Hotel investors typically have two paths to take ownership of a hotel asset: Build or Buy. In my experience as a hospitality and transactional attorney, I have learned that those that build (via ground-up new construction or re-development of an existing asset) generally prefer to build a hotel asset over buying an existing asset for a variety of reasons. Historically, those that built their own hotels generally enjoyed a lower cost basis, an opportunity to develop a new brand or modern prototypes of an existing brand and the ability to dictate a hotel’s location. However, many developers are finding themselves in unique and challenging positions since the beginning of the COVID-19 pandemic. Those developers with unimproved land, franchise rights and/or permits are unable to proceed with construction at this time. Due to the uncertainty in the economy and hospitality industry, lenders have been reluctant or unwilling to extend construction financing to hoteliers through most of 2020. As we make our way through 2021 and the vaccinations have become more readily available and administered, certain segments of the hospitality industry have seen an overall improvement which gave rise for third-party lenders to gradually begin evaluating hotel construction debt. However, many developers continue to find challenges in the construction debt markets and now hotel developers are running into an even bigger issue: rising construction costs, such as unprecedented spikes in lumber costs, labor shortages and the unavailability of a variety of materials.
For the first time, many hotel developers are now reevaluating their strategies and asking themselves: “Is it more cost-effective and financially rewarding to buy instead of build?”. This article is intended to provide general guidance to first-time hotel buyers or those with limited experience as a buyer.
Letter of Intent:
When submitting an offer to purchase an existing Hotel, it is critical for a Buyer and Seller to agree to the key business and legal terms of purchase through a Letter of Intent (“LOI”) or Term Sheet. The LOI provides the basic framework for the Purchase and Sale Agreement (“PSA”) or Contract. Such key terms generally include the Purchase Price, Critical Deadlines, Deposits, Franchise matters, allocation of costs or expenses and key obligations of a Seller or Buyer. While an LOI is non-binding, it will ensure both parties are on the same page as the PSA is drafted to cover all the business and legal terms.
Purchase and Sale Agreement:
Once the LOI is agreed upon and fully executed, parties are advised to employ their respective attorneys to begin drafting and negotiating the PSA. The PSA, which is binding and legally enforceable, provides the overall framework, rights, liabilities, and obligations of each party throughout the course of the transaction. The following provides a general summary of the critical sections of a PSA and is not intended to be exhaustive:
The PSA should clearly define Property (or “Hotel” or “Asset”) which is the real and personal property (such as the buildings, structures, signage, and improvements to the land) being conveyed with a legal description. In addition to the real and personal property, a Buyer should ensure the Property includes Furniture Fixtures & Equipment (“FFE”), Inventory, Licenses, Permits, Certificate of Occupancy, Intangible Rights, Rights and Obligations related to Operating Contracts (to be discussed further below). Unless the Buyer is assuming any existing debt or lease in connection with the Property, the Seller must convey the Property free and clear of any monetary liens or encumbrances to be independently verified by the Title Company.
- Parties must clearly define the Purchase Price and identify the sources of payment. Oftentimes, parties fail to identify the source of payment upfront which may give rise to issues on or before the Closing Date. Examples of sources below:
- Third-Party Financing
- Combination of 2 or more of the above.
- Generally, a Buyer will pay for the Hotel via their own funds (the “down payment”) which generally falls between 20-30% of the Purchase Price plus third-party financing (from a traditional lender). The third-party financing will either be a conventional loan or if the situation allows for such, a Small Business Administration (“SBA”) loan.
- If a third-party lender is not involved and the Buyer requires the Seller to finance a portion of the Purchase Price, the PSA should clearly define key terms of the loan, such as the interest rate, loan amount, maturity date, amortization period and the collateral (with the Hotel serving as the collateral in most cases). At Closing, the Buyer will enter into a loan agreement with the Seller and execute certain documents, such as a Deed of Trust and Promissory Note. The PSA should clearly define which documents the parties will execute at Closing.
- Earnest Money (deposited and held in escrow with the Title Company)
- The PSA will require a Buyer to deposit Earnest Money (or a “Deposit”) within 1 to 3 days of execution of the PSA with the designated title company for the PSA to become fully effective. The title company serves as an impartial third-party that holds the Earnest Money in trust for both parties and acts in accordance with the PSA. The Earnest Money is considered a token of security for a Seller that the Buyer is “invested” in the transaction and will either become non-refundable after a certain period or trigger event (such as the Due Diligence Period – defined below or a Buyer’s Default), applied towards the Purchase Price at Closing or remain refundable to the Buyer. The PSA, in various sections, should clearly define the treatment of the Earnest Money. Often, parties find themselves in conflict over the refundability or non-refundability of the Earnest Money therefore a well-drafted PSA can ensure parties avoid such issues.
