As hotel owners, investors and operators know, capital improvement projects or furniture, fixtures and equipment updates often loom on the horizon for their hotel. During the economic downturn, many owners deferred capital expenditures because of the challenging operating environment in the sector.
As the operating environment stabilized and is showing signs of growth, many hotel owners and investors are actively reinvesting in their hotels to make them more competitive and to meet brand standards (many of which were relaxed during the downturn). Unlike other real-estate asset classes where an investor might complete a particular capital project as precursor to the sale of a property, for hotel owners, CapEx and FF&E replacements and renewals often are ongoing at the time of a disposition because these projects need to be completed regardless of whether a sale occurs.
There are two critical issues to address when selling or acquiring a hotel with ongoing or recently completed capital improvement projects and FF&E replacements. The first is reviewing and analyzing the status of the agreements and relationship with architects, general contractors, subcontractors (and sub-subcontractors) and suppliers involved in the capital project and/or FF&E replacement. The second is assessing and confirming the issuance of title insurance coverage against mechanics’ liens that might arise in connection with the capital project and/or FF&E replacement, especially for the buyer’s lender.
Benjamin C. Tschann
For the buyer, it starts with a simple question to the seller: Are there any ongoing or recently completed CapEx and/or FF&E installations? If this question is left for exploration during the due diligence period (and after the execution of a purchase and sale agreement), the buyer will have lost meaningful leverage to address and resolve important financial issues in the purchase and sale agreement related to ongoing or recently completed capital projects and FF&E replacements. These issues include the following:
- The assignment of the construction and design agreements (even for completed work so the buyer gets the benefit of any warranty obligations of the contractor);
- If required under the applicable agreements, the contractor’s approval of the assignment of the construction and/or design agreement (and depending on the contract or the nature of the project, the buyer might want to make such approval a condition precedent to its obligation to acquire the property); and
- The hotel operator’s or franchisor’s approval of the work or other confirmation that the work satisfies current brand standards.
For ongoing, but unfinished capital projects and/or FF&E replacements, there are a few additional considerations:
- The proration between buyer and seller, and reimbursement of any costs and expenses incurred by the seller and allocation of responsibility between the parties for the remaining costs to complete the capital project and/or FF&E replacements;
- an indemnity from 1) the seller with respect to liabilities first arising prior to the closing and 2) the buyer for post-closing liabilities and any prior liabilities before closing to the extent assumed by the buyer; and
- assessing the source of funds to complete work, including any FF&E or capital reserves held by the operator or the seller’s lender, which could be transferred to the buyer.
With respect to the proration of the costs for ongoing work, the seller generally credits the buyer against the agreed purchase price for the hotel in an amount equal to the cost to complete the work. Reaching agreement on the cost to complete the work often is a source of meaningful negotiation as the buyer will want to be satisfied that the credit it receives from seller is, in fact, sufficient to complete the capital project and/or FF&E replacement. Once agreed, the buyer assumes the obligation to complete the work following its acquisition of the property.
Understanding mechanic’s lien claims
The recent market downturn led to costly mechanic’s lien claims and defense for title insurance companies. As a result, title insurance companies are focusing more intensely on mechanic’s lien issues, which naturally drive a higher order of complexity into the issues. Consequently, getting what had previously been fairly easy coverage to obtain from a title company is now subject to stricter underwriting requirements and often requires financial support from a credit-worthy entity.
Mechanic’s liens are difficult for title companies because mechanic’s liens can be effective without recording and, in many jurisdictions, the lien attaches at the time the claimant’s work commenced (and in some jurisdictions, the lien attaches when any work relating to the project commenced, and not just when the claimant’s work commenced). Unless the contractor executed an unconditional lien waiver, the contractor could still file a lien after the closing of the sale. This puts the title insurance company in a difficult underwriting position.
Regarding ongoing work, the issue is further complicated because the contractors and the subcontractors are usually not in a position to issue final and unconditional lien waivers, with respect to their work.
Most lenders require full mechanic’s lien title insurance coverage because a lien filed after the lender’s mortgage or deed of trust is recorded would, in most instances, have priority over the lender’s security interest in the property for the reasons noted above (the lien attaches when the work was commenced and not when the file is actually filed).
Various factors will influence the title company’s underwriting requirements for mechanic’s lien coverage on both the owner’s and lender’s title insurance policy. The parties should be prepared to provide the title company with detailed explanations of the work undertaken at the property, the cost of the work, copies of the contracts and other agreements relating to the work, and the source of funds for completing the work. The title company will want to review any partial lien waivers and/or proof of periodic payments on work completed to date. A buyer, therefore, will want provisions in the purchase agreement that require the seller to provide these documents. The hotel owner/seller should insist their construction contracts require the contractor and all of its subcontractors to provide unconditional lien waivers as a condition to payment in full for the work.
Increasingly, title companies also are requiring an indemnity from a credit-worthy entity as a condition to issuing the coverage. The indemnity might have to come from a parent company or the sponsor of the seller and/or buyer. In addition to the negotiation between buyer and seller of which party (i.e. seller or buyer) will deliver this indemnity, there might also be restrictions under the governing documents of the various seller/buyer entities, which restrict or prohibit such entities from providing guarantees and indemnities.
In addition to—or as an alternative to—the indemnity, the title company might require the parties to reserve, in an escrow controlled by the title company, the cost to complete (and in some instances 125% of the cost to complete) the project. The title company then would disburse funds from the escrow upon written proof of completion of the work. The impact of “locking up” cash for an extended period of time should be considered by both buyer and seller early on in the acquisition process.
Identifying ongoing and recently completed capital projects early on in the hotel acquisition process is vital to avoid difficulties and potential delays in the negotiation and closing of the transaction. A simple question from buyer to seller about recent capital projects at the property will get the process moving. Depending on the response to the question, the parties are well served to identify and begin an active dialog with all relevant stakeholders, including the title company, contractors and lenders as early on in the process as possible. This will crystallize the issues and allow the parties to develop a road map to successfully navigate through them in a timely manner.
Benjamin C. Tschann is an associate in the San Francisco office of Goodwin Procter LLP. He focuses his practice on the representation of hotel owners, investors and operators in a variety of matters relating to acquisitions, dispositions, joint ventures, development and management of hotel, resort and other leisure facilities around the world.
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