By Jim Butler and the Global Hospitality Group®
Hotel Lawyers | Authors of www.HotelLawBlog.com
22 June 2010
Hotel Lawyer with some tips for hotel lenders so they can take advantage of higher yielding loans with less risk.
This article will focus on 8 pitfalls of hotel lending - the special traps that hotel lending presents beyond all the typical considerations of traditional real estate lending - and how to avoid them. These are hotel-specific structuring, documentation and legal issues that can really snare the unwary lender.
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This is the third article in a series. As the article titles of this series suggest, there are several aspects to successful hotel lending:
"NOW" could be the best time for hotel lending in 20 years
Why hotel lending is different. . . and some things you should know.
How to avoid the pitfalls of hotel lending
Sometimes hotel lenders just need to say, "NO" (coming)
8 pitfalls of hotel lending, and how to avoid them
Lessons from the past
by
Jim Butler and Guy Maisnik
This article will focus on 8 pitfalls of hotel lending -- the special traps that hotel lending presents beyond all the typical considerations of traditional real estate lending -- and how to avoid them. The word "pitfall" is a good descriptive term for these special traps in hotel lending.
The classic definition of a pitfall is a pit or other trap flimsily covered or camouflaged, used to capture and hold animals or men. Those who know where the pitfall is located, simply avoid it. So the pitfall is only a danger to the unwary or uninformed.
The "take away" from this pitfall metaphor is that hotel lending is not inherently dangerous. It is only dangerous to those who don't understand it, or fail to follow precautions. Knowledge is power. And this article will alert you to some of the most common and dangerous pitfalls in hotel lending.
Most of these pitfalls are created by a hotel's operating business -- things that make hotels different from other classes of real estate. (See "Hotel lending is different, and there are things you should know.")
8 pitfalls to avoid in hotel lending
1. Lack of experienced hotel experts.
Don't even think about hotel lending without an experienced lending officer who understands hotel lending, and who is supported by an experienced team of advisors who specialize in hotels - hotel lawyers, hotel appraisers and hotel consultants.
In the wake of the financial crisis, we have witnessed some of the biggest international law firms' disastrous handling of hotel loan documentation and troubled loan workouts -- in one such case, literally forfeiting $65 million of lender collateral and nearly $50 million in another. These firms have great reputations for "real estate" loans, and may have "some" limited experience with hotels -- but hotels clearly have not been the major focus of their practice.
One of the biggest mistakes that a lender can make is hiring the "wrong" professionals. The "safe choice" for an important hotel situation is a qualified hotel law firm. You don't hire the country's foremost brain surgeon to do your heart transplant.
The same specialization concept applies in selecting counsel for an important hotel project. You want hotel lawyers working on hotel projects. The hotel's OPERATING BUSINESS accounts for more than 50% of the hotel's value. And, unless your counsel has wrestled with thorny hotel issues on hundreds of troubled hotels - issues such as hotel SNDAs, hotel management agreements, hotel cash management agreements, hotel employment and labor issues, hotel union strategies, licensing, local, state and federal tax requirements, inn-keeper laws and other hotel-specific issues - critical complexities will be missed that require specialized knowledge of hotel operations, customs and practices.
We should know, because we wrote the book with the experiences gained by a team of hotel lawyers with more than $60 billion of hotel transactional experience gained over 1,000 bankruptcies, receiverships and workouts. The Lenders Handbook for Troubled Hotels. There is no question that hotels can be real estate's most challenging asset class, but hotels also can provide yields disproportionately greater than the risk if managed properly. For more than 20 years, we have faced and solved the most difficult hotel legal issues, creating state of the art, cutting edge solutions to enhance and maintain hotel value.
2. "Mixed-collateral" security issues.
