The rewards of buying such loans are substantial, as they usually are sold at a discount—often steep—to the outstanding amount of the loan. The goal when purchasing a hotel loan is usually to obtain title to the hotel as quickly and inexpensively as possible, not to remain as the lender on the loan. However, too often buyers approach a note purchase like they are simply buying the underlying hotel—without adequately analyzing the numerous landmines along the path to hotel ownership. When you analyze whether to purchase a distressed hotel loan and what price to pay for it, it is important to assess all of those risks.
How quickly you can get title to the hotel depends on a number of factors. Obviously, if the borrower cooperates, you can get title quickly through a deed in lieu of foreclosure or consent foreclosure process. It may be difficult to assess whether the borrower will cooperate, but there are some factors to consider.
For instance, if the loan is in a commercial mortgage-backed securitization, it will usually be nonrecourse to the borrower except in certain instances, such as if the borrower files for bankruptcy. Few CMBS borrowers have been willing to file bankruptcy as a result. Consequently, you may have greater assurance that you will not face a borrower bankruptcy when buying a CMBS loan. Even if the loan is held by a lender that has personal guarantees, the borrower may be willing to hand over title just to avoid that guarantee liability. However, the borrower may be more willing to fight to retain title if it owns the hotel as part of a 1031 tax-deferred exchange because a loss of the property will trigger tax liability. The borrower also may be more willing to fight if it is managing the hotel because it may want to preserve its stream of income. Of course, if the owner thinks there is equity in the hotel, it may oppose any effort to take the title away.
Are the loan documents you are acquiring in order?
It is important to obtain a legal review of all the loan documents you are acquiring so you know whether there are any problems with them. At the outset, you need to confirm that the seller possesses properly perfected security interests in the hotel and its related personal property. That is usually not an issue; however, the terms of hotel loan documents vary and they are not all perfectly written.
You cannot assume that just because a reputable law firm prepared the loan documents that there are no issues with them. Nor can you assume that the provisions in all loan documents are the same. Even provisions that you might think are standard—such as the nonrecourse carve-out clause mentioned above—are not. Seemingly small points can make a big difference in how quickly you might be able to foreclose on the hotel.
What issues might you face when the hotel is turned over?
How difficult and costly a turnover will be depends on many factors, such as whether it is occurring in a hostile fashion (for example, by appointment of a receiver), whether the current manager is a professional hotel management company and whether the owners are honest people. The list of what can go wrong is endless, but special attention should be paid to any challenges you might face obtaining liquor licenses, retaining employees and maintaining the good will of vendors and customers.
You also have to thoroughly analyze any claims against the hotel that may be senior to the mortgage you are buying, such as mechanics’ liens and unpaid real-estate taxes. You also need to be aware of whether you can eliminate any unpaid sales taxes and utility charges or whether any such unpaid bills will impact your ability to obtain necessary licenses or services for the hotel.
What will happen with the hotel’s brand affiliation?
If you intend to retain the hotel’s brand affiliation, you need to determine how difficult and expensive that will be. Although the franchise company may have signed a comfort letter in favor of the lender that sets forth the terms under which it will allow its flag to remain in place after the lender takes title to the hotel, that comfort letter usually is not assignable to a note purchaser.
Consequently, you will not have the benefit of the franchise company's contractual obligation to leave its flag in place upon a change in ownership to you. Moreover, determining what the franchise company will do (including any potential property improvement plan it may require) may be challenging as you will need to be careful in any communications with the franchise company to avoid potential liability for tortious interference with the hotel owner's franchise agreement with it.
What is the worst-case scenario?
Usually, the worst-case scenario in buying a note is that the borrower files for bankruptcy and confirms a plan over your objection. In that instance, the note buyer becomes a long-term lender as opposed to the owner of the hotel as it intended. As a result, you have to consider how likely it is that the borrower will file for bankruptcy and be able to confirm a plan over your objection.
Each situation has to be analyzed on its own merits, as the result will depend on a host of factors, including the jurisdiction where the hotel is located and its controlling law and the likely value of the hotel.
As is apparent, the potential risks and rewards of buying distressed hotel loans in order to obtain title to the hotels are substantial. They key to making wise decisions is taking appropriate steps to analyze all the risks and then pricing your purchase in accordance with those risks and the potential benefits of ownership.
David M. Neff is co-chair of the Hotel & Leisure Group at Perkins Coie in Chicago, Illinois. He can be reached at 312-324-8689 or dneff@perkinscoie.com.
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