Hotel industry players have noted an uptick in hotel lending activity and predict a further increase in financing transactions in the last months of 2012. As HotelNewsNow.com’s Jason Q. Freed writes, “For as long as the debt market was dormant, its awakening seemed to happen overnight.”
While lenders appear ready to lend against hotels again, they have learned lessons from the financial downturn. Loan-to-value ratios for today’s financings hover around 50% to 60%, and seem unlikely to return to the 80% to 85% range common in the 2005-2006 timeframe any time soon. Lenders require more time than in the past to conduct their due diligence and underwriting, resulting in a protracted term sheet-to-closing process. Lenders also appear more cautious in their underwriting and less willing to accept property-specific risk than in the past.
One mechanism lenders have employed to lessen their risk is expansion of the non-recourse carve-out guaranty. Affectionately referred to as a “bad boy guaranty,” the traditional non-recourse carve-out guaranty protected the lender against bad acts by the borrower (or its principals) that had the effect of depriving the lender of its collateral.
Typical bad boy carve-outs that result in full loan recourse to the guarantor include a sale or other transfer of the property or a voluntary bankruptcy filing on the part of the borrower. Bad boy carve-outs that allowed the lender to recover its actual damages from the guarantor include failure to pay real-estate taxes, failure to maintain insurance required by the loan documents and misappropriation of insurance proceeds. These carve-outs provide critical protection to lenders in non-recourse secured financings.
Recent transactions suggest an expansion of non-recourse carve-outs to cover not just bad acts, but to mitigate due diligence, operational or other property-specific risks, including the following.
Due diligence issues: Virtually every deal has its due diligence issues. Traditionally, lenders assess these issues and build the risk into their underwriting of the deal. Recently, however, lenders have been quicker to turn to the guarantor to backstop these risks. An ages-old easement was never removed from title? An original certificate of occupancy that cannot be located? A tenant estoppel, a rule of evidence that bars a person from denying or alleging a certain fact owing it already has been settled, and might not be delivered on time? An easy resolution of these issues from the lender’s perspective: adding them as recourse carve-outs for which the guarantor is liable.
Failure to pay operating expenses: Non-recourse carve-out guaranties might seek to impose liability on the guarantor in the event the borrower fails to pay the operating expenses of the property. Read literally, this carve-out could require a guarantor to fund money for operations of an underwater hotel indefinitely. Any carve-out along these lines should be limited to the borrower’s failure to apply funds generated by the property to operating expenses and then only for a closely prescribed look-back period. Otherwise, any distributions made to upstream owners could be at risk.
Management agreement issues/property improvement plans: Lenders lending to hotel owners must by necessity underwrite the management agreement or franchise agreement covering the hotel. These agreements often include obligations on the part of an owner beyond the routine payment of management or franchise fees. If a lender forecloses on a hotel and is required to assume the management agreement pursuant to subordination and non-disturbance agreement, the lender will step into these obligations. For example, an owner may commit a detailed PIP to be implemented over several years. Lenders may turn to guarantors to provide any funds required to complete a PIP or other required capital improvements, beyond funds available from the hotel’s reserve fund.
Repayment of key money: For many branded full-service hotels, the hotel operator has provided “key money” to the owner to fund a portion of the costs of constructing or redeveloping the hotel. The key money is typically amortized over the term of the management agreement, and any unamortized portion is generally required to be repaid to the hotel operator in the event of an early termination of the management agreement. Lenders might view the key money—long ago spent—as money it does not benefit from and try to push liability for repayment to a guarantor.
Borrowers should guard carefully against expansion of non-recourse carve-outs. This expansion demonstrates a fundamental shift from imposing liability on the principals of a borrower for their bad acts to imposing liability for events beyond the principals’ control. Such an expansion dilutes the protection afforded by employing special purpose entities to hold property, by creating more circumstances in which the upstream owners have to come out of pocket to address an issue at the property. Moreover, this expansion will likely affect a borrower’s assessment of whether to ultimately walk away from a property, by imposing ongoing liability on guarantors for events that may occur at the hotel after the borrower’s period of ownership.
Borrowers should have an honest discussion with their lenders about which issues should be the subject of guarantor liability and which issues are more appropriately reflected in the lender’s underwriting of the deal.
Teresa K. Goebel is a partner in the San Francisco office of Goodwin Procter LLP. She focuses her practice on the representation of hotel operators and investors in a variety of matters relating to the acquisition, development, financing, management and sale of hotel, resort and fractional ownership properties around the world.
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