A hotel is comprised of real property and a lot of personal property. The personal property component can often account for 25% or more of the cost or value of the hotel. And the presence of both real and personal property creates a "mixed collateral" situation with interesting legal implications. Obviously, a hotel lender needs the mortgage or deed of trust that any real estate lender typically requires. But typical real estate security interests and insurance are not adequate for a hotel's substantial personal property. For the personal property elements, hotel lenders should also obtain:
- A separate security agreement
- UCC-1 financing statements
- Perfection of interest under Article 9 of the UCC in all the personal
property, FF&E, software and other tangible and intangible personal property
- Title insurance on the real property, and tie-in endorsement with personal property
- UCC insurance on the personal property
- Liquor license and inventory controls
3. UCC and personal property insurance.
Lenders should know that while recent changes in Article 9 have simplified and clarified the process for obtaining and perfecting a security interest in hotel personalty, there are still plenty of pitfalls. Therefore, lenders would be wise to obtain UCC insurance.
If structured correctly, a lender's UCC insurance policy insures against losses relating to the attachment, perfection, and priority of a UCC Article 9 security interest in personal property (in some limited instances, Article 8 of the Code may also apply). The policy also ensures that the security interest as created by the security agreement is enforceable against the borrower, that the security interest has been perfected by filing, possession, or control, as the case may be, and finally, that the lender has obtained the desired lien priority in the personal property collateral.
Furthermore, given the potential significance of personal property in a hotel, lenders will be underinsured if they only obtain a title policy on the real property. Title insurance only insures the real property and not the personal property. Therefore, lenders should also get the UCC personal property insurance and an endorsement to the title policy to tie in this personal property coverage.
In addition to describing the collateral, lenders will need to evaluate the implication of liens on the personal property even if the lender is not financing such personal property. For example, if a leassor under an FF&E lease were to remove all the beds, room furniture, TV sets, kitchen and banquet equipment, and meeting room chairs, there could be a significant impact on the hotel lender's non-personal property collateral.
4. Management agreement assessment.
Hotel management agreements or HMAs are a key factor in the success and value of a hotel -- particularly, getting the right operator and a fair hotel management contract. It is no surprise that articles on hotel management contracts are some of the most frequently viewed items on www.HotelLawBlog.com. We have a rich library of resources on this topic - everything from "How to get a great hotel operator" to "Terminating hotel management agreements when things don't work."
In few lending situations is the lender's collateral so completely controlled by a third party (the hotel operator) other than the borrower. In the hotel context, the operator sets policies, procedures, operating standards, staffing levels and benefit plans, room rates, operating budgets, capital budgets, and determines when cash from operations must be supplemented by the owner. The operator runs the day-to-day business that is a critical part of the lender's collateral, controls all the cash received and dispersed, and is responsible for generating all the business for the hotel. The operator also takes about 12-14% of the gross cash revenues of the hotel for base fee, management fee, centralized services, marketing fees, purchasing, reservations and the like. Not all of this cash is "profit" to the operator, but the operator receives and controls all the cash revenue of the hotel.
The operator also generates all the reports, financial information and data on the hotel's performance.
The hotel management agreement is one of the most important hotel-specific aspects affecting the value of a lender's collateral, and yet many lenders check only to be sure that a hotel management agreement is in place.
Lenders have to check the provisions of the hotel management agreement, and insist on amendments to improve the value of their collateral!
From experience gained in negotiating, renegotiating, litigating, arbitrating and advising on more than 1,000 hotel management agreements, we have identified approximately 20 major issues in a hotel management agreement that we regard as critical for preserving the value of the hotel for an owner or lender. The provisions in each of these areas have a "value" or "cost" for a owner - as well as a subsequent owner or lender who has become an owner. In short, these provisions affect the value of the hotel and the collateral.
Some issues are very important to a lender and cost the operator (and owner) nothing, such as ability to request a variety of information and reports, including flash reports (the raw data of daily or monthly information on hotel performance and costs), information about competitve staffing levels and salary surveys, and other critical information that a diligent owner or concerned lender may want.
Other issues may have a cost associated with them, but are important to maintain or enhance collateral value. Such matters might include subordination of operator fees to debt service or an owner return, owner approval rights over operating budgets, absolute approval over all capital expenditures, easy transfer rights with minimum or no operator approval, termination rights against operator in certain important circumstances (such as change in control of operator, deterioration of the brand, material changes in the brand, or sale of the property by owner), indemnification rights, and many more.
One provision in particular -- the subordination of the operator's rights under the hotel management agreement to the lender's rights under the loan -- are so significant that we discuss that matter under a separate topic called "SNDA" for Subordination, Non-Disturbance and Attornment agreement.