- Assumption of Operating Contracts
- As additional “consideration” beyond cash (or cash equivalent), a Seller may also require that a Buyer assume any existing Operating Contracts for the property. Operating Contracts are essentially contracts, licenses, service agreements, equipment leases or other agreements a Seller may enter for the operation of the property. For example, a Seller may have financed a telecommunication system or have entered into a 10-year electricity agreement. Depending on the type of Operating Contract, the term may be month-to-month or for years. This can be a critical point in a transaction as the Seller may require the Buyer to assume these as they may be cost-prohibitive for the Seller to terminate (IE: liquidated damages or early-termination fees). Oftentimes, the Buyer may find the costs associated with such Operating Contracts excessive or perhaps the Buyer has better options. Therefore, this is a critical aspect of a PSA that should be addressed by both sides.
- In the case of a franchised hotel, the Seller owns and operates the hotel through a franchise agreement with the respective franchisor. Generally, a Buyer is obligated to enter into a new franchise agreement (or license) with the franchisor of the Hotel which provides for a total release of the Seller from its contractual obligations with the franchisor. If a Buyer does not intend to maintain the same franchise (or brand), the parties must agree in the PSA on the rights and obligations of such franchise. In such case, a Buyer would require the Seller terminate the franchise agreement on or before the Closing Date and be responsible for any termination fee or liquidated damages related to such termination and any de-identification requirements (such as removing the franchisor’s logos, signages, etc.).
Due Diligence Period (or Feasibility or Inspection Period)
In limited circumstances, a Buyer deposits non-refundable Earnest Money with the Title Company and a Seller presumes the Buyer has performed sufficient investigations into the Property.
In most instances, however, a Buyer is granted a Due Diligence Period (also known as the “Inspection Period” or “Feasibility Period”). During the Due Diligence Period, a Buyer performs various forms of due diligence as it relates to the Hotel. A Buyer generally has the right to terminate a PSA before the expiration of the Due Diligence Period and is considered a “free evaluation” by the Buyer of the Hotel. However, a Seller may require the Buyer to forfeit a portion of the Earnest Money or separate consideration for the Buyer’s right to have a Due Diligence Period. This is oftentimes referred to as “Independent Consideration”. During the Due Diligence Period, if the Buyer determines after its own due diligence that the Property is not suitable for purchase for any reason, the Buyer may give proper notice to the Seller and the Title Company would return the Earnest Money (held in escrow) to the Buyer. Buyers should request as much time on the Due Diligence Period as possible.
If a Buyer does not terminate the PSA before the Due Diligence Period expires, then the Earnest Money becomes non-refundable (with exceptions) and the presumption is the Buyer is proceeding with the purchase of the Hotel. During the Due Diligence Period, the Buyer generally performs the following activities:
- Review of Documents (which pertain to the operation, use or ownership of the Hotel) that the Seller is obligated to provide the Buyer during the Due Diligence Period, such as the following:
- Financial historical data (IE: Profit and Loss Statements, Payroll Reports and Capital Expenditure Reports)
- Property Surveys
- Environmental Studies (commonly referred to as “Phase I” reports)
- Operating Contracts (if the Buyer is required or elects to assume the same)
- Title Commitment (to serve as the basis for any Owner’s Title Policy issued to the Buyer by the Title Company) which shall show all monetary and non-monetary liens, leases, easements and encumbrances. Title insurance offers Hotel buyers, lenders and others protection against losses from certain title issues, provided through responsive title underwriting, closing and recording services on commercial transactions.
- Buyer’s right to object to any items shown on the Title Commitment and Survey
- Property Inspection Reports (Such inspection may include examinations of the physical condition of any improvements on the land; mechanical, electrical, and plumbing systems at the Hotel).
- If the timeline permits and the Buyer has achieved a comfort level upon review of the due diligence documents, the Buyer must begin communicating with the Franchisor to obtain a new or transferred franchise license to the Buyer for the operation of the Hotel upon Closing. The Buyer will submit a franchise application to the respective Franchisor and in turn, the Franchisor may issue a Property Improvement Plan (“PIP”) Report to the Buyer. The PIP Report provides the improvements a prospective Buyer must implement at the Hotel and a timeline for each improvement. For example, a Franchisor may require a Buyer to replace all FF&E (or case goods) within twelve (12) months of the Closing Date to ensure the Hotel meets the Franchisor’s most recent brand standards. The costs (IE: materials and labor) associated with a PIP can be tremendous and a Buyer should be mindful of this when evaluating the viability or profitability of a Hotel. In addition, the Franchisor will provide the terms of a new (or transferred) franchise agreement with the Buyer which includes the total royalties and marketing fees. Experienced hotel developers will find that the margin for negotiation with franchisors is much more limited on hotel transfers when compared to new development. Furthermore, the possibility always exists that a Buyer may not be granted approval for the franchise, or the PIP costs may be too excessive. If a Buyer suspects this may be the case, it is advisable that the Buyer negotiates a “Franchise Contingency” in advance to allow them to terminate the PSA after the Due Diligence Period and receive a refund of the Earnest Money upon such a trigger event. In addition, a Buyer may request that the Seller produce a PIP Report for a “Transfer” in case the same is already available and recent. Note: the PIP obligations imposed on an existing owner generally vary greatly from the PIP obligations imposed on a Buyer and a Buyer must independently verify that any PIP estimates being conveyed by a Seller (or Broker) to the Buyer are specifically for a transfer of the Hotel. More importantly, most third-party lenders will treat the PIP costs as an additional cost on top of the Purchase Price and will underwrite the loan and provide financing accordingly.
