Mr. Brewer III

Hospitality Law

Who Will Win When the Hospitality Industry Improves?

By William A. Brewer III, Managing Partner, Bickel & Brewer

Monitoring the Forecast: the Economic Recession and its Effects on the Hospitality Industry

The economic recession has had a tremendous effect on every aspect of the hospitality industry. Hotel owners, operators, and investors alike are experiencing the negative effects of reduced consumer and business spending on the industry. Leisure travel has suffered as consumers cut spending in response to lost jobs and the 2008 credit crisis. Corporations have cut spending wherever they can, resulting in less business travel and less convention and conference business for hotels. Although the luxury and upper-scale segments have been most impacted, due to their higher rates and higher cost structures, the entire industry is experiencing occupancy rates that are hovering near 30-year lows.

Faced with declining occupancy and reduced cash flows, many hotel owners are struggling to meet debt service. Owners have responded to the crisis in various ways. Some have put up additional equity capital to pay down debt. Many owners, however, do not have additional equity capital and are forced into survival mode. In the most severe cases, owners have lost their investments altogether.

While owners are concerned with protecting their investment, operators confront declining revenue streams due to lower management fees resulting from lower occupancy and room rates. In many cases, owners demand cost cuts and service standards that are less expensive to maintain. Faced with these demands from their business partners, operators are attempting to manage their risks, which include damaged reputations, costly litigation, or contract termination.

One would think this distressed environment would be ideally suited for hotel investors. However, buyers are sitting on the sidelines as industry fundamentals, a lack of realistic valuations, and scarcity of debt capital are conspiring to choke off any appetite for risk.

According to Jones Lang LaSalle, Commercial Mortgage Backed Security ("CMBS") issuance, once the primary source of hotel debt financing, dropped to $10 billion in year-to-date 2010 from the high of $315 billion, set in 2007. This precipitous drop in the availability of debt capital has had the predictable impact on transaction volumes. In fact, the same LaSalle report shows that global hospitality transaction volumes are expected to be $13 billion for 2010, an alarming decline from the $120 billion peak set in 2007.

The owners, operators, and investors that best manage their risks through this difficult economic climate will be best positioned to profit from future opportunities in the next market upswing.

Hotel Owners: A Guide to Survival

During times of economic crisis, the fundamental conflict of interest between owners and operators is a source of considerable friction. Due to the structure of most hotel management agreements, wherein the operator receives management fees based on a fixed percentage of gross operating revenue ("GOR"), there is an inherent incentive for the operator to maximize revenue.

Although many hotel contracts contain incentive fee structures to more closely align the interests of owner and operator, the fixed portion of hotel management fees is typically the main source of revenue for hotel operators. A resulting conflict of financial interests is often apparent during times of economic stress - when hotels can run at levels insufficient to fund debt service.

This conflict is exacerbated by the operator's inherent interest in protecting its brand. Operators seek to accomplish this by maintaining uniformity of service, facility quality, and consistent rates. This is important to operators, given the size of the investment necessary to create a viable brand. During periods of economic expansion, most owners benefit greatly from the brand's reservation networks, uniformity of service, and yield management. However, an operator's failure to adjust overhead costs in response to changing economic conditions and lower occupancy rates is potentially a breach of its fiduciary duty to the owner.

Within this context, it is important for owners to practice effective preventative maintenance of owner-operator relations in order to minimize potential problems. Owners should perform asset management seriously. Constant, constructive vigilance and dialogue with the hotel operator should allow for course-correcting problems before they develop into full-blown disputes. For example, an annual review of the hotel's books and records is an integral part of this process.

The annual hotel budgeting process should be an area of focus for all hotel owners. This process should be seen as a way for the owner to firmly dictate expectations to the operator. The primary goal in this process is to set the stage for maximizing patronage by ensuring operators are employing effective yield management strategies, improving efficiency, and monitoring profit margins, in order to meet debt service. Labor costs are usually the largest variable cost at most hotel operations. Accordingly, owners should insist that their operator establish a realistic "crisis" plan for reducing personnel. Operators may resist any attempts to reduce staff, but an owner in crisis must persevere or risk having to fund negative cash flows, an untenable situation.

There are various remedies available in the event an owner's agent-operator becomes uncooperative or openly adversarial. If the hotel is in reasonably good financial shape (e.g. able to meet debt service for the foreseeable future), but the owner and operator are having a disagreement about certain aspects of the budget, then a budget mediation may be the recommended course of action. As a last resort, after all attempts to reason, with the operator have failed, litigation may be considered as a mechanism to protect the owner's asset.

Litigation is sometimes the only way for a distressed hotel owner to save its asset from an operator not inclined to employ the measures needed to protect the owner's investment. If the owner has followed the prudent path and made reasoned efforts to convince an operator to cut costs and improve operational efficiency, then the litigation position is often strong. An operator that works against the owner's interests may find its legal position vulnerable.

