With business and commerce opening up again across the UK, this issue of REF messages and views we are revising articles dealing with real estate finance legal matters. Obviously, the pandemic is not over yet and we continue to closely monitor changes in the regulatory environment and market movements and will post any major updates as they occur.
One of the key industries that grew rapidly prior to the pandemic is the hospitality industry. Although we have been badly hit by the pandemic, we are seeing green shoots from the reopenings as well as several opportunity acquisitions currently underway. We take this opportunity to introduce a special hotel finance series as this area will undoubtedly return to its former glory after the pandemic.
In this six-part hotel finance series, we’ll look at some of the most common topics and terms in hotel finance facilities. The comment has a European focus, particularly with regards to security and cash control mechanisms.
In this Part 1 of the series, we discuss the key differences between a hotel finance facility and a general real estate facility. Obviously, real estate financing has many special features and the procedure differs from transaction to transaction. Generally speaking, hotel finance is one such area that requires a very different approach. The crucial difference is that a hotel property is a single-purpose property. Therefore, understanding the (good) operation of the hotel operations is key to analyzing the business and therefore the reasonable conditions of the establishment.
Another thing to keep in mind is that, like many businesses, cash flow is not fixed and often cyclical, unlike properties where rent is relatively fixed, subject to any issues that may arise with the rental. This has two implications. On the one hand, in contrast to conventional real estate covenants, covenants should be specially tailored to the hotel industry and measured against business success. In particular, the financial covenants and cash controls are very specific, which we will go into in more detail in later parts of the series. It is important for lenders to analyze the underlying business by looking at the income statement and manager accounts and other reports – such as expected income and expenses, capital expenditures (both incurred and planned), labor issues, regulatory issues, etc – in the analysis of hotel operations. Additionally, given the cyclical nature of the business, it is customary for lenders to continue to closely monitor reporting.
A second implication of cyclical cash flow is that borrowers often demand some flexibility in using cash. A traditional real estate facility may require the borrower to deposit all net rental income into a controlled account with the lender, but hotel facilities may not. This is because the cash out date does not necessarily coincide with the gross profit deposit for any given period and therefore the borrower may need to withhold a portion of the cash to cover the expected expenses for the next period or to pay for some of the expenses in the Before the money comes in. As a countermeasure, lenders can often set up a buffer for regular debt servicing, such as cash reserves. In addition, the franchisor can demand that control over company accounts and investment amounts be maintained within the framework of the franchise agreement. These can be used for the purpose of providing a guarantee or as a minimum investment for renovations / improvements. This is discussed in more detail later in this series.
Many hotels operate under a specific brand, and brand name / reputation is an integral part of the hotel’s value. Due diligence on the franchise agreement and hotel management agreement (if the owner hires a professional manager to run the hotel) is paramount. In the case of franchise agreements, the franchisor often has a specific catalog of requirements (also known as “brand standards”) that must be adhered to so that the hotel remains part of the brand. The franchisor also conducts regular reviews to ensure the quality of the brand is maintained and asks the owner to make certain improvements. It is important to keep these points in mind, as non-compliance can result in certain penalties (e.g. the franchisor can step in or even terminate the franchise agreement if they believe that the franchisee is not involved in maintaining the franchise Brand standards). For the lender this means the careful implementation of a due diligence with regard to the hotel operation, the suitability / performance record of the hotel management as well as the examination of the respective franchise contract or hotel management contract. After all, the franchisor sets standards in terms of maintenance and ongoing modernization / renovation of the systems. Therefore, it is also important to look at the underlying sponsors and ensure that they have the financial resources and projected cash flow to fund required investments.
In terms of exit strategy, the exit strategy for lenders in a hotel finance facility is more complex than other properties, which usually boil down to selling the property and / or securing tenants (where a main tenant is involved). You can’t just sell the hotel quickly when the loan is in need, as the hotel operations may not have been operational in the first place, creating problems with the facility’s terms and conditions being met. Hence, the lender must be willing to run the hotel business or nominate a candidate who has the necessary experience and skill to do so until the lender can find a buyer. In addition, the circle of potential buyers is also smaller, as the hotel business requires expertise in this area and the franchisor often wants to approve the potential buyer. This is where the agreement with the franchisor (and, if applicable, the hotel operator) comes into effect. In the case of hotel financing transactions, the lender usually concludes three-party agreements with the franchisor (interference agreement) and, if necessary, a due diligence agreement with the hotel manager. These documents set out the circumstances under which the lender can intervene to assume the obligations of the hotel owner / operator if he breaches the relevant agreement and also provides the lender (and also the franchisor) with other safeguards by requesting the The franchisor to first notify the lender if there is a breach by the hotel owner (borrower) that would justify a right of termination so that the lender can take measures to remedy the failure and avoid termination of the franchise agreement. This is discussed in more detail later in this series.