Choose Site

Newsletter

Buying Hotel Properties: What Buyers and Their Lenders Need to Know About Third-Party Management Agreements

Real Estate Report

July 01, 2020

Hotel acquisitions are complex transactions that require lenders and borrowers to be knowledgeable about a hotel property’s relationship with any existing franchise or associated brand, the lender’s relationship to the collateral, and other potential issues that purchasers and their lenders need to consider throughout the deal.

Franchise and Brand Management Agreements

First things first. What is the difference between a franchise management agreement and a brand management agreement?

Franchise management agreements are generally personal to the hotel owner, who in turn may either (1) hire a third-party management company to run the day-to-day business operations of the hotel under the applicable brand, or (2) self-manage the hotel through a license from the brand. If a hotel has a franchise agreement in place, the buyer and lender will have to determine whether they want to negotiate for an assignment or termination of the franchise agreement in connection with the acquisition of the hotel and review the franchise agreement to understand any existing assignment and termination provisions.

Branded management agreements are generally agreements between the owner and a branded management company that runs the day-to-day business operations of the hotel. Assignment provisions in branded management agreements vary greatly and need to be carefully navigated by a potential buyer and its lender.

Hotels may also be independent, with no brand affiliation, or have a so-called “soft-brand,” which provides the benefits of a brand’s reservation system but offers more stylistic and operational freedom to the hotel owner and its lender.

Relationship to Collateral

Hotel lenders will have less control over collateral due to the existence of a franchise or brand management agreement. These management agreements are often difficult to terminate. In addition, franchise and brand management agreements may require that the owner of the hotel make major capital investments in the property based on the brand’s corporate schedule, rather than the lender or owner’s schedule. This can raise important economic considerations for a potential buyer and its lender. In addition, a lender may find itself in a position of having to defer to a brand’s requirement for capital and replacement reserves, and may not be able to require additional lender reserves.

How does one terminate a management agreement, given that the brand typically has more bargaining power? Whether the hotel operates under a franchise management agreement or a third-party branded management agreement, the buyer and lender will have to think ahead to anticipate how to cancel such an agreement if needed.

Savvy lenders will negotiate to become “qualified transferees” in the event of a borrower default under a brand management agreement that would otherwise allow the brand to terminate the agreement. A qualified transferee provision allows lenders to step in for the owner to cure the default. It should also allow time for a lender to exit without losing its return on investment, or even potentially find a replacement owner acceptable to the brand to replace the defaulting owner.

Since third-party branded hotel managers have nearly absolute control over day-to-day operations, purchasers and lenders should also negotiate performance termination provisions allowing the owner and/or lenders to terminate the agreement without any penalty payments in the event the managers do not meet certain metrics over a stated period. These manager performance metrics should be explicitly stated in the management agreement to avoid ambiguities down the road.

Other Considerations

Especially when dealing with a branded hotel, the related management company will often have consent rights over assignments to new hotel owners, reserve accounts and reserve account balances, brand standards, and property improvement programs (PIPs). Brand standards and PIPs can be onerous, and buyers and their lenders should negotiate to share the costs with the brand for requirements that may arise that are not already accounted for in existing hotel budgets. An alternative approach is to negotiate for a phased implementation of brand standards or property improvement requirements so the related expenses can be spread over time.

Another potential concern for buyers and their lenders are radius restriction provisions. Such provisions restrict the area where a certain hotel owner and potentially its lender may open, or even in some cases invest in, another hotel project (whether it is the same or different brand of hotel). Accordingly, potential purchasers and their lenders will need to consider whether the investment in one hotel property requires divestiture from another hotel property.

Transfers of permits and licenses associated with the hotel often require negotiations with third parties. Accordingly, buyers and lenders need to contemplate the following questions: Will there be a separate operator for the restaurant/bar at the hotel? What types of service contracts are in place, and are they assignable to the new ownership or are they terminable if the new ownership no longer wants to be obligated by the terms of existing service contracts? Are there any licenses or permits that will need to be transferred to the new ownership in order to continue operating the hotel?

Conclusion

Buyers and their lenders must put together a team of specialists that will be able to address every component of a hotel transaction. Because owners and lenders may have less control over the collateral than they are used to with other commercial properties, it is important to strategize at the outset of a potential acquisition—especially with respect to management agreement considerations and other long lead-time items. With these considerations in mind, purchasers and their lenders will be able to jump into the deal with confidence.

This is the second article in our Buying Hotel Properties series. In our first article, we discuss what buyers and lenders looking to invest in hotel properties should generally negotiate for in purchase and sale agreements, and we emphasize the importance of working with a diverse team of experts to address the multiple unique issues that often arise during hotel acquisitions.