Hotel Operators: Avoiding Conflict

During times of economic distress, the balance of financial risks and rewards lies in favor of the operator. While the owner is faced with paying for operating costs, labor expenses, and debt service, operators only have to worry about their fees. Therefore, the prudent operator should do everything to maximize the fee-revenue stream without taking actions that imperil the balance of financial risks. Operators that are disloyal to their hotel owners and inflexible will suffer the long-term consequences of their actions. Operators can tarnish their image after being associated with foreclosures or public disputes with their owners. In the event of foreclosure, operators will usually remain in place - the beneficiaries of lender subordination and non-disturbance agreements.

During times of financial distress, operators gain more currency with owners when they strive to be seen as a partner to the owner as opposed to an adversary. Full disclosure is essential to accomplishing this goal. Operators that obstruct attempts by ownership to gain access to things like the hotel's accounting records, while resisting ownership's demands for cost cutting, will pay a steep price, the least of which will be a loss of trust and confidence among all the parties.

In sum, an operator managing a hotel that cannot meet debt service must make every reasonable effort to reduce labor costs and cut expenses in order to help the owner close the gap relative to the shortfall.

Hotel Investors: Guidelines for Distressed Hotel Acquisitions

The number of hotel transactions has declined in the last two years because of the lower spending by consumers and the corporate sector, a scarcity of debt financing, and the determination by sellers to "hold on" for higher prices. Attractive opportunities seem few and far between in this environment. Part of the problem is a lack of consensus on the shape of an economic recovery. In this uncertain environment, hotel investors should re-focus on the fundamentals of valuation and due diligence - in order to protect themselves and their equity partners.

Investors should ensure that hotel properties are acquired at the right price. Hotels encumbered by long-term management contracts should be discounted in relation to properties offered "free and clear." The difference should be obvious. An encumbered property forces the owner into a contract they did not negotiate, with an operator that could be the wrong fit. Great care should also be taken to make realistic pro-forma assumptions and plan for a prolonged recession. Although the recession may be shorter than expected, the prudent investor will prepare for the worst even as he hopes for the best.

Once an investor is lucky enough to find an attractively valued property, a willing seller, and financing, due diligence should become the top priority. This process should focus particular attention on the contracts and agreements being assumed in the purchase. A deep and thorough understanding of employment agreements, management contracts, and lender/operator/owner agreements is vital to a successful investment.

If the acquisition target is a hotel encumbered by a long-term management agreement, then every effort should be made to renegotiate the contract with more favorable terms for the new owner. New money always has some negotiating leverage and operators may be willing to concede on some points. Some specific areas of focus to consider include: (i) shortening the term of the agreement, (ii) contract extensions at the option of the owner, (iii) strengthening the performance provisions in the management contract in favor of the new owner, (iv) enhancing the owner's rights to full disclosure and access to hotel books and records, (v) enhancing the owner's rights of contract termination, and (vi) establishing provisions to give the new owner more input and control over the annual budgeting process.

On the Horizon - Looking Ahead

In this economic recession, hotel owners are faced with the most pressure, but have a wide range of options and degrees of escalation in their relationship with operators. Owners should focus on controlling costs as a means of surviving the storm. When faced with an uncooperative or disloyal operator, termination of the manager may be the next realistic "fix."

Hotel operators that do not heed their owner's financial distress will face conflict and damaged reputations. Operators can take a "bend but don't break" attitude, as the most prudent approach is to work as a partner and not an adversary. Operators must realize these can be desperate times for many owners, and flexibility may be necessary in order to thrive in the long term.

Hotel investors must focus on buying assets at the right price and under the right circumstances. The due diligence process should be given additional priority. Now, more than ever, an unfavorable management agreement could doom an investment in the long term.

Alejandro B. Merson, CFA, of the Bickel & Brewer Consulting Group contributed to this article.

Under Mr. Brewerís direction, Bickel & Brewer has become renowned for its innovative handling of major disputes in a number of industries, including the hospitality industry. Not only has his work in this area changed the state of the law, but it also has resulted in the formulation of creative solutions to countless problems confronting the industry. The firm has represented hotel franchisors, management companies, owners, developers, and investors in many of the highest-profile matters in the industry. Mr. Brewer is frequently published on a wide range of legal and business issues effecting the hospitality industry. He is a member of several leading industry associations, including the American Hotel & Motel Association and the Academy of Hospitality Industry Attorneys. Beyond these associations, Mr. Brewer is active in a broad range of professional groups and philanthropic organizations. Mr. Brewer III can be contacted at 214.653.4000 or wbrewer@bickelbrewer.com Extended Bio...

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