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Due diligence tips for your next hotel acquisition

By Jim Butler and the Global Hospitality Group®
Hotel Lawyers | Authors of www.HotelLawBlog.com
9 January 2013


Hotel Lawyer with the due diligence wakeup call.

As an introduction to today’s article on due diligence, I would like to reprint a portion of my blog from December 31, 2008:

Bernard L. Madoff — Maybe the Madoff debacle provides the quintessential anecdote. In what is clearly the largest Ponzi scheme in history — probably involving $50 billion — one man seduced the elite of the elite in the financial world. Who would think that Henry Kaufman, former Chief Economist of Salomon Bros. would be hoodwinked by a Ponzi scheme for several million?

And how did respected institutions like BNP Paribas, Royal Bank of Scotland and Nomura Holdings get tagged for around $500 million each? Or HSBC and other professional investment firms for more than $1 billion each?

The answer to these questions is pretty simple: It was a fundamental failure to perform due diligence.

I think one commentator at dealbreaker.com recently summed up the syndrome best that became an international epidemic. It was his answer to the question of how someone could trust their entire fortune to Madoff. The answer?

Goldman did due diligence in 2001
["no we didn't", "yes you did"]
and gave them a pass.

That kind of sums it all up. No one wanted to say that the emperor had no clothes. No one wanted to do all the due diligence when it seemed like someone else must be doing it. Everyone just “assumed” that it must be OK. Who needs due diligence anyway?

You do (on every hotel acquisition)! Here are some tips.

Due diligence tips for
your next hotel acquisition

by
Catherine DeBono Holmes | Hotel Lawyer

What is due diligence?

Particularly in the context of a hotel acquisition, “due diligence” generally refers to the investigation conducted by a potential buyer of the hotel that is the target of the acquisition. The investigation covers both the physical asset (i.e. the hotel structures, parking, systems, equipment, inventories) as well as the operating business conducted at the hotel facility, and the relevant markets and environment.

The purpose of the investor’s due diligence is to understand and evaluate the potential investment in the hotel. It is the analytic review of the real and personal property, the business operations and potential of the specific hotel. This effort all seeks to validate the investor’s reasons for buying the hotel and to avoid surprises after the purchase has closed.

Perhaps the most significant element in the buyer’s calculation of a bid or purchase price is the analysis of the potential earnings to be derived from the hotel. To 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 on stabilized operating projections. 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.


Because your bid or purchase price is based upon a calculation of anticipated revenues and expenses, the due diligence process is critical to validate or gain comfort with your assumptions on these cash flow analyses, and to avoid unnecessary surprises. Unforeseen expenditures to replace leaking window systems, replace boilers or cooling towers, demolish a portion of the hotel which encroaches on adjoining property, or meet a new property improvement program from the brand — these can all play havoc with purchaser’s expectations if they weren’t anticipated.

What are the biggest complaints from buyers about hotel due diligence?

The complaints we hear usually go something like this:

  • I wish I had done more due diligence sooner!
  • If I had found this out two weeks ago, I would have had better options.
  • We could either have renegotiated the deal or saved a lot of money before we walked from the deal.

In today’s seller’s market, the time allotted for due diligence, deposits going nonrefundable, and closing has been greatly compressed. All sophisticated buyers know they have to act fast. But it bears repeating:

  1. Assemble your due diligence team. Coordinate your team with detailed due diligence checklists. And control the process or have a quarterback do it for you.
  2. Start your due diligence as early as possible.
  3. Prioritize and push critical areas of due diligence so potential “show stoppers” and other important factors can be identified and evaluated early.

Great due diligence begins with properly drafted seller’s representations and warranties in the purchase agreement.

Because most hotel purchase agreements are written with strong “as is” language, and express provisions that a buyer must rely on its own due diligence, many buyers do not spend enough time focusing on seller representations and warranties. This is a mistake. Regardless of significant disclaimers in the purchase agreement, having a set of properly drafted representations in the purchase agreement by experienced hotel counsel can significantly help flush out critical issues concerning the physical and operational hotel issues that only a seller or its management company would understand.

