Coming to Terms: The Importance of Term Sheets in Late Cycle Hotel Transactions

In recent months, industry insiders report that hotel transactions are increasingly difficult, and taking far longer to complete. After 10 years of growth across the hospitality industry that fostered a robust transactional market for sales/acquisitions, development, joint ventures and financings, substantive commentary coming out of this year’s Americas Lodging Investment Summit (ALIS) was cautiously optimistic. However, this was before the global COVID-19 outbreak and potential trigger of a global recession. Not surprisingly, the global hospitality industry is already severely impacted by COVID-19. In China, Marriott has already reported that February revenues were off an astonishing 90% from a year earlier – erasing nearly a quarter of Marriott’s market cap in under two weeks. In the U.S., the Dow Jones U.S. Hotel & Lodging REIT Index fell 19% in the same period and STR is predicting that 2020 will be the first year without RevPar growth since 2009.  Nearly every hospitality REIT, publicly traded management company, and other C-corps have already withdrawn their 2020 outlooks and expectations. 

While it is far too early to predict what the impact will be on hospitality real estate transactions in the U.S., without a doubt, upfront deal structuring will be critical to successful and efficient transactions. Even before the commencement of the COVID-19 outbreak, in 2019, aggregate hotel real estate sale transactions in the Americas were down 21% to $28.7 billion, according to JLL. Despite several large M&A deals in 2019, a large part of the decline can be attributed to fewer of the headline-making portfolio transactions that were seen in 2018. While occupancy levels in the U.S. remain above historic averages, the decline in overall hotel sales was coupled with anemic increases in RevPar (0.9%) and effectively flat U.S. occupancy levels, with CBRE observing that “hoteliers have been unable to achieve gains in average daily rate (ADR) commensurate with what we have seen during equally strong market conditions.” With inflation running at 1.76%, the hotel sector is effectively in a revenue recession. The lackluster 2019 hotel data came despite a backdrop of the lowest unemployment numbers in decades, a year of almost weekly record highs in the public equity markets, and unprecedented liquidity in the debt markets.

With sellers reluctant to sell at prices which buyers can justify – particularly where money can be taken off the table relatively easily with debt at historically low rates and deals receiving intense underwriting and due diligence scrutiny from buyers and lenders – transaction timelines are certainly becoming elongated. With such a backdrop and the COVID-19 outbreak, we expect that completing hospitality transactions in 2020 will be even more challenging. However, with unprecedented “dry powder” raised in the real estate private equity space influencing the buy side, and the normal cycle of investment funds influencing the sell side, we anticipate that thoughtful, considered transactions will continue to occur through 2020, especially when COVID-19 concerns dissipate.

To effectively complete transactions in reasonable timeframes, it will be imperative that buyers, sellers, borrowers and operators fully come to terms before diving into the deal documentation.  Often in a rush to move to documents, buyers, sellers, lenders and operators in the hotel space will sign term sheets having glossed over what they mistakenly relegate to “legal points,” extending substantive negotiations of the definitive agreements deep into the back end of expected transaction timelines. Getting legal advisors involved at the term-sheet stage can help expediate transactions and remove the “sword of Damocles” associated with later-stage negotiations of critical commercial points, often when the parties believe they are nearing the completion of the negotiations and documentation of the operative agreements.

Below are some key issues that should be fully considered up-front when negotiating term sheets for loan agreements and management/franchise agreements in the hospitality space:

• Loan Non-Recourse Carveouts: While the carveout guaranty was for many years, agreements which covered truly bad acts of borrowers such as fraud or misappropriation, today, lenders are increasingly looking to borrowers to guarantee collateral-specific operational and due diligence matters. This marks a fundamental shift of liability to the principals of borrowers and a dilution of the protections afforded by the special purpose entities through which most commercial real estate is held – a shift that hotel owners must fully understand before borrowing. Unexpected carveouts in the hotel context can include unauthorized amendments or terminations of the hotel franchise or management agreement, failure to fund PIP or other capital improvements, or a requirement to repay key money upon sale or management termination.
• Loan Equity Transfer Limitations: Borrowers often expect lenders to simply sign off on the transfer provisions of any joint venture agreement. If one party has the ability to remove another, borrowers expect such remedies to be respected by lenders, but this is often not the case unless negotiated in advance. Lenders will inevitably underwrite the management experience of operating partners and the balance sheet of so-called “money” partners, and are often reluctant to sign off on a change to the status quo pursuant to a joint venture agreement that may not be fully baked at the time of term sheet negotiations.
• Lender’s Structuring Considerations: Loan Agreement term sheets frequently include what borrowers often mistake for boilerplate language allowing lenders to structure hotel loans as a single mortgage, a mortgage with multiple syndicated notes and/or a mortgage and mezzanine loan. Borrowers will often be surprised when lenders ultimately decide to exercise such rights, as the inclusion of a mortgage and mezzanine structure can add significant legal costs and complexity. On the front end in terms of negotiating multiple loan agreements and intercreditor agreements, and on the back end where lenders usually expect borrowers to cover these costs. With a mezzanine loan in a capital stack, lenders obtain a UCC security in the property owner which severely limits borrowers’ legislative foreclosure protections, making foreclosure a significantly less painful option for lenders.
• Management Agreement Performance Tests: In longer-term hotel management agreements, the performance test may not be the only way to terminate the agreement early (and without payment of a termination fee). Absent a default by the manager – it may also serve as an effective lever to apply pressure on a manager for an underperforming hotel. The components of the performance test – whether tied to projected NOI, budgeted operating profit or market performance (usually measured in terms of a RevPAR penetration against a competitive set) – are critical. The test components, the test years, the thresholds for performance and the competitive set should be detailed in term sheets. In addition, any cure rights in favor of the manager in the event of a performance test failure should be identified (together with any limit on the number of times a manager may cure within the term). While parties often will wait to figure out the details of the performance test until drafting the agreement, doing so is likely to result in not only more protracted negotiations, but potentially a less owner-favorable set of terms.
• Management Agreement Termination Rights Upon Sale: The term length of a hotel management agreement is critically important to the hotel management company and the hotel owner. In exchange for accepting long-term agreements, an owner may negotiate for a right to terminate the agreement early in specified—and heavily negotiated—situations. Socializing in advance the date upon which such contracts can be terminated upon sale, the method of calculating any termination fees owed (typically some multiple of trailing 12-month management fees), and even the definition of what “sale” actually means (what percentage change in ownership counts?) are critically important.
• Management to Franchise Conversion Rights: Management companies such as Hilton Worldwide and Marriott International will sometimes include a right to convert some of their brand-managed properties to franchises as part of the management agreement term sheets, however many pitfalls can be found in the negotiations for such right. While the franchise agreement will ultimately be on the franchisor’s then-applicable form, the parties should pre-negotiate certain key terms such as any radius restriction as well as the conditions to the exercise of such a conversion (e.g., whether the owner must complete a PIP). It behooves owners and operators to agree in advance to permitted managers and purchasers as well as to what happens to any outstanding key money contributed by the brand as part of the initial management agreement.

As execution of transactions become increasingly complicated, owners, lenders and operators should all have honest discussions with one another early in the process and fully understand the scope of the deals being struck.