JMBM's bankruptcy lawyers say that they have not been this busy in 20 years. The “sleeping cells” of JMBM's SWAT workout teams that have dealt with more than 1,000 receiverships, handled some of the biggest real estate, timeshare and hotel assets for the RTC nationwide in the last great meltdown, and helped lenders and owners alike optimize value, have been “awakened” and have dusted off all their checklists, polished their troubled asset technology and are providing decades of experience that has been largely lost by most institutional players from too many prosperous years.
I cannot tell you how many requests we have had (from those who still remember) for the great JMBM articles, checklists and materials on how to win the war against real estate troubled assets. We have also had a lot of requests to repeat our seminars and educational programs, which we will still provide for our clients and friends on request, when it makes sense for all.
But here is the first updated article talking about what is different with troubled loans on hotels and other special purpose real estate assets associated with operating businesses, such as casinos, entertainment parks, senior living facilities, franchised gasoline stations, convenience stores, restaurants, and the like. [This stuff is pretty technical, so if you are not a special servicer, lender workout person, or owner looking at how to keep a troubled special asset, you should wait for some “lighter fare.” ]
Workouts, receiverships, deeds in lieu and bankruptcies involving “Special Assets”
After many years of economic expansion, our economy was shoved rudely toward recession by the subprime mortgage problem and a global financial crisis soon followed.
This article will provide a brief reminder to lenders about the basics for dealing with troubled loans, and then it will quickly go beyond those fundamentals to discuss some of the unique issues and problems encountered in dealing with troubled loans on special purpose real estate assets with operating businesses such as hotels, franchised gasoline stations, convenience stores and restaurants.
Quick Review: Basic Dos and Don't for Working With Troubled Loans
While the early 1990s and 2000s saw an explosion of troubled real estate loans and specialized lender teams to handle them, the ensuing years saw veteran workout teams clean up the mess and ultimately disband as troubled loans all but disappeared. While each lender tended to have its own name and acronym for the troubled loan department, most lenders recognized the need for special servicers or a special assets group (the “SAG”) to handle the problems presented by troubled loans.
Savvy lenders also realized that workouts take time, and that line officers who spend time on workouts can't spend that time generating new deals.
These lenders focused on prevention, monitoring and early detection. At the first signs of trouble, they brought the SAG into the picture or transferred responsibility to the SAG. In the CMBS world, the special servicers got responsibility mandated under the pooling agreements or servicing agreements.
But however the bad loans got to the troubled loan specialists, they recognized that information is powerful and constantly updated critical information about the loan, the collateral and the borrower. They analyzed their options in light of clearly defined goals and policies. They developed a game plan for each asset and they stuck to it. And having been burned by lender liability claims, they used pre-workout agreements and team members knowledgeable about lender liability matters. They also knew that complete documentation of any deal was essential. (These fundamentals are summarized in the “Basic Dos and Don'ts for Working with Troubled Loans” which you can find at www.HotelLawBlog.com under the TOPIC of “Workouts, Bankruptcies & Receiverships”).
What Makes Some Special Purpose Assets Different?
Special purpose real estate assets associated with operating businesses present unique problems. The pipelines of lenders and special servicers are filling with troubled loans secured by such hotels, casinos, entertainment parks, senior living facilities, franchised gasoline stations, convenience stores, restaurants, and the like. Each of these assets involves an operating business that is integrally intertwined with special purpose real estate, and that operating business comprises a large component of the asset's value.
It is the operating business that raises some thorny problems. The operating business often needs management and franchise affiliations, licenses and permits, extensive vendor relationships, marketing efforts and a significant work force. Many of these aspects of the operating business are critical to the value and success of the asset and the recovery to be realized. They can evaporate very quickly during the handling of the troubled loan.
For example, what is the value of the underlying real property of a Marriott, Holiday Inn, Hilton, Hyatt or Four Seasons if it loses the brand and professional management? It becomes just a big box hotel with no name, no reservation system and no professionally run staff. What impact does it have on the lender's collateral if a breach of a management or franchise agreement exposes the owner to the expected profit of the brand or operator for a remaining 20 or 30 year term, or more? What damage is done to the public image of the asset if quality is not maintained, rumors of bankruptcy taint expectations of service, inventories fall below acceptable levels, and relations with critical vendors are damaged?
Or, to use another common example of loans secured by a gasoline stations with franchised restaurants and convenience stores, it may be easy enough to renegotiate gasoline supply agreements, but what is the value of the underlying real property of a Burger King or Del Taco restaurant that loses its franchise, jeopardizes its ground lease, and faces defaults under its franchise agreement and other contracts?
