Beyond the basics: How to deal with troubled loans on special purpose real estate assets with operating businesses.

Prevention

Initial underwriting includes focus on brand, operator, terms of management and franchise agreements and borrower's track record. It also requires a market analysis and use of consultants and counsel experienced in hospitality matters, because the hospitality industry has its own unique standards, norms, customs, and players. Lenders should use professionals familiar with the industry who can apply a checklist approach to hospitality financing, like the Hospitality Investment Task List or HIT List(R) developed by the authors' firm and published by the Educational Institute.(2)

With hotel loans, there are at least four categories of issues that lenders don't usually encounter with traditional real estate loans such as those on their office buildings or apartment houses. These special issues should all be addressed in the prevention stage and considered as a loan gets into trouble. They include:

1. Subordination and SNDA. Subordination agreements and SNDAs will be addressed in depth later, but many prudent lenders will require the subordination of management and franchise agreements so that in the event of a default, the lender or its successor will have the option to either reaffirm and continue the arrangement under an automatically approved assignment, or the right to terminate the arrangement if it wishes to do so. In many cases, a management agreement can add or subtract up to 25 percent of the value of a hotel.

2. "Rents vs. accounts." Hotel revenues are not the same as "rents" from other kinds of commercial real estate. As a result, a lender's security interests in the revenues of a hotel are perfected differently (requiring both a deed of trust along with a security agreement and a UCC-1 adequately describing the collateral revenue source). Hotel revenues are also subject to different treatment in bankruptcy than rents from traditional real estate, but we will talk about these issues shortly under the so-called "rents vs. accounts" topic on page 54.

3. Need for access to more information. Because hotels and other special assets have operating businesses, there is a vast amount of information that can and should be provided by the operator on a monthly or other regular basis that will greatly assist a lender in monitoring developments with the asset events that may happen months before the effect is seen on the income statement or balance sheet. The prudent lender will assure access to such vital information, and may provide that a default occurs if there is deterioration in certain operations or procedures reflected in such reports.

4. Lender liability. There is a much better balance today than 10 or 15 years ago between the lenders' needs to protect their collateral and realize its value and aggrieved borrowers to obtain redress for excesses and abuses of overzealous lenders. But lender liability should still be a significant concern or focus for the careful lender, and these concerns are likely to be aggravated by dealing with a more active operating business such as a hotel than a passive real estate asset like an office building. Binding arbitration and jury trial waivers continue to be important elements in the lender's defensive arsenal.

Early Warning Signs

For the same reason a lender needs access to information, it needs an excellent early warning system. In addition to obvious items such as a default under a franchise agreement or material contract, knowledgeable industry people are likely to know or be able to detect when a geographic area, market segment or particular hotel is getting into trouble--long before it shows up in the profit and loss statement. A decrease in inventories, failure to maintain the property, a cutback in marketing, and/or other changes in the annual, budget, or marketing plans may all be early warning signs. Many prudent lenders have consultants watch their asset portfolios for significant trends and changes that indicate problems. The SAG team should become involved early in the process. But special assets generally also require availability and advice from industry-savvy consultants and counsel.

Information Update

The concept of updating all information for special assets is the same as for any troubled assets. However, in the case of a hotel, one will typically look for items such as hotel franchise agreements and amendments, management agreements and amendments, any agreements, leases, and other arrangements with golf pros, concessionaires, and the like, recreational use agreements for golf, tennis, aquatics, equestrian, or other amenities, and tax information and returns including occupancy, sales and use, employment, personal property, and real property taxes. A checklist approach is helpful.

Comprehensive Situation Analysis and Selection of Alternatives

What is the value of the asset and how do you optimize it?--The comprehensive "situation analysis" is the cooperative effort by the lender's SAG team, experienced hospitality lawyers, and hotel consultants. It examines the business, legal and hotel-specific factors affecting the asset--the complexities captured by the following update of what many know as Baltin's Law:

"Each hotel or other special purpose asset is a unique combination of physical plant, available market, location, brand identification, management, contractual arrangements, and capitalization. The mix of these factors is different for each asset, and therefore the value of a hotel or other special purpose asset will be optimized by implementing intelligent, property-specific plans, and management for both the asset's business and real estate." (3)

In other words, to understand the value, potential, and problems with the hotel, one has to look at all these factors affecting the hotel real estate and business.

In the physical plant assessment, one should look at the intrinsic value of the building, as well as how it enhances or limits operations, rebranding opportunities, and marketing alternatives. One has to look at inventories, FF&E, and a host of systems for food and beverage, labor management, reservations, marketing, and other operations. The market and the property will each affect the other and upside potential. Is this property properly positioned? Would value be optimized by taking it upscale or downscale? Are product improvement plans (PIPs) warranted to maintain a certain franchise? What capital improvements are necessary or valuable?

Is the current brand or management right for this property? Can it be changed and what will it cost to change, both in terms of exit fees or damages and in terms of rebranding or repositioning? Who is a logical and optimal buyer of the property through foreclosure, a deed-in-lieu, or bankruptcy? Can the universe of buyers be expanded and improved? In short, what is the highest and best use for this property and what are the costs and limitations on positioning the property for such use?

What are the contractual and business constraints?--If the Situation Analysis is to be more than an intellectual exercise if it is to have practical value it must consider the web of complex agreements affecting the property the franchise, management, amenity and use agreements, leases, licenses, and the like. Management or franchise agreements tend to be very long term agreements (say 10 to 50 years) and often have limited or even no termination rights. They are usually not assignable by the borrower without consent, and transfers to "competitors" are frequently prohibited, although there are usually exceptions for transfers upon foreclosure or deed-in-lieu.

The SNDA--The lender's rights are often vitally affected by the terms of a subordination agreement or a common variation called the SNDA (4) which the owner, lender, and operator may have executed. Such agreements typically provide comfort to lenders that, upon a foreclosure, deed-in-lieu, or sale in bankruptcy, the lender or its successor in interest will continue to enjoy the benefits of the management agreement.

This may be of great value in some circumstances. However, as many surprised lenders learned in the last downturn of the early 1990s, approximately 80 percent of the buyers for properties selling for $10 million or more were either other hotel companies or joint ventures of capital sources and hotel companies. In either event, these buyers would only purchase assets they could brand and manage, so the ability to terminate existing management and franchise agreements could make the asset attractive to a larger universe of buyers and could add tens of millions of dollars to the hotel's value.

But the typical SNDA contractually obligates the lender to the terms of the management agreement, by providing that if the lender or anyone succeeding to the property by foreclosure, deed-in-lieu, or otherwise ever comes into possession of the hotel, the lender or its successor shall immediately be bound by the original agreement. Alternatively, they are obligated to execute a new agreement on identical terms to the original for the remaining term of the original agreement. The lender faces liability for breach of contract if it does not fulfill its obligations and ensure that successors are similarly bound.

While this would seem to suggest that long-term, no cut management contracts and franchise agreements cannot ever be terminated, the use of a court-appointed receiver will generally not constitute a breach of an SNDA by the lender, and certain sales pursuant to a plan of bankruptcy will also likely avoid breach of a lender's obligations under even the most stringent SNDA. Long-term management agreements will generally be viewed as executory contracts that can generally be rejected in bankruptcy, and the operator then becomes an unsecured creditor in the bankruptcy to the extent of damages sustained for rejection of the contract. Thus, where the lender is properly secured and there is no equity, the rejected operator will take nothing for its damages.

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