Mr. Migdal

Hospitality Law

Hotel Acquisition Landmines

By Nelson Migdal, Real Estate, Shareholder, Greenberg Traurig LLP

A sophisticated real estate investor may know all the ins and outs of purchasing office buildings, retail venues, residential complexes, and mixed-use properties, but may fall short when it comes to identifying and avoiding potential landmines in hotel acquisitions. While purchase agreements used in hotel acquisitions may appear familiar at first glance, there are several key differences purchasers and sellers should be aware of before jumping into a hotel acquisition. Since every acquisition by a purchaser requires a sale by a seller, this article will provide some insight about things to look for during the entire hotel sale and acquisition process.

Flag or No Flag

There are many very familiar "brand" names of hotels and national hotel operating companies. The name carries value that investors and underwriters recognize in hotel valuation. Whether or not a hotel carries a "flag" "franchise" or "brand" is an important factor for prospective sellers and purchasers to consider in the universe of transactions representing components of what we consider the hotel sale and purchase. The flag impacts everything. The financial health of the hotel today and in the future as a result of the management of day-to-day operations of the hotel, the inventory of personal property that is sold along with the physical structure of hotel, collective bargaining agreements with unions, such as UNITE-HERE, unfunded pension liability, and intellectual property rights are all relevant.

The flag of the hotel is critical to the revenue generated and the value of the hotel. For example, if a hotel changes its franchise affiliation and goes from a strong franchise to no franchise or to a weak franchise, the hotel may lose a portion of the revenue stream that might have come through a strong central reservation system and an array of amenities provided by the brand through what is commonly referred to as "centralized services". A hotel that is sold "encumbered" (in the language of hotel owners) or "enhanced" (in the language of hotel operators) by a strong flag may be valued much higher than an independent hotel or a hotel that is sold with a weak flag. Purchasers must consider that along with the physical structure of the hotel, comprised of the land and the building, they may also be purchasing the right to use the name of the hotel, and all the benefits and obligations that entails. Sellers must ponder the same consideration, along with one other. The potential that the hotel management agreement includes a right of first offer, right of first refusal or some other purchase right or option for the benefit of the hotel manager. Hotel seller's should not assume that the sale of the hotel can occur without the involvement of the hotel manager as a matter of right. If the seller does not have an asset manager that may be intimately familiar with the management agreement, the seller needs to check for purchase options as part of the initial selling strategy.

This will play out in the negotiation of a purchase and sale agreement ("Agreement") through a clear understanding of the terms and conditions of the franchise agreement or management agreement, the ability to terminate that agreement, and the elements of the asset and the operations that are encompassed within such an agreement. Specifically, it is a common oversight to see an Agreement that defines the "Property" being sold and conveyed by the seller to include rights and duties relating to employees, permits and licenses, and marks and brands used in commerce to identify the hotel. With a "flag" in place, all of those rights are generally owned and controlled by the hotel operator and cannot be sold or conveyed by the seller. The hotel employees are often employed by the manager. The operating permits, particularly the liquor license, are often in the name of the manager. The proprietary marks are almost always the sole and exclusive property of the manager or its parent company. The lesson to be learned is assume nothing. The initial due diligence for both seller and purchaser should involve an assessment of who owns what and if and how it can be conveyed. This should come before the development team and the legal team spends too much time developing the checklist of what the seller is expected to sell under the Agreement. The seller may not actually own everything.

Franchise Agreements vs. License Agreements

As indicated above, during the due diligence period, purchasers must examine all the documents that may be transferred from seller to purchaser in connection with the right to use the flag. These rights may come in the form of a franchise agreement or in the form of a license agreement or branding agreement, or through a hotel management agreement.

Traditionally, branded hotels have operated through management agreements or franchise agreements, whereby the owner of the hotel acquires the right to use the name of the hotel and other benefits in exchange for the payment of monthly royalty fees, or the right to have the hotel managed by the franchisor in exchange for base fees and incentive fees. There may still be lease relationships in the marketplace, particularly operating leases to accommodate the REIT structure, but essentially, there are franchise deals and management deals. There are also relationships in which the owner hires a manager or operator, and it is the manager or operator that obtains the franchise from the flag. The benefit of this structure is that the manager hired by the owner is obligated to maintain the operating standards set forth in the franchise agreement. The significant point to remember is that when an owner hires the flag as its manager, rather that becoming a franchisee under a franchise, the primary economic responsibility resides with the owner. The manager must manage to the operating standards of the brand, but all at the expense of the owner. The manager will not be in default for failure to properly operate the asset if that failure is the result of or arises from the owner's failure to fund operations as required by the approved annual budget.