Using a Hotel Example
Many lenders and servicers are unfamiliar with the business and legal “structure” of these special assets, so we will first use a hotel example to illustrate the franchise and management overlay that complicates working with many of these assets. The typical hotel is owned by an individual, institutional investor or investor group, and this owner is usually the borrower on the hotel loans. Complications grow geometrically when the operator also has a joint venture or other investment interest in the ownership, and such arrangements are common with many hotels. The hotel company — Marriott, Starwood, Hilton, Hyatt, or whatever — is a separate entity that will manage or franchise the owner's hotel.
Hotel franchise or management agreement. When you drive by a hotel and see a big red Marriott sign on top, the chances are great that an owner has entered into a franchise or management agreement with Marriott to brand the hotel and plug into Marriott's reservation system and expertise. But it is fairly unlikely that Marriott owns the property or a significant interest in it. In many instances, the hotel is managed by the branded hotel company, but often the hotel will have a franchise from Marriott or one of the other branded hotel companies, and an independent management company-unaffiliated with the brand-will manage the hotel under a separate arrangement.
Independent operators. In the jargon of the hotel industry, these independent management companies are often called independents or “third party managers” because they do not own a brand and are a third party to the owner-franchisor-operator relationship. In any event, these arrangements are governed by complex and critically important franchise agreements and management agreements that can add or subtract millions to the value of the hotel.
Other licenses and agreements. Depending upon the nature of the property, there are also likely to be a host of important agreements, licenses and permits. Resort properties often have “use agreements” or leases that provide access to hotel guests for golf, tennis, marina, spa or other facilities. Licenses may include cabaret and business licenses, liquor licenses, and many other permits such as FCC licenses for base-to-shuttle or ship-to-shore communications for shuttle buses, marina and similar operations. The ability of a foreclosing lender or buyer to continue to enjoy rights under these agreements and licenses can be critical. One can imagine the impact on value when a resort hotel loses its golf, tennis, beach club or other amenities, or can't serve liquor at large group meetings, banquets, weddings and events. And, of course, it is almost certain that there will be a significant work force that may be technically employed by either the owner or the operator, but for which the owner will have full legal responsibility and extensive indemnity obligations. There may even be union contracts and potential labor claims and liabilities.
Complications. The lender's choice of options in dealing with a troubled loan on a hotel is complicated by the typical hotel management or franchise agreement. It tends to give tremendous control and many exclusive rights and powers to the operator and franchisor. The owner's (and thus the lender's) access to information, the work force, and the asset itself may be greatly limited. It is also common for the lender's position on the loan to be subordinated to the hotel management and franchise agreements so that upon a foreclosure, the lender or its successor will continue to be bound by the old management or franchise agreement. Alternatively, and sometimes worse, the lender may lose the benefit of the franchise or management agreement and find itself with an unbranded and unmanaged asset.
The Practical Impact: Special Purpose Assets Mean Special Problems
All the basics of troubled loans summarized in “Basic Dos and Don'ts for Working with Troubled Loans” (referenced above) apply to the special purpose assets we are focusing on.
One need only add the overlay that the operating business creates. Without repeating the basic principles, we can continue using the example of a troubled hotel loan and focus on what is different, beginning with the first principle-prevention.
Four “special issues” for Lenders with troubled hotel loans and other special assets with operating businesses
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 Jeffer, Mangels, Butler & Marmaro LLP and published by the Educational Institute.
Four special issues. With hotel loans, there are at least four categories of issues that lenders don't usually encounter with traditional real estate loans such as their loans on 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:
Subordination and SNDA. Subordination agreements and SNDAs are frequently encountered with branded hotel management agreements, and 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% of the value of a hotel.
Management and Franchise Agreements. Most hotels in the United States operate under a brand name. They acquire the right to use that brand name in one of two ways: (a) as part of a “bundled” deal with a branded management company (like Marriott, Hilton, Starwood or InterContinental) where the management agreement typically provided the operator will manage the hotel and include branding rights for free as long as the operator runs the hotel, or (b) in a separate franchise or license agreement with the brand, and not including management. Where a hotel has a franchise agreement, it will also likely have a “third party” management agreement with an independent (i.e. unbranded) operator. An industry rule of thumb is that the right brand and operator can easily raise or lower the nominal value of a hotel by 25% or more. In other words, a hotel nominally worth $10 million might be worth only $7.5 million or as much as $12.5 million, depending on the management and franchise agreements — and these numbers are “scaleable” so add as many zeroes as you want. Dealing with the management and franchise agreements can be very technical and tricky.
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.
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 over-zealous 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 other changes in the annual plan, budget and marketing plan 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.
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.
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.
