This year UK lawyers are being presented with an unprecedented volume of transactions involving hotels. This is due to a number of factors. First, real estate investors seeking opportunities to make high capital returns against a backdrop of falling yields and rising interest rates are switching to alternative asset classes such as nursing homes, health clubs and hotels.
Second, it has been well publicised that private equity funds are looking to invest in asset-rich businesses such as retailers and hotels. And third, operators want to dispose of their real estate interests so that they can stay focused on what they do best – running hotels.
Lawyers commonly come across hotels in contexts that include: acquisitions of hotels; leases to operators; operating company (OpCo)/property-owning company (PropCo) structures; and the negotiation of hotel operating agreements.
Hotels are bought and sold as property investments and going concerns and there is a number of specific due diligence considerations for the lawyers involved that make these acquisitions more complex than buying offices or retail property.
Hotel transactions are likely to involve employment and pension law advice given the nature of the businesses acquired, and consideration needs to be given to how licensing law affects the hotel’s business. Planning law may be important, especially in respect of any restrictions on the hours of use and in ensuring that the principal hotel use or any ancillary uses upon which the hotel relies for income are not in breach of planning legislation.
In acquiring a hotel there is a degree of complexity involved in determining the price on completion. Consideration is given to the exact amount of stock that the hotel contains on the day of completion, whether items of cutlery or bottles of wine in the cellar, and there is a need to apportion income from guest receipts where the length of stay of the guests in question straddles the completion date. Lawyers need to understand the drafting of these apportionment clauses and be able to work through the calculations with clients and their accountants.
Most hotels are leased by hotel investors to operators. The leases tend to be for terms of 30 years or more, often with tenant options to renew.
Rents may be calculated as a percentage of the hotel’s turnover, protecting the operator from fluctuating occupancy levels. Landlords may protect themselves by having a minimum annual rental figure in the lease and in acquiring diverse portfolios of hotel properties rather than individual assets so that local fluctuations in occupancy rates are potentially aggregated over the portfolio.
Landlords will want to protect their investment by obliging the tenant to maximise the hotel turnover and may try to impose restrictive covenants to prevent the tenant from operating a rival hotel within a set radius.
OpCo and PropCo structures
These structures are favoured by private equity firms looking to create value from businesses that are rich in property assets. The structure works by the private equity firm acquiring the hotel business and separating the ownership of the hotel property from the operational business. The PropCo leases the hotels to a separate OpCo for an open market rent reviewed five-yearly or on an annual indexation basis, which private equity firms sometimes prefer due to the greater certainty of steady rental increases.
Because the PropCo receives an annual rent and is remote from the operational risks of the business, it can sustain high levels of debt finance and can be sold to third parties so as to provide a return to the private equity investor. The OpCo can appoint a hotel operator to run the hotel under an operating agreement.
Lawyers acting for operators as part of an OpCo/PropCo structure will want to ensure that the operating agreement does not fall away in the event of the insolvency of the OpCo or forfeiture of the lease from the PropCo, and this can be done by the operator entering into a direct agreement with the PropCo and its lender, under which they agree not to terminate the operating agreements in these circumstances.
The PropCo will need to ensure that the rental levels payable by the OpCo under its lease are sustainable from the income that the OpCo will receive from the property. Additional comfort can sometimes be obtained by way of a guarantee or letter of credit to cover any shortfalls in the rent paid to the PropCo.
Some commentators have doubted whether the trend for OpCo/PropCo structures in the hotel market will continue at current levels because of a combination of falling yields in the hotel sector and the desire for private equity investors to retain a direct involvement in the operation of the business.
An operating agreement is the mechanism that an operator will use in order to continue its running of the hotel business while no longer owning or being responsible for the hotel property. This may result in the operator obtaining a capital sum for the sale of the hotel property, which can be put back into the business.
Operating agreements are usually drafted by the operator, and lawyers who try to make substantial amendments on behalf of an investor to an agreement drafted by one of the main hotel chains will find they meet severe resistance: operators do not want their property owners to interfere with their businesses.
Under an operating agreement a hotel investor commonly pays the operator a basic fee (often around 2-4 per cent) of revenue and an incentive fee (of around 10-15 per cent) of the profit from the hotel. The sums payable to the owner are based on the net operating profit from the hotel (sometimes referred to as net operating cashflow), which is calculated by deducting from the hotel revenue gained from room charges, bars and restaurants, conference suites and leisure centres the cost to the operator in running the hotel.
It is these costs that most concern investors – operators will expect to include not only the cost of stock and employees, but also an allocation of the cost to the operator of its central office facilities such as reservation call centres.
Lawyers acting for investors will want to ensure transparency in the way in which revenue and costs are calculated and particularly in the way that central costs are allocated to a property. Sophisticated hotel investors will expect the ability to have a say over the appointment of the hotel manager and to meet with the senior management on a regular basis to discuss the hotel budget and examine how revenue and expenditure are in line with expectations.
The responsibility for paying for the maintenance and refurbishment of the hotel property will fall on the investor and will usually be by reference to a set of documents describing the hotel’s ‘brand standards’. Hotel chains update their brand standards regularly in order to protect the brand and ensure that the hotel remains competitive in the market.
There is a tension here: the operator wants to ensure that its brand is protected by keeping the hotel in a high state of repair and decoration, whereas the owner wants to ensure high revenues and low costs. This can be a topic of discussion in negotiations. Whose hotel is is it anyway? nSimon Price is a partner at Herbert Smith