Recently, high end hospitality companies and even celebrities, have been licensing the right to use their brand name to hotel owners. This right comes in the form of a license agreement or a branding agreement and very specific brand standards that the owner of the hotel must comply with in order to maintain the right to use the brand. In this case, the owner purchases the right to use the brand name of the licensor but is not required to have the hotel managed by the licensor. The pitfall here is that in the event the hotel is not managed in compliance with the brand standards, the licensor can terminate the license agreement and pull the brand name from the hotel. More often than not the strength of the brand name is a critical component when obtaining hotel financing, and if the license agreement is terminated, if the owner is not immediately in default with its lender, a default is most probably imminent.

Although it is beyond the scope of this article, consider the information above in the structure of a condo-hotel or other asset type that might include residential property, fractional ownership or time-sharing. The potential for the loss of the brand after real estate purchasers have paid a premium to buy within a branded asset creates even more chilling and complex legal issues.

Lender Comfort

Upon the transfer of a hotel from seller to purchaser, many lenders will require a comfort letter from the franchisor or, in the management environment, a subordination, nondisturbance and attornment agreement ("SNDA") as part of the purchaser's financing. The purpose of the comfort letter is to provide lender "comfort" that in the event the new owner (its borrower) is in default under its loan documents, the lender can step into the shoes of the owner, cure the default and assume the obligations under the franchise agreement in order to keep the flag with the hotel. Because the flag carries value, the lender needs the comfort that the franchisor will send the lender default notices upon a default under the franchise agreement and recognize the lender under the franchise agreement, if necessary. Many franchisor's keep all of their options open, and reserve to the franchisor the right to terminate the franchise, or, at least, charge the new owner an application fee or other transfer fees in connection with the transfer of the franchise to a new owner. The SNDA is vastly more complicated because the hotel manager must preserve the right to continue to operate the asset, receive, at least, the base fee, and essentially not be terminated by the lender or any subsequent owner through foreclosure solely based upon the owner's default under its loan documents.

From the perspective of the purchaser's Agreement, the purchaser must anticipate the need for an SNDA to close its loan, and that the hotel management agreement may already stipulate a form of SNDA or the requirements of the SNDA. The sooner this aspect of the transaction is examined and resolved, the better it will be for both seller and purchaser.

Property Improvement Plan

Purchasers should not be complacent about the transfer of a franchise or assignment of a hotel management agreement upon sale. Franchisors and operators often use the transfer of the hotel to a new owner as an opportunity to upgrade the hotel. The franchisor will provide the new owner with a Property Improvement Plan (PIP). The PIP is a plan for renovation of the hotel which will generally set forth a massive list of hotel improvements the franchisor will require the owner to make if the hotel is to maintain the flag. Initially, this "face-lift" for the hotel may seem like a good idea to give the hotel a fresh start with the new ownership, however, the implementation of the PIP may come at a staggering cost, which often is not part of the purchaser's initial calculation of acquiring the hotel. In addition, there are many PIPs in progress at the time the hotel is changing hands. The PIP itself is usually the schedule of renovations and repairs. It does not set forth the cost. It becomes incumbent upon the careful purchaser to dig deeper and determine contracts in place, contracts being negotiated and contracts yet to come so that the purchaser can factor PIP related costs into its debt and equity structure.

Hotel Management Agreements

The day-to-day operations of the hotel are far more cumbersome than the day-to-day operations of other real estate investments. For example, a typical office lease runs for a ten year term, may contain two renewal terms of five years each, and contains obligations for the tenant to maintain its premises. This guarantees the owner an income stream and maintenance for 10-20 years. Hotel rooms have to be sold and maintained every day by owner. More often than not, the owner of the hotel does not want to take on the day-to-day operations of the hotel. This has never been more true than it is today with the universe of owners including life insurance companies, private REITS, pension funds and other private and public entities with investors or shareholders demanding economic results.

Hotel management agreements cover every aspect of the management of the hotel from employees, reservations, general maintenance and capital improvements to books and records and all the accompanying issues. During the due diligence period, the purchaser must carefully review the existing hotel management agreement or have an experienced hospitality attorney prepare a comprehensive hotel management agreement.

