The burst of hotel purchases and sales in 2011 was driven in part by real-estate investment trusts’ healthy appetite for hotel assets. Fueled by cash raised in equity offerings, REITs such as Pebblebrook Hotel Trust, LaSalle Hotel Properties and Chesapeake Lodging Trust snapped up noted hotels managed by third-party operators in key markets such as San Francisco, Los Angeles, Chicago and New York.
The legal structure REITs (and certain other tax-exempt investors) employ to hold hotel assets differs from the more traditional structure in which the fee owner of the hotel enters into the hotel management agreement with the operator. For complicated tax reasons beyond the scope of this article, REITs create so-called “taxable REIT subsidiaries” (or “TRS”), which lease the hotel (and related assets) from the REIT (or “landlord”) and are the counterparties to the hotel management agreement with the hotel operator. This result is typically achieved in one of two ways.
First is the “assignment option,” pursuant to which the landlord becomes a party to the hotel management agreement with the hotel operator and then assigns its interest in the hotel management agreement to the TRS in connection with its lease of the hotel to the TRS.
Second is the “pure lease option,” pursuant to which the landlord leases the hotel to the TRS, and the TRS enters into the hotel management agreement with the hotel operator directly.
Either approach creates potential pitfalls for hotel operators. Under both approaches, the “owner” party to the hotel management is in reality the TRS, whose sole asset is generally its leasehold interest in the hotel. The worse-case scenario for the hotel operator: The landlord terminates its lease with the TRS, leaving the hotel operator with a hotel management agreement with a party that no longer has an interest in the hotel and a claim for damages against an entity with no assets.
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The landlord non-disturbance agreement
Hotel operators must ensure their hotel management agreements anticipate a lease structure and include appropriate protections to avoid the worse-case scenario. Hotel management agreements should require a so-called “landlord non-disturbance agreement” in the case of any related party lease. The landlord non-disturbance agreement should cover the following points:
• Lease termination. In the event of a lease termination, the landlord must step into the shoes of the TRS under the hotel management agreement or, alternatively, enter into a new lease with another TRS, which will in turn be the party to the hotel management agreement. This requirement ensures that under all circumstances the hotel management agreement remains in place with the entity that has a present possessory interest in the hotel.
• Sale of the hotel. The landlord must ensure the continuity of the hotel management agreement if it sells the hotel, by either transferring its interest in the TRS or terminating the TRS lease. Any purchaser of the landlord’s interest in the hotel must satisfy any purchaser requirements specified in the hotel management agreement (e.g., a purchaser may not be a competitor of the hotel operator), and must itself deliver a landlord non-disturbance agreement if it employs a lease structure.
• Mortgage of the hotel. Generally, financing for a hotel owned by a REIT will be provided to the landlord, not the TRS. The landlord non-disturbance agreement must ensure that any lender taking a mortgage on the hotel is bound to the lender non-disturbance provisions and other mortgage restrictions (e.g., loan-to-value limitations) outlined in the hotel management agreement. Critically, the lender to the landlord must enter into a subordination and non-disturbance agreement with the hotel operator ensuring the hotel management agreement will remain in place following a foreclosure of the mortgage.
• Guaranty. As noted above, a TRS’ sole asset is generally its leasehold interest in the hotel, which from the hotel operator’s perspective may be terminated at any time. To ensure the obligations under the hotel management agreement are met and the hotel operator has meaningful recourse for any breach of the agreement or third-party claim relating to the operation of the hotel, the landlord non-disturbance agreement should include a guaranty from the landlord of all obligations of the TRS under the hotel management agreement. To ensure enforceability, the guaranty should include all of the bells and whistles typically included in guaranties. Alternatively, if the REIT uses the “assignment option” described above, the same result may be achieved by the landlord remaining liable for all obligations under the hotel management agreement, despite the assignment to the TRS.
• Dispute resolution. Given the overlapping interests of the TRS and the landlord, and the desire of all parties for disputes to be resolved efficiently, resolution of any dispute between the operator and landlord must be resolved in accordance with the dispute resolution provisions of the hotel management agreement. Similarly, any dispute under the landlord non-disturbance agreement may be joined with any dispute under the hotel management agreement, so as to avoid duplicative processes.
• Lease amendments. The hotel operator should secure a right to approve any modifications to the landlord/TRS lease that may affect the hotel or the rights and obligations of the hotel operator under the hotel management agreement.
• Consents and notices under the hotel management agreement. Which entity—the landlord or the TRS—needs to approve the annual budget and provide other consents under the hotel management agreement? Which entity should receive notices under the agreement? The landlord non-disturbance agreement should make this clear, so the operator has clear direction.
The substantial equity raised by hotel REITs during 2010 and 2011 ensures they will remain active purchasers of hotels. Hotel operators should double-check their hotel management agreements to confirm they include a mechanism to require the true owner of the hotel to stand behind the obligations of a related party lessee and maintain the hotel management agreement in place following a lease termination. If this is done, hotel operators should have no trouble accommodating a REIT’s hotel ownership structure.
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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