Physical plant assessment. 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?
Rebranding and new management opportunities. 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 ten 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 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. (See “Hotel Management Agreements: SNDAs or Subordination Agreements” on www.Hotel LawBlog.com or http://hotellaw.jmbm.com/2008/10/hma_subordination_agree.html)
This may be of great value in some circumstances. However, as many surprised lenders learned in the last downturns, approximately 80% 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 agreement or is obligated to execute a new one 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.
Avoiding the SNDA. 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 reorganization in 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.
Evaluating the Options
The lender's alternatives — issues of possession and control. From the lender's perspective there are several options or alternative courses of action on a troubled asset. It can do nothing of course, or it can pursue a strategy that is directed toward one or more of the following
Deed-in-lieu of foreclosure
From one important point of view, these lender options all do one of two things: electing to either (1) leave the borrower in control (as in the workout option), or (2) move the control to someone other than the borrower (which is what all the other options do — and respectively, they move control and position of the asset to a receiver, the lender, a buyer of the property, or a bankruptcy trustee).
Key to Evaluating Alternatives: “Butler's Matrix”.
Some of the Parties' Considerations. Each party to a troubled hotel loan has different considerations, including goals, hopes and concerns for each of the lender's options. Jim Butler, Chairman of the Global Hospitality Group of Jeffer, Mangels, Butler & Marmaro LLP developed an analytical tool in the last great real estate and hotel downturn in the late 1980s. It has come to be known as “Butler's Matrix.” Given the complexities of the typical Special Asset, it is sometimes helpful to boil it down to a summary form that may over-simplify, but at least provides a grid or framework for analysis and that is what “Butler's Matrix” is all about.
1 James R. Butler, Jr., Co-Author, Chapter 14 “Special Legal Considerations for Hotel Investors,” Hotel Investments Issues & Perspectives (2nd Ed. 1999), Educational Institute, American Hotel & Motel Association.
2 Baltin's Law was formulated by Bruce Baltin, Senior Vice President of PKF Consulting in Los Angeles, California. Mr. Baltin has more than 30 years of hotel experience.
3 The SNDA is the acronym for Subordination, Non-Disturbance and Attornment agreement, which is usually a three party agreement involving the owner, the operator and the lender of the hotel. Such agreements typically provide comfort to lenders that upon a foreclosure, deed-in-lieu or sale in bankruptcy that 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, many such agreements also limit the lender's or successors' options in purporting to bind them to the terms of the agreement whether they want it or not. This poses many interesting issues where the lender or a successor want to remove or terminate a brand or operator.
About the Authors
Jim Butler and Bob Kaplan are partners with Jeffer, Mangels, Butler & Marmaro LLP (“JMBM”), a full-service business law firm with more than 160 lawyers in Los Angeles, San Francisco and Orange County, California. JMBM's Global Hospitality Group(R) is internationally recognized for its premier hospitality practice in a full-service law firm. It has more than $50 billion of hotel transactional experience, including billions of dollars of workouts, receiverships, foreclosures and bankruptcies. Butler leads the Global Hospitality Group(R) and chairs the real estate department. Kaplan works in the Firm's San Francisco office and focuses on representing lenders in all aspects of lending, collection and insolvency. Both of the authors have extensive experience with troubled loans involving both traditional real estate loans and those involving the Special Assets described in this article, such as hotels, restaurants, senior living facilities.
About Jim Butler
Jim Butler is recognized as one of the top hotel lawyers in the world. He devotes 100% of his practice to hospitality, representing hotel owners, developers and lenders. Jim leads JMBM's Global Hospitality Group(R) — a team of 50 seasoned professionals with more than $40 billion of hotel transactional experience, involving more than 1,000 properties located around the globe. In the last 5 years alone, they have brought their practical advice to more than 80 “hotel-enhanced mixed-use” projects, a term Jim coined to fill a void in industry lexicon. This term describes one of the hottest developments in real estate-where hotels work together with shopping center, residential, office, retail, spa and sports facility components to mutually enhance the entire project's excitement and success.
Jim and his team are more than “just” great hotel lawyers. They are also hospitality consultants and business advisors. They are deal makers. They can help find the right operator or capital provider. They know who to call and how to reach them. They are a major gateway of hotel finance, facilitating the flow of capital with their legal skill, hospitality industry knowledge and ability to find the right “fit” for all parts of the capital stack. Because they are part of the very fabric of the hotel industry, they are able to help clients identify key business goals, assemble the right team, strategize the approach to optimize value and then get the deal done.
Jim is the author of the www.HotelLawBlog.com. He can be reached at +1 310.201.3526 or firstname.lastname@example.org .