As a real estate class, hotels provide unique opportunities and challenges for investors, lenders, managers and, of course, the "Flags." At the same time, a hotel is both traditional "bricks and sticks" real estate and a living breathing operating business. The current white-hot market for hotel properties has captured the attention of nearly ever source of capital, including the Tenancy In Common (TIC) market. In fact, the two largest syndications our firm has handled in the past year involved hotel properties valued at over $190 million, including debt and equity. TIC investors have an appetite for hotel properties as a product class and particularly crave marquis names and popular destinations. Hotels provide a glamour and recognition factor that stable, anchored power centers and single-tenant industrial projects cannot deliver.
When a Sponsor looks at a hotel deal as a possible syndication opportunity, it must recognize and deal with the unique elements that provide both the pitfalls and opportunities in this product class.
The most significant factor which differentiates hotels from more common TIC deals is the introduction of an empowered third-party: The Flag. In most cases, a TIC deal will only work if the hotel is up and running. As such, the property will be the subject of an existing hotel management agreement or license agreement (HMA). Like a lease in a single-tenant deal, the terms and provisions of the HMA can make or break a TIC deal. But unlike a single-tenant that pays a net rent and is relatively passive in relation to ownership, the Flag's interest in ownership is more pervasive and "activist."
Our experience is that the TIC market favors the most recognizable and, therefore, most powerful Flags. The Sponsor's negotiating leverage with the Flag that has a pre-existing HMA in place is often minimal. A typical HMA will give the Flag: (a) wide latitude to use property cash flow to operate the property; (b) to reserve amounts for replacement of furniture, fixtures and equipment or to perform capital improvements; (c) to call upon the owner to perform substantial hotel upgrades or property improvement plans (PIP) from time to time; and (d) approval rights over transferees of the hotel property.
As such, the TIC Sponsor will need to ensure that:
Knowing whether a hotel property can be positioned as a TIC deal requires an extensive review of the HMA and, in most cases, the approval of the TIC structure by the Flag. Because of the capital and liquidity requirements that a hotel may face in a deal life, the Flag is usually laser focused on making certain that ownership is properly capitalized. The Flag will look to the Sponsor to provide adequate assurances of liquidity in its structure.
A second unique element to the TIC hotel structure is the requirement of a master lease. For tax purposes, a master lease is required as the TIC's cannot own an operating business under Revenue Procedure 2002-22. Most Flags utilize HMA's and will not operate today as a "lessee" of the real estate. A master lease is therefore used with the TICs acting as the landlords and a separate entity (controlled by the Sponsor alone or with a strategic partner) acting as the tenant. The tenant entity then enters into the HMA with the Flag. Consistent with this structure, the FF&E assets, reserves and all elements of the "business" end of the hotel are segregated into the tenant entity in order to protect the tax-deferred exchange structure for the TIC investors.
The Flag, however, is usually not satisfied with only having recourse to the tenant entity for HMA defaults. It wants to have the "equity" in the hotel supporting the tenant's obligations under the HMA. As such, the Flag will usually require the TIC investor entities to: (a) agree to assume the HMA in the event the master lease terminates for any reason; and (b) guaranty the obligations of the tenant under the HMA. These are structured as non-recourse obligations of the TIC entities, but they are true guaranty obligations none-the-less. The tax implications of these guarantees must be carefully considered. Also, if the loan is of a kind and size where non-consolidation opinions are required, the TIC guarantees of the HMA can raise other issues which counsel must consider and resolve.
An additional problem we have faced with the Flags of major hotel projects is the desire on the part of the Flag that the Sponsor or asset manager be granted a power of attorney to act on behalf of the TIC investors in connection with hotel issues. Hotels involve permitting and licensing issues not present on other deals because they involve liquor operations, swimming pools and the like. Flags perceive that fractionalized ownership may prove to be an impediment to usual hotel operations. Because of these licensing and operational issues, a Flag may request that a single party hold a power of attorney to bind the TICs. This is obviously problematic from a tax perspective and the Sponsor must be prepared to provide substitute assurances to the Flag.
Finally, the Sponsor must be prepared to deal with the unique transfer restrictions contained in the typical HMA. Unlike a lease, HMA's will usually prohibit transfer of the hotel without the consent of the Flag. Just like the TIC lender, the Flag may wish to run OFAC searches, review investor questionnaires and ensure that "competitors" are not becoming TIC owners of the hotel. As such a new round of approvals and possible impediments to syndication arise because of the powerful Flag at the table. Obtaining the appropriate concessions from the Flag and agreements to promptly cooperate in the process is key to a successful syndication of a hotel property.
What all of this means to the Sponsor: Begin to position a hotel TIC deal from day one with a few extra considerations in mind. Getting in front of the Flag early on in the diligence process, presenting your structure in an effective manner and obtaining the required concessions will make the difference in a successful hotel TIC project. Additionally, the fact that a hotel is a business enterprise (in addition to traditional real estate) necessitates that you involve qualified legal and accounting professions early on in the process in order to spot and solve issues which are not present in the typical real estate deal.