Please note: Contracts between hotel owners and managers (or operators) controlling the management of a hotel go by various names. They are called "hotel management agreements", "HMAs", "hotel management contracts" or "hotel operating agreements." For convenient reference, this article will generally use the term "Hotel Management Agreement" or "HMA", but all these terms mean exactly the same thing. There is no difference. Similarly, for variety we will use the terms "hotel manager" or "hotel operator" interchangeably.
To see all the articles on hotel management agreements on the Hotel Law Blog, go to www.HotelLawBlog.com, click on the tab for "Hotel Law Topics" and then select "Hotel Management Agreements."
5. Subordination, Non-Disturbance and Attornment agreement or SNDA.
A loan secured by a hotel will provide for package of typical documents, such as a note, mortgage, UCC-1, security agreement, and so forth. However, as most hotels are operated under third party franchise and/or management agreements, additional instruments must be added to ensure the lender's security interests and rights are properly maintainable and enforceable against these third parties. Knowledgeable hotel lenders will employ a "comfort letter" with franchisors and a subordination agreements with third party managers (or a subordination, non-disturbance and attornment agreement) with branded third party managers.
Hotel management agreements allocate risk between the hotel manager and the hotel owner. There are numerous provisions in the hotel management agreement that are of great concern to a hotel lender, such as reimbursement obligations, termination rights, performance standards, indemnifications, reporting, annual plans, controls over the use of hotel revenues, priorities with respect to the payment of hotel expenses, insurance and taxes. However, the hotel lender is not a party to the hotel management agreement. The provisions of the hotel management agreement may be inconsistent with the terms of the loan documents. Thus, the subordination agreement between the hotel lender and hotel operator is designed to align the interests of the hotel operator with those of the hotel lender.
Of prime importance, the hotel operator must subordinate the hotel management agreement and any other interests it has to lender's lien in the hotel, including lien claims on any hotel revenues. Often, the lender is asked by the hotel operator (particularly if the operator is a branded operator) to agree not to disturb the operator's right to manage the hotel (i.e., not to terminate the hotel management agreement executed by the owner/borrower or to remove the manager) following foreclosure. While this makes sense as long as a loan is performing, it can seriously diminish asset value and flexibility after a loan default by the owner/borrower. The sophisticated hotel lender will understand that the business and legal terms of the hotel management agreement -- wholly apart from the operator's abilities -- can easily add or subtract 25% of the nominal value of the hotel, or more. That is huge! Take a hotel nominally worth $10 million. By this industry rule of thumb, the hotel's value could easily swing from $7.5 million to $12.5 million depending on the operator and the management contract terms. If you multiply the nominal value by 10 for a $100 million hotel, the same rule applies, but gives you a swing of $50 million in value from $75 million to $125 million. We have seen the difference be much more in many situations.
Thus, it will be critical to the lender that a properly drafted subordination agreement, upon default under the loan documents, give the lender the option to continue the HMA or terminate it. This flexibility will have a dramatic impact on the value of the hotel, and how many bidders are interested in buying the distressed property, thereby affecting both sales price and absorption period.
6. Franchise Agreements and Comfort Letters.
Similarly, the franchise agreement can have an enormous impact on hotel value, even through the franchisor will not be the hotel operator. A lender needing to retain a franchise may find itself with unexpected obligations paying delinquent application fees, royalty fees, advertising or marketing fees, reservation charges, and the like. Or worse, a lender may be required to comply with a franchisor's property improvement plan (PIP) to bring the hotel into compliance with brand standards. This could be a significant cost but necessary to sustain the franchise. Moreover, an unsuspecting lender may be looking at paying early termination, default and liquidated damages if the comfort letter is not properly negotiated.
Knowledgeable hotel lenders and their counsel and consultants know that lenders need both certainty and flexibility with respect to hotel management agreements and franchise agreements to maximize hotel value. They need the certainty that a capable, professional hotel operator is running the property to maximize cash flow and preserve the value of the asset securing their loan. It typically makes more sense if the brand and operator stay in place when loans go into default or foreclosure to maintain professional management, reservation systems, and avoid suffering the significant cost and disruption of re-branding. But to maximize the value of the hotel collateral, the lenders would like for a potential hotel buyer (or the buyer at any of the distressed sales) to have the right on closing the purchase, or thereafter, to terminate the hotel operator or franchise.
