The hotel industry appears to be on an uptick, which is good news for lenders. Hotel construction in May 2014 is up over 13% from the same time period in 2013. Moreover, record high occupancy rates and low supply could continue to drive an influx of new rooms into 2015 and beyond. As more lenders are called upon to secure these projects, lenders should consider that hotel projects require a particular diligence not always found in other types of commercial projects. Below are a few of the more commonly overlooked issues.
The Elevated Role of UCC Financing. A significant percentage of the value of a hotel property is in furnishings, artwork, televisions, dining equipment, and other personal property. As such, lenders should obtain a separate security agreement that specifically identifies the personal property and prevents the borrower from disposing of the property except in the ordinary course of business. The lender should consider obtaining UCC insurance as well.
Management Agreements. Hotel properties are frequently managed by a third party under a management agreement between the manager and the borrower. The hotel manager controls the day-to-day operations of the hotel, hotel procedure, operating expenses, budgets and financial reports. The lender should review the management agreement to insure that it is adequately protected and has access to all financial and other reports of the hotel. The management agreement should be subordinate to the interests of the lender. Furthermore, a lender should carve-out an exception from any non-disturbance agreement between the lender and hotel manager, giving the lender the right to terminate the management agreement in the event of the borrower’s default or a distressed sale.
Comfort Letters. Lenders secured by franchised hotels should obtain a comfort letter from the franchisor as part of the loan documentation. The comfort letter is an agreement between the hotel franchisor and the lender that grants certain protections to the lender in the event that the borrower defaults on its obligations under the franchise agreement or the lender takes control of the property. A typical comfort letter gives the lender rights to assume and transfer the franchise agreement in the event of a foreclosure, receivership, or distressed sale. It also allows the lender an opportunity to cure any defaults of the borrower under the franchise agreement. Because the value of a franchised hotel is often tied to its brand, the comfort letter is a valuable tool to protect the value of the lender’s collateral.
Occupancy rates, business operations, the hotel manager, and the franchisor all play a significant role in the success of the hotel and ultimately, the security in the loan. As a result, hotels are different than other commercial properties and require different diligence in underwriting. The additional time and attention given to these matters at loan origination can save a lender a great deal more time and expense later.