Hot Buttons for Hotel Lending in 2016

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Hotel financing remains an attractive business for commercial real estate lenders.  Lenders can realize returns higher than for other commercial real estate lending due to the unique attributes of hotels as an operating business, the smaller pool of active hotel debt providers and the greater volatility. But the sensitivity of hotel valuations to the economy can be good or bad depending on the drivers of revenue for the particular property and when origination occurs relative to local or broader economic cycles.

As the business world and technology have changed, so have hotels. The channels to reach guests, and the products and services they receive, now go far beyond renting a room. Lending against tangible hotel assets has changed in response, too.

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New brands have continued to enter the market, often using technology in a better way than traditional brands and often catering to millennial guests who expect more from public areas, amenities and design. That often produces higher construction costs and complexity. A construction lender will want to confirm that the owner and its contractor have understood, and the lender has adequately underwritten, the extra work involved. That’s just the beginning of what makes some newer brands different and more expensive.

Many hotels, particularly at the high end, continue to brand residences and hotel condominiums and timeshares. Some luxury product brands like Armani and Bulgari have moved into that business—sometimes as a comprehensive, integrated marketing strategy and other times capitalizing on the strength of the brand alone.

Whenever branding is central to the business plan, the lender must understand the brand’s contribution to revenue, the cost of the brand and the marketing support. Even after foreclosure, the brand needs to work and protect the lender’s return. Security arrangements must capture the widely varying agreements for the brand rights. If a foreclosure occurs, the lender may not know whether the brand will be a gem or an albatross. The manager and franchisor may also want a chance to balance the prospects for continued financial return against any damage to the brand.

Real estate and branding are only the beginning of what the lender must capture within its security. What about offsite amenities? Parking arrangements? Garages in urban settings can be very profitable and essential.

In a mixed-use project, what about rights in the overall building? Typically an agreement governs how the pieces work together—usually a condominium, raising issues on cost allocations and use, operations, signage, entrances, building systems and more. A lender will want to assure that, if a foreclosure occurs, the hotel can continue to operate even if other pieces of the project have problems.

Today a mixed-use building with a hotel in it will often involve a “public-private partnership,” where a government agency has a direct say, often as ground lessor, in operations and decisions. This may limit repositioning or change of operations or marketing. The lender, who will have to abide by these limitations after foreclosure, must understand them when closing the loan.

In higher-end hotels, lenders find that restaurant operations are structured very differently than 20 years ago. For many hotels, restaurants were money-losing afterthoughts, but today, destination restaurants often make a substantial contribution to the bottom line. Rather than lease the restaurant space to an operator, the owner may sign a management agreement where the owner, not the restaurant operator, bears much of the business risk. Food and beverage often affects the appearance of the hotel at street and lobby levels, has its own branding, raises liquor licensing concerns, affects the lobby, involves a separate labor force and directly affects guest experience. These arrangements vary widely and can encumber the hotel even after foreclosure, so they require scrutiny from any hotel lender.

Data security and personal data protection have found their way, sometimes dramatically, to the top of today’s business agenda. Many hotel managers have developed robust policies and systems to reduce risk and respond to guest concerns on data security. Lenders want access to data needed for booking and operations, while maintaining cybersecurity and prudent privacy practices if a lender (or a receiver) takes control of a hotel.

Lenders also have learned to pay more attention than ever to union contracts, maintenance of inventory and consumables at the property and meshing the lender’s cash management agenda with ordinary operations of the hotel—not always easy to do.

Hotel finance continues to be a particularly interesting area of the business. Whether it’s interesting in a good or bad way for lenders will depend on where hotels stand in this particular cycle.

Joshua Stein and Andrew Lance are attorneys with Joshua Stein PLLC, and Gibson, Dunn & Crutcher, respectively.