Hint: A review of all the individual hotel purchase and sale transactions over the past 20 years -- which transacted for $10 million or more per property -- shows that in 80% of the transactions, the buyer was either a hotel management company or a joint venture of a capital source with a branded hotel management company. What happens if the long-term management agreement and the management agreement cannot be terminated on foreclosure or bankruptcy sale or on a deed in lieu sale, and 80% of the typical buyers for the hotel don't bid because they cannot substitute their management or brand? What is the impact on value? Thus, a subordination agreement and comfort letter can be a critical component in creating or giving up part of this value.
7. Liquor Licenses.
The status of a hotel's liquor license may have a critical impact on its business. There may be a lot of customers who do not want to have their wedding reception or annual convention at a hotel without a bar. Food and beverage operations can be significant profit centers and may suffer if the hotel can't serve beer, wine or other alcoholic beverages.
Loss of a liquor license could cause cancellation of critical business. Obtaining new licenses may be expensive, time consuming, and uncertain because of political considerations or limited license availability. Lenders may also not want to have all the directors and officers of every entity up through a parent holding company fingerprinted 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. A blanket security agreement and UCC-1 are completely ineffectual unless properly used. Depending upon the situation and local law, knowledgeable hotel counsel can usually resolve the problems of securing the economic benefits of a security interest in the liquor license.
In some instances, the license may be transferred to a separate management company (independent from the borrower). Or, the lender may require the borrower (owning the liquor license) to pledge its stock or other ownership interests, or to 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 the correct structure can generally accomplish a lender's needs.
8. Cash Management Agreements.
Central to sound hotel lending practices is lender's ability to control hotel cash revenue. One of the primary methods of accomplishing such control is through the use of a deposit account control agreement. Under revised Article 9 of the Uniform Commercial Code, the only method by which a security interest in a deposit account as original collateral may be perfected is by "control" as defined in UCC § 9-104(a). One common method for a lender to obtain control of cash flow is for the lender to require the borrower (i.e. the hotel owner) to enter into a so-called "control agreement" (often called a "deposit account control agreement") with the depositary bank by which the depositary bank agrees to follow the hotel lender's instructions as to the funds in the deposit account without the hotel owner's further consent.
Unfortunately, in the typical hotel managed by a major brand, the owner/borrower does not control the hotel's cash flow. The operator does under the hotel management agreement. And compounding the problem, lenders often sign the branded operator's typical SNDA which provides that the hotel lender will not disturb the branded operators' rights under its hotel management agreement. One serious consequence of this is that even upon a borrower default and where the hotel has a terrible negative cash flow, the lender may be unable to obtain control of the cash from the hotel operator. In other words, the lender has no practical ability to control hotel operator expenses, and stem the bleeding.
But there is also a potentially serious UCC legal issue caused by this situation that could interfere with a hotel lenders' perfection of its security interest in the cash deposit account. Specifically, UCC § 9-314 provides that the hotel lender, as a secured party, may perfect a security interest in a deposit account only by control as defined by UCC § 9-104. And, UCC § 9-104 requires that the hotel lender have an agreement that the account bank holding the funds "will" comply with the hotel lender's instructions directing disposition of the funds in the deposit account without further consent of the hotel owner. By leaving control over the account to the branded hotel operator, the lender arguably may have jeopardized the perfection of its security interest in the account. The argument against proper perfection would be that the branded operator is the agent of the owner (at least for receipt, deposit, and disbursement of the hotel's revenues), and thus by virtue of the SNDA, the lender has no power to interfere with or direct the disposition of funds. This could be a big problem for the lender.
What's it all mean?
The hospitality industry may be emerging from a historic low point with great opportunity for investors and lenders alike. However, lenders must realize the unique nature of hotels as compared to traditional commercial real estate. The operating business and hotel-specific factors require the use of industry experts for legal and advisory services. If lenders properly evaluate the collateral and document the hotel loan, they have tremendous prospects for sound lending -- particularly if they lend at the bottom end of the market instead of near the top. That time appears to be now.
