HOTEL BUSINESS REVIEW
DECEMBER FOCUS: Hotel Law

The Challenges and Opportunities of Foreign Investment in the U.S. Hospitality Market

By William A. Brewer III Managing Partner, Brewer, Attorneys & Counselors | December 2016

Why Foreign Investors Like the U.S. Market

The U.S. hospitality market remains particularly attractive to foreign investors. The Boston Hospitality Review reports:

"In 2015, total U.S. hotel transactions soared above $43 billion, largely due to full-service hotel sales in key gateway markets such as New York and San Francisco. During the first three quarters of 2015, cross-border hotel investments in the U.S. amounted to $6.4 billion, representing more than 20% of total deal volume, a 165% increase in foreign investment over the prior year period."

Foreign buying in 2015 accounted for 16% of total investment in U.S. real estate, about double the 8% average in the ten years through 2012. Bloomberg reported in October 2016 that China accounted for the majority of a surge in Asian investment in international real estate.

There are numerous reasons why foreign investors find the U.S. market attractive. Asian institutions, specifically insurance companies, have relatively low allocations to real estate, which can offer higher yields than available on bonds at a time of low to negative interest rates.

It has been reported, international funds "invest abroad in order to diversify their portfolios and hedge currency, political, and regional risk. Real estate is an attractive form of investment for any investor given its tangible nature, inflation-hedging track record and easily-quantifiable valuation… Purchasing hotels in international markets allows investment firms to gain broader recognition, customer base, and market intelligence."

For example, China's Anbang Insurance Group purchased the Waldorf Astoria New York for $1.95 billion in 2014, making it the crown jewel in its U.S. hospitality portfolio. Anbang assumed a significant stake when it bought most of Strategic Hotels & Resorts Inc. from Blackstone in September 2016. Blackstone reportedly is selling about one-quarter of Hilton Worldwide Holdings Inc. to Chen Feng's HNA Group for approximately $6.5 billion.

In April 2016, HNA agreed to buy Minneapolis-based Carlson Hotels Inc. and its majority stake in Rezidor Hotel Group AB, owner of the Radisson brand. HNA last year purchased a minority stake in Red Lion Hotels Corp. It appears that HNA is positioning itself to market a full range of travel services - including booking trips, hotel rooms and airline tickets.

Foreign Investor Profiles

History shows foreign groups who invest internationally tend to prefer long-term investments. When Anbang Insurance Group bought the Waldorf Astoria, it signed a 100-year HMA with Hilton International.

Foreign investors traditionally have preferred to acquire assets in large U.S. cities. As real estate prices in major metropolitan areas increase, however, other markets are becoming attractive. In our experience, many foreign investors prefer luxury hotel investments because these hotels tend to have higher property values and are conservative investments.

The luxury segment comes with many advantages. Luxury operators are typically well-known, which provides a level of comfort with a known commodity. There is also prestige associated with a luxury hotel experience - an association valued in investment portfolios.

Foreign Investor Challenges

Of course, foreign investors face a number of challenges in the U.S. as they look to expand hotel investments. These challenges arise prior to the deal's commencement. Foreign investors entering the hospitality market often have limited familiarity with the U.S. hotel market. It is important for the investor to outline all of the risks associated with the asset. All risks must be properly vetted and mitigated before purchasing a hotel. Financing, U.S. tax laws, foreign exchange risk, competitors, and the cyclical nature of the industry are all key considerations. Foreign buyers may prefer to obtain financing in their own country; however, this may not always be possible on large hotel purchases.

There are several issues to consider with complex financing deals using foreign and U.S. debt. U.S. tax laws, such as the Foreign Investment in Real Property Tax Act, are important to consider when deciding on the purchase of a hotel. In addition, a competitive environment is evolving in the U.S. with the advent of Airbnb and younger customers shifting away from full service hotels. In regard to the industry cycle, there has been a significant development of hotels since the great recession in 2008. This increased supply of rooms will impact profitability and, if sustained, could cause an eventual downturn in the market.

And, there are challenges that relate to the responsibility for the operation of the hotel. The operation of the asset ultimately impacts the property's valuation. Foreign investors need to be particularly careful in crafting the HMA to ensure that the terms meet the financial goals and expectations for the development and continuing operation of the property. The HMA is the foundational agreement that will govern the relationship between the owner and operator into the future.

The negotiation of a proper HMA is critical to both the immediate and long-term relationship of the parties, ensuring flexibility in both proactive and reactive hotel operations responsive to changing industry markets.

Hotel Management Agreement - The Last Vestige of Pay Without Performance

HMAs are often long-term contracts with difficult termination provisions that provide for operator damage - unless termination is for cause. For owners who are predominantly investors - not operators - HMAs are vital tools to drive the economics of their deal, and their relationship with their operators.

In negotiating HMAs, parties should understand how the agreement will impact their profitability, how it may be interpreted in the future and what steps should be taken to limit any extra-contractual duties. In reviewing the agreement, close attention should be given to not only its terms, but also to any extra-contractual duties that may be implied by law. Foreign investors, who may not have an institutional grasp of the subtleties of U.S. law, should have a full understanding of their rights and responsibilities under their HMAs. They should also constantly monitor actual operation activity and processes in connection with the terms of the HMA.