Employees

One of the big issues for hotel owners is which party is the employer - the owner or the manager? There are pros and cons to each scenario, and the terms and conditions of the Agreement with respect to employees and employment matters must be complete. Typically, the owner is responsible for the costs of employment as an operating expense of the hotel regardless of which party is the employer. Similarly, the issues of imputation of liability for the conduct of certain employees are often the same regardless of who the employer is. What tips the scale will vary based upon many factors, and the applicable law of the jurisdiction in which the hotel is located. It is not unusual for the manager to be the party best equipped to deal with the legal aspects of employment issues, including collective bargaining agreements.

Although it is capable of being adequately address in the Agreement, particularly when the current manager is the employer, the purchaser must be mindful of how the transfer of ownership of the hotel might trigger the applicability of the Worker Adjustment and Retraining Notification Act (WARN Act). The WARN Act protects workers by requiring employers to provide notice 60 days prior to hotel closings or mass layoffs.

If the hotel will continue to operate, the manager is the employer and the owner assumes the hotel management agreement upon the hotel acquisition, the employees stay in place. However, upon the transfer of ownership of the hotel, if the hotel employees are employees of the seller (other than employees who have worked less than 6 months in the last 12 month period or worked an average of less than 20 hours a week), on the date of closing the employees of seller become the employees of purchaser.

There are many issues related to employees when transferring ownership of the hotel, for example the Agreement should address the allocation of all accrued but unpaid employee salaries, wages, bonuses, profit sharing and other benefits. This can be a hidden cost if not addressed during the hotel acquisition process. Purchasers should discuss the issues related to the employment of hotel employees with an experienced employment attorney prior to purchasing a hotel.

Food and Beverage Operations

Food and beverage operations are an important component of a hotel, whether the hotel simply has a minibar in each room, or has a full service catering and banquet operation. The first line of inquiry is which party holds the liquor license or other licenses necessary for the food and beverage operations. If the manager holds the licenses and the purchaser assumes the hotel management agreement or food and beverage management agreement, this transition should go smoothly. If the seller holds the licenses, the purchase agreement should address the transfer of the licenses. The purchase agreement should require the parties to cooperate in the effort to transfer the licenses, and that in the event that the licenses cannot be transferred prior to the date of closing, the purchaser may operate the hotel using the existing licenses for a period of time. Typically the seller will require a concession or indemnification agreement in connection with the continued use of the licenses by purchaser. This is one are of the Agreement that depends almost entirely upon local law. It is essential that all of the local rules be understood. The opening of a full service hotel without a liquor license does happen, but it is not a very pretty situation.

Transfer of Inventory and Reservations

The transfer of inventory upon the sale of a hotel can be quite an undertaking. For example, if the hotel is branded, much of the consumable inventory (toiletries, towels, napkins) contain the brand logo and even specific location of the hotel. If this inventory is not transferred to the new owner, license agreements typically require that all the inventory be destroyed. Often in purchase agreements the parties expressly agree not to comply with and agree to waive any statutory bulk sale requirements which are applicable to the sale of a hotel, and instead contractually agree to address the bulk sale and the transfer of inventory in the Agreement.

Reservations for hotel rooms, meetings, special events and banquets must be addressed in the Agreement. Reservations and deposits must be transferred to the purchaser upon the acquisition of the hotel and the seller must agree to cooperate with purchaser and act in good faith in the taking reservations prior to the transfer of ownership.

And There Will Be More Work Ahead

This is just a sampling of how the acquisition of a hotel differs from other real estate acquisitions. Best bet, assume nothing and read everything prior to purchasing a hotel.

This article was co-authored by Tara Gorman. Ms. Gorman is a Shareholder at Greenberg Taurig. She focuses her practice on general commercial real estate transactions, including commercial real estate acquisitions and sales, hotel acquisitions, operations, development and finance, office leasing, various financing transactions involving lender and borrower representation and telecommunications and access matters on behalf of building owners and managers. Ms. Gorman has represented institutional investors such as life insurance companies and pension funds in connection with their real estate investments, as well as governmental and quasi-governmental agencies with respect to their real estate holdings.

Nelson F. Migdal is a Principal Shareholder at Greenberg Traurig and head of the Mid-Atlantic Real Estate practice group. He has practiced hospitality law for over 25 years. He handled the management agreements for The Echelon Place, in Las Vegas. In Panama, as owner's counsel, he obtained the first "Trump" license in Central America. Nelson is owner's counsel for The Trump Soho Project, and handled the Exclusive License with Trump in Istanbul. Nelson is an officer of the Academy of Hospitality Industry Attorneys and a member of the International Society of Hospitality Consultants. Mr. Migdal can be contacted at 202-331-3180 or migdaln@gtlaw.com Extended Bio...

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