- If a Buyer intends to utilize a third-party lender, the Buyer should begin communicating with the lender as soon as possible. During this time, the Buyer must submit all personal and property-level financials, the PIP Report (and associated costs) and various other forms of due diligence period. Apart from franchising and general underwriting matters, the financing of a hotel purchase is oftentimes the most critical component of a hotel transaction. Prior to entering a PSA, it is critical for a Buyer to have potential lenders on stand-by to ascertain the viability of a loan. Doing so prevents unnecessary time and resources only for a transaction to fail due to financing or a disparity on what a Buyer may bring to the table as a down payment. Apart from the above, a third-party lender will generally require an independent appraisal, survey, lender’s title insurance policy (to be issued by the Title Company), an environmental study and an approved survey. These items all require a lead time and the Buyer should be aware of this when negotiating timelines with a Seller.
Representations and Warranties.
As a material part of a Buyer’s offer to buy a Hotel, the Seller must represent and warrant to the Buyer that certain facts or matters are accurate, valid, and legally enforceable. For example, a Buyer should ensure the Seller (or Hotel) does not have any active, pending, or potential lawsuits, that entering the PSA does not violate any agreement, the Hotel is not in violation of any law and has all permits and certificates of occupancy to operate the Hotel and the Seller has full authority to enter into the PSA. Also, the Seller should warrant that all books, records, and due diligence materials are complete, valid, and truly represent the operations and financial condition of the Hotel. Beyond that, the Seller should guarantee to the Buyer that no material defects exist or the land upon which the Hotel sits does not have any hazardous or contamination. Also, the Buyer should ensure that a Seller delivers the Hotel to the Buyer at Closing in good and operable condition with all rooms and FF&E being in working order. A Buyer should ensure the Seller agrees to and continues to operate the Hotel in good condition and continue to make any repairs or improvements, as necessary. If a Seller fails to meet these requirements on or before Closing, the Seller may be in default and the Buyer would be entitled to receive a refund of the Earnest Money if the circumstances allow (even if the Due Diligence Period expired). Should such issues be identified after the Closing and the PSA is drafted accordingly, the Buyer would have recourse against the Seller post-Closing.
- In addition to defining the Closing Date in a PSA, it is critical for parties to address any requirements of Seller and Buyer to close – often known as “Conditions Precedent to Closing”. Furthermore, parties generally agree in advance on any Adjustments to the Closing Costs, including prorations of real estate and personal property taxes, revenue and expenses (such as the costs of an Owner’s Title Policy of Franchise Transfer Fees).
- Extensions. Should the Buyer anticipate needing additional time to “Close” the transaction, it is advised that the Buyer negotiate this upfront. For example, a Buyer may require an additional thirty (30) to sixty (60) days to Close in exchange for an additional Earnest Money Deposit (the “Extension Deposit”). The Extension Deposit would generally be non-refundable (subject to exceptions) and applied towards the Purchase Price.
- The Title Company that holds the Earnest Money in escrow and issues the Owner’s Title Policy Insurance will also serve as the intermediary that coordinates the actual Closing. Should a Buyer utilize third-party financing for the acquisition of the Hotel, then the Buyer’s Lender will rely on the Title Company to issue a Lender’s Title Insurance Policy insuring the Lender for the amount of the loan. Further, the Lender will require the Title Company to facilitate the execution of any loan documents and any requirements for funding the actual loan.
- Documents. At Closing, there are several transactional documents signed by either the Seller, Buyer or both parties. Such documents include the General or Special Warranty Deed (which conveys the real property), the Bill of Sale (which transfers the personal property and FF&E) and certain assignment documents which may either transfer Operating Contracts (if applicable) or any leases or licenses related to the Property. In addition to these and the loan documents, the Title Company will have certain disclosures and documents that each side must side.
While the intent of this article is to provide a summary of the key terms of a PSA, drafting, navigating, and negotiating a PSA is a very in-depth process and a Buyer should employ an attorney that is well-versed in hospitality transactions in order to address the complexities involved. For more information or assistance on a hotel transaction, feel free to contact Managing Attorney Kishan Patel at firstname.lastname@example.org or 832-696-0053.