Although there are many instances when an established brand manager will enhance the value of a property, the opposite also can occur. In the view of many owners, once a manager becomes the beneficiary of a long-term agreement, they may allow brand interests to become paramount over owner's concerns.

The HMA details the duties and obligations of the manager. Generally, this includes an array of services - from directing core hotel operations to managing the hotel in accordance with an approved annual budget. Based on the HMA, the manager typically receives management fees based on a fixed percentage of gross operating revenue (GOR) and incentive fees on gross operating profit. HMAs also designate the period of the contract's term and renewal periods - typically without regard to performance.

Natural Allies/Sometimes Enemies - Owners and Brands

There is a disconnect in some agreement structures. Fees based on gross revenue ignore costs associated with the operation. Costs may not be a concern of the operator if its focus is on luxury brand recognition. Consequently, an owner's reasonable expectation regarding value and profitability is sometimes ignored by the manager's focus on development, promotion and preservation of its brand at the expense of the owner. This is where the disconnect between the respective parties can give rise to unstable, and often contentious, relationships.

Hotel owners make money if the value of their property increases and if profit is generated from the hotel's operation. Conversely, operators earn their management fees based upon revenue generation and brand recognition. Operators typically are paid a percentage of a hotel's revenue irrespective of the hotel's profitability. This can create misalignment when the owner's focus on profitability is ignored by an operator's focus on revenue generation and brand recognition. This disconnect between the priority and goals of the parties can create unstable relationships and litigious situations.

Owners may consider terminating an HMA for a number of business or strategic reasons. A fixed or long-term tie to a certain brand, for example, may hamper the interest of prospective buyers in situations where asset divestiture becomes necessary. In such situations, terminating an HMA and rebranding may increase the value of the owner's assets.

Operators should provide the stability of a distribution network, a reservation system, and access to trained staff at all levels. In the view of some owners, operators do not always act in the owner's best interest and ignore the need for investment return on real estate property when assuming the responsibility and control of an owner's valuable asset. In some instances, operators have been found to ignore profitability when it is not a condition of their fees, and this ultimately affects property value. This scenario is unacceptable and often leaves an owner with no option but to seek termination of the relationship with the operator.

Foreign investors can take heart in knowing that in the U.S., owners may rid themselves of ineffective operators who do not adhere in good faith to their duties to operate the asset in the best interest of the owner. Depending on the operator's actions, the operator may be liable to the owner for damages resulting from mismanagement, operating losses, and a decrease in property value.

Our experience in representing hotel owners and management companies (at trial and in arbitration proceedings) has taught us that the greatest risk is uncertainty. Specifically, HMAs that do not address such fundamental matters as those discussed in this article are breeding grounds for disputes between owners and operators.

The rights and obligations of owners and operators should be fully identified and defined in the written contract between the parties. Responsibilities for project design, development costs, operating expenses, and profitability must be addressed in negotiations and memorialized in clear and unambiguous terms in the HMA. This is the best way to avoid disputes and ensure a smooth, productive and mutually beneficial relationship.

Trouble in Paradise - Breaches of Contract and Breaches of Fiduciary Duty

Operator's Obligations Outlined in HMAs

There should be an obligation in an HMA for managers to maximize the owner's profit. This obligation is expressed in HMAs in two ways: (1) the obligation to maximize revenues (i.e., the proceeds of room sales, food and beverage sales, etc.); and (2) the obligation to minimize costs by efficiently managing labor and payroll costs. This obligation is also expressed by obtaining the lowest pricing in connection with the purchase of necessary goods and services, operating the hotel efficiently and in the most cost effective manner, avoiding waste, protecting against fraud and preventing employee and corporate self-dealing.

Management contracts also typically set forth a general operating standard, which often references the market segment in which the subject hotel competes. If effectively drafted, this standard establishes precedent that the hotel operator should perform at least as well as its competitive set. It is common practice in the hotel industry to benchmark against similar hotels in a geographic area. For instance, luxury hotels in a certain geographic location should achieve similar average daily rates, occupancy, revenue per available room (RevPAR) and expense ratios.

Operators Obligated as Fiduciaries

Hotel management companies generally are recognized and understood throughout the hospitality industry as agents and fiduciaries of the owners of the hotel properties and assets they operate. A number of duties and responsibilities arise from this fiduciary relationship, including obligations of utmost loyalty, due care, candor and good faith.

This is appropriate given that HMAs typically provide the agent-operator with wide discretion and substantial control with respect to hotel operations. The operator can have exclusive responsibility and full control and discretion in the operation, direction of management and supervision of the hotel and its staff. The greater discretion and control invested in an owner's managing agent, the greater the need for undivided loyalty, due care and transparency on the part of the operator. This is especially true with regard to operators of luxury hotels, because properties in this market segment typically represent hundreds of millions of dollars of investment with tens of millions of dollars of business activity flowing through them annually.

