This legal alert focuses on the impact that hotel operators may have on workouts of loans secured by hotel properties and summarizes the likely considerations that inform the decisions of hotel lenders and operators in loan workouts. A separate legal alert addressing the impact of the Coronavirus Aid, Relief, and Economic Security Act, also known as the CARES Act, on real property assets is forthcoming.
As the COVID-19 pandemic continues to impact the economy and the commercial real estate market, the restrictions on public gatherings and travel have placed the cash flow of many hotel properties in jeopardy. There are many factors to consider in preparation for a potential workout.
A hotel property derives much of its value from its operator and brand. When a hotel owner is in distress regarding its loan obligations, the operator also plays a critical role in the resolution of the workout process between the owner and the lender. The rights and obligations of the operator contained in its agreements with the owner and the lender affect any workout decision that the parties may make.
Considerations of Lenders and Operators in Workouts
In non-hospitality workouts, a lender will evaluate the property’s tenants and cash flows, and the history and solvency of the borrower, in deciding whether to exercise remedies or to modify the loan. Installing a new property manager in non-hospitality workouts is usually not a prohibitive consideration. While a hotel lender will still evaluate the cash flows and the borrower, issues regarding the operator will be a significant driver of the workout process due to the importance of the operator on the overall performance of the hotel in the property’s particular market.
While the COVID-19 pandemic has had immediate negative impact on hotel occupancy and revenue across the board, in the short-term lenders are not likely to consider removal of an operator absent pre-existing performance issues. In the longer term, if lenders and borrowers are forced to consider more comprehensive loan restructures, a lender will likely take one of three approaches when dealing with the operator in a hotel loan workout:
- Keep the operator in place under the existing management agreement.
- Terminate the management agreement and seek a new operator.
- Keep the operator in place under a revised management agreement, either giving or receiving concessions depending on the relative leverage of the operator and the lender.
In deciding the best available approach to take with the operator in the workout process, the lender will consider four main issues:
Property-specific issues: Is revenue from the property sufficient to cover operating expenses? How is the property performing compared to the rest of its market segment? Does the property primarily rely upon group or convention business? Does the hotel have substantial food and beverage revenue?
Identity of the operator: How important is the identity of the operator to the performance of the hotel? For example, a luxury hotel in a unique central location likely will be analyzed differently from a motel clustered with competitors at a suburban highway exit. Separately, in the case of a branded operator, a lender will consider the difficulty and expense of rebranding the hotel and reaching an agreement with a new operator. For a hotel operating at a loss, a lender may consider allowing the hotel to "go dark" while it seeks a new operator.
However, operating a hotel at a loss may prove less costly to a lender than allowing the hotel to go dark, depending on the expenses of maintaining a vacant building and later reopening, and perhaps rebranding and/or selling, the hotel.
Management agreement/SNDA issues: A lender will evaluate whether foreclosure, under the management agreement and the subordination, non-disturbance and attornment (SNDA) agreement, will: (1) allow the operator and/or the lender to unilaterally terminate the management agreement; (2) require the payment of damages to the operator; or (3) impose liability on the lender for amounts owed to the operator by the owner before foreclosure (such as deferred incentive management fees). A lender also will consider whether the terms of the management agreement are incompatible with operating the hotel profitably over the near to medium term, whether the agreement conforms to current market terms, and the burden of meeting required capital expenditures and maintenance of “brand standards.”
Credit enhancements: If the operator is bound by guaranties or capital commitments, or if the operator has given the owner subordinate financing or key money, what effect would foreclosure have on such credit enhancements?
Strategies of the Operator in Dealing with the Lender
In general, an operator will take one of three approaches when dealing with the lender in a loan workout. An operator may elect to:
- Remain in place under the existing management agreement, with either the current owner or the lender, following foreclosure.
- Terminate the management agreement (if permitted by the SNDA) and vacate the hotel, although operators typically disfavor termination absent unusual circumstances.
- Remain in the hotel under a revised management agreement, either giving or receiving concessions depending on the relative leverage of the operator and the lender.
In deciding the best available approach to take with the lender in the workout process, the operator will consider four main issues:
Property-specific issues: How profitable is the property for the owner and the operator? Is the property producing incentive fees for the operator? The operator will evaluate the strategic location of the property and the value of the property to the brand, as with an iconic location. The operator also will consider the ability of the property to maintain the operator’s “brand standards” either under the current owner or under the lender following a foreclosure.
Perceived Specialized Capabilities of the Operator and/or Leverage Vis-à-vis a Lender as Successor Owner: Does the operator bring any unique strengths (for example, particular brand recognition or centralized services) that add value to the property? An operator will evaluate the lender’s perceptions about the advantages of the particular operator, including the likely time and expense that would be incurred if the lender replaces the operator. Additionally, an operator will assess the economics of its existing arrangements in light of current market conditions and whether the lender, as a successor owner, may be unsuitable, due to its status as a competitor or otherwise.
Management agreement/SNDA issues: Does the management agreement allow the operator to terminate the agreement unilaterally, either with or without foreclosure? If so, do the operator’s agreements with the lender allow such a termination? Would the operator receive damages? The operator has a unique interest in the owner’s potential bankruptcy, because a termination of the management agreement in bankruptcy would convert the operator’s damages claim into an unsecured claim against the owner. The operator will evaluate the lender’s obligations to cure pre-foreclosure defaults of the owner or to pay amounts owed to the operator attributable to periods preceding the foreclosure. Finally, the operator will consider the value of the management agreement when faced with current projections of occupancy and revenue.
Credit enhancements: Like the lender, the operator will consider the impact of any action on its obligations under any credit enhancements that it has given to the owner or the lender. Depending on the burden imposed on the operator by such enhancements, the operator’s ability to restructure these obligations may be one of its primary considerations.
Conclusion
Unfortunately, there is no standard method to approach or analyze issues involving operators of distressed hotel properties. Due to the multiple considerations, the answer to any question will often be that “it depends.” However, the complex relationship among the operator, the owner and the lender arising from the various agreements will require the loan parties to take the hotel operator into account when considering any workout options.
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