which is either (i) a set ramp-up period, or (ii) a period keyed to the performance test. Thereafter, the owner may terminate for any reason. Unless terminated for cause, the owner typically must pay the operator a negotiated termination fee. If keyed to the performance test, the owner may have an out if the operator is not meeting the test. Also, the termination fee may be less on sale vs. other termination events.
- Performance Test
Review the performance test established in the management agreement. Failure to meet performance requirements for a set period will allow for termination prior to expiration of the term or cure by the operator through cash make-up. The operator will have a reasonable period of time to cure any performance shortfalls and unforeseen conditions. Economic downturn may be considered an "adverse condition" which excuses the performance test for a period of time.
- Sale of Property
Review circumstances which require operator consent to assignment of the management agreement. There should be standards for certain assignments which do not require operator consent. Also, consent may be required only during a specified number of years. Further, the termination fee may be less if based on a sale.
- Employees
If the operator is terminated or terminates and employees are employed by the operator, the owner may have the option to hire employees. If not, employee transition may be more difficult.
- Right of First Refusal
ROFR can be a deal killer in a good market but not necessarily in a downturn, where the operator may be glad a new owner is coming in.
- Territorial Restrictions
Territorial restrictions are even more important in a down market as ADR and occupancy will decline.
- Subordination and Non-Disturbance Provision
The terms of the SNDA are critical, as they will set the stage for the operator's rights vis-à-vis the lender and what happens to the management agreement if the lender forecloses.
- License – Conversion to Franchise
There may be a right of the owner to convert to a franchise if the management agreement is terminated.
A Long-Term Relationship
In short, the hotel management agreement is the lynchpin to a successful restructuring. Before considering termination options, remember that the hotel operator views the hotel piece of a mixed-use project as a long-term relationship and is typically willing to work with owners on issues caused solely by an economic downturn. Having the hotel operator on your side will be a huge value-add in negotiating a workout with your lender.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