Guy Maisnik is a partner and senior member of JMBM's Global Hospitality Group®. Guy advises clients on hotel transactions, representing lenders, opportunity funds, banks, special servicers, owners, REITs and developers in hotel transactions, including senior and mezzanine financing, workout and debt restructure, co-lender, participation and securitization arrangements, joint ventures, management agreements, buying, selling and ground leasing of hotels, complex mixed used resort development, fractional and timeshare. For troubled hotels, Guy develops and executes strategies for CMBS and whole loans, and REOs. He also assists investors with recapitalization of distressed borrowers and purchases of troubled assets. Guy has recently assisted 3 major lenders in completely revising and structuring hotel lending programs and documentation, including a hotel construction lending. Guy's practice is both domestic and foreign, where he has advised on hotel matters all throughout the United States, Mexico, Canada, South America, Caribbean, Europe and Asia. He has been recognized in California Real Estate Journal's Best Real Estate Lawyers, Los Angeles magazine's Top Southern California Lawyers, as well as a Top Real Estate Lawyer in Real Estate Southern California magazine. For more information, please contact Guy Maisnik at 310.201.3588 or mgm@jmbm.com.
This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We've done more than $60 billion of hotel transactions and have developed innovative solutions to unlock value from troubled hotel transactions. Who's your hotel lawyer?
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Our Perspective. We represent hotel lenders, owners and investors. We have helped our clients find business and legal solutions for more than $60 billion of hotel transactions, involving more than 1,000 properties all over the world. For more information, please contact Jim Butler at jbutler@jmbm.com or 310.201.3526.
Jim Butler is a founding partner of JMBM and Chairman of its Global Hospitality Group®. Jim is one of the top hospitality attorneys in the world. GOOGLE "hotel lawyer" and you will see why.
JMBM's troubled asset team has handled more than 1,000 receiverships and many complex insolvency issues. But Jim and his team are more than "just" great hotel lawyers. They are also hospitality consultants and business advisors. For example, they have developed some unique proprietary approaches to unlock value in underwater hotels that can benefit lenders, borrowers and investors. (GOOGLE "JMBM SAVE program".)
Whether it is a troubled investment or new transaction, JMBM's Global Hospitality Group® creates legal and business solutions for hotel owners and lenders. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them.
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For more than 28 years, founding partner Marc Marmaro has provided exemplary service to JMBM's clients, but effective August 5, 2010, Marc will be sworn in as a Judge in Los Angeles County Superior Court, fulfilling his passion for public service to the people of California. The California State Bar requires that his name be removed from the Firm's name.
In recognition of his commitment and contributions to the Firm for almost 25 years, the JMBM partnership elected to include Burton Mitchell's name in the Firm name. Burton is the Firm's Assistant Managing Partner and, as head of JMBM's Tax Department, has built one of the leading Tax, Trusts and Estates practices in California. 
Alan X. Reay, with over 30 years in the hotel industry, is President and Founder of Atlas Hospitality Group (AHG), a brokerage/consulting firm specializing in the California hotel market. Atlas is widely recognized as the market leader in California hotel sales, having completed over $2 Billion in sales transactions. In addition to their brokerage division, Atlas has established a world class research department that is utilized by major lending institutions, law firms and hotel owners/operators. AHG surveys on hotel sales and development trends have resulted in Reay being regarded as the "expert" on the California hotel market. In fact, Reay was the first in the U.S. to publish statistics on the distress in the California hotel market and in 2008 was the first to accurately predict the percentage decline in California hotel values. Reay is a regular speaker at major industry events. He has authored a number of articles for both the U.S. and international markets. He publishes two monthly newsletters--Atlas Hospitality News and Atlas Hospitality Lender News. Reay has been featured in numerous trade publications, newspapers, and on television and radio, including the Wall Street Journal, CNN Money, Bloomberg, Business Week, USA Today, LA Times, LA Business Journal, San Diego Tribune, Hotel & Motel Management, California Real Estate Journal, FOX News, KTLA News and National Public Radio.
Mark Tobin 