A few buyers may rely upon a seller’s representations and warranties in place of their own due diligence plan, but that too is a mistake. A buyer must execute on its own due diligence plan as if the seller made no representations. A fundamental part of a buyer’s due diligence plan should be in the discussions, negotiations and tailoring of the seller representations. Even if the seller is unwilling to make a specific representation and warranty on a particular condition, focusing on the issue up front will help frame the buyer’s post-signing due diligence. For further information, Seller representations and warranties in a hotel purchase agreement — What are the big issues today?” from HotelLawBlog.com (November 4, 2012)

Some buyers erroneously believe that the indemnification clauses of a purchase contract will protect the buyer.

However, indemnification clauses usually are inadequate to protect a buyer from additional costs that could have been avoided with proper due diligence. Indemnification generally applies only for breaches of representations and warranties, and if the seller limits or qualifies its representations and warranties, the indemnification provision may not be triggered.

In addition, indemnification is often limited by deductibles, buckets, caps and expiration dates, any of which may exclude indemnification. Further, in many cases, once the seller sells the property, the seller (or selling entity) will distribute the proceeds of sale and may have no assets left with which to pay any indemnification. Finally, even if none of the above limitations apply, the seller may simply refuse to pay the indemnification, and the buyer will then incur the cost of suing the seller to obtain the indemnity.

See The hotel purchase and sale agreement — What is the value of the seller’s representations and warranties to a hotel buyer from HotelLawBlog.com (November 9, 2012).

While indemnification can have limited value, it is no substitute for the buyer’s independent due diligence.

Conclusion

Because of these issues, the buyer’s first line of defense from unexpected loss is solid due diligence, accompanied by a process of working through representations and warranties in the purchase and sale agreement. Indemnification is the last line of defense. By performing due diligence in the early stages of a contract negotiation, the buyer will have more alternatives, less costs and more negotiating power to deal with the issues.

HOW TO BUY A HOTEL — Free handbook

Until the free handbook on HOW TO BUY A HOTEL is published (expected soon), you can access all the materials on this subject at www.HotelLawyer.com. Look on the right hand side of the home page and click on “Buying & Selling a Hotel.”

Here are a few of the articles on the subject under this topic:

Due diligence tips for your next hotel acquisition

Buying a hotel? Financing a hotel? 10 things every borrower should know. (part 1)

Buying a hotel? Financing a hotel? 10 things every borrower should know. (part 2)

The hotel purchase and sale agreement — What is the value of the seller’s representations and warranties to a hotel buyer?

Can I use the EB-5 Visa Program for financing hotel acquisition and renovation?

Seller representations and warranties in a hotel purchase agreement — What are the big issues today?

How to buy a hotel — What you don’t know about undocumented workers could really hurt you!

HOW TO BUY A HOTEL Handbook: Franchise issues in hotel purchase and sale transactions

HOW TO BUY A HOTEL Handbook: labor and employment tips

5 Things to remember when buying hotel notes

Picture of Catherine Holmes Catherine Holmes is a transaction and finance partner with JMBM’s Global Hospitality Group® and Chinese Investment Group™ and specializes in hotel management and franchise agreements, resort and hotel purchase and sale transactions, resort and urban mixed-use financing and development and hospitality asset workouts. With her background in securities transactions, she also assists hotel developers with public and private offerings of securities. For more information, please contact Catherine Holmes at +1 310.201.3553 or cholmes@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 help investors be successful in bidding for hotel acquisitions, and helping investors and lenders 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® and Chinese Investment Group™. Jim is one of the top hospitality attorneys in the world. GOOGLE “hotel lawyer” and you will see why.

Jim and his team are more than “just” great hotel lawyers. They are also hospitality consultants and business advisors. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them.