Operator's Failure to Meet Obligations

When an operator fails to meet its obligations, even if there is a long-term HMA, an owner can be left with no option but to rescue their investment. A viable economic option that should be considered in the HMA is the termination of the operator.

Proper financial management provides investment returns to owners. Proper financial management also means an operator must successfully maximize revenues and minimize costs. The failure to attempt to attain these objectives is, at a minimum, a violation of industry standards applicable to hotel operators. A refusal to pursue these objectives because of an operator's pursuit of its own interests is a breach of duty, which undermines the business relationship.

A failure or refusal to fully, timely and faithfully disclose to the owner any of the types of conduct described above is equally irreverent. Such acts and omissions are grounds for the operator's termination. No operator deserves the right to continue functioning as an owner's agent in those circumstances, and no reasonable owner should have to tolerate an operator's continued control of the owner's hotel in that event irrespective of an HMA.

These are important issues and considerations, particularly for those who are navigating the terrain of foreign investment in the U.S. hotel market.

Brewer, Attorneys & Counselors', director of consulting Susan C. Dillon contributed to this article.

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11. MEMBERSHIP FEES

Hotel Business Review Subscriptions

If you choose to purchase a subscription, member subscription payments can be made in U.S. Dollars, as well as a variety of international currencies. Membership terms are Annual Recurring, and Monthly Recurring. The Annual Recurring subscription is an annual commitment and subscribers will be charged each consecutive billing cycle. Annual Recurring subscriptions can be cancelled after the first billing cycle and within 30-days of the billing date for a full refund. Monthly Recurring subscriptions are ongoing and subscribers will be charged each consecutive monthly billing cycle. Monthly Recurring subscriptions can be cancelled after the first month and within 7 days of the monthly billing cycle for a full refund.

12. PAYMENT AUTHORIZATION

Payment for the services provided to you in, at, through or in association with HotelExecutive may be made by automatic credit card, debit card, direct debit, bankwire or Paypal and other approved payment means offered in, at, through or in association with HotelExecutive, and you hereby authorize HotelExecutive and its agents to transact such payments on your behalf.

You hereby authorize HotelExecutive's Internet Payment Service Provider to charge your credit card to pay for your membership to HotelExecutive. You further authorize HotelExecutive's Internet Payment Service Provider to charge your credit card for any and all purchases of products, services in association with HotelExecutive. You agree to be personally liable for all charges incurred by you in association with your access or other use of any content provided by HotelExecutive or any third party in association with HotelExecutive. You acknowledge and agree that your liability for all such charges shall continue after termination of your access or any type of membership arrangement with HotelExecutive.

In the event that you have chosen to have your membership automatically rebilled, unless and until you notify HotelExecutive that you wish to cancel or terminate your membership to HotelExecutive, you hereby agree and authorize HotelExecutive's Internet Payment Service Provider to automatically renew your membership to HotelExecutive on a continuing basis and to charge your credit card (or other payment means you have selected) to pay for the ongoing cost of your membership. You hereby further authorize HotelExecutive's Internet Payment Service Provider to charge your credit card (or other approved payment means you have selected) for any and all purchases of products, services and entertainment provided to in, at, through or in association with HotelExecutive.

13. PRIVACY POLICY

The following is the Privacy Policy for HotelExecutive

We can be reached via telephone, email, or online at our contact page. When you visit our site we do not log any information regarding your domain or email address. Information Sharing: We do not share user information with any third parties other than via press release distribution as described below.

Hotel Newswire is a newswire service that distributes press releases on behalf of our users. If you decide to submit a press release for distribution through our system we will transmit your entire press release including any personal information therein contained to our media contacts and online distribution points including search engines. This is the only redistribution of your information that we engage in. Your submission of press releases through our system indicates consent with this policy. The information we collect during your registration process is used to notify users about updates to our service and inform users of any special events hosted by Hotel Newswire. This information is not shared with other organizations for commercial or non-commercial purposes.

Cookies: Our system requires the use of cookies to enable the user to log back into our website to access information from the newswire, without having to log in each time using the required username and password.

If you do not want to receive email from us in the future, please let us know by following instructions included in our communication with you. Users who supply us with telephone numbers online may receive telephone contact from us regarding their account, or informing them of new products and services available on the HotelExecutive website. If you do not wish to receive such telephone calls, please edit your account and remove your phone number from your account profile. This can be done from your user account menu.

Ad Servers: We do not partner with or have any relationship with any ad server companies. From time to time, we may use customer information for new uses not previously disclosed in our privacy notice. If our information practices change at any time, we will post the policy changes to our website to notify you of these changes and provide you with the ability to opt out of these new uses. If you are concerned about how your information is used, you should check back at our website periodically.

Upon request we provide site visitors with access to all information (including proprietary information) that we maintain about them. Users can access this information by logging in to their account.

Security: We always use industry-standard encryption technologies while transferring and receiving user data exchanged with our site. We have appropriate security measures in place in our physical facilities to protect against the loss, misuse, or alteration of information that we have collected from you on our site. We do not store credit card information in our systems.

If you feel that this site is not following its stated information policy, you may contact us.

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HOTEL BUSINESS REVIEW
DECEMBER FOCUS: Hotel Law