Hotels
On a hotel financing, arrangements with the hotel manager and/or franchisor will be fundamental. A hotel’s brand is an inherent part of its value and any lender will be keen to ensure continuity of that brand during the life of the loan, as well as continuity of operations. As such, in advance of lending, the lender will typically want to sign a direct agreement or non-disturbance agreement with the hotel franchisor and/or hotel manager, in which certain arrangements are agreed. Hotel franchisors in particular are often keen not to deviate from their standard terms that they apply to all of their hotels, and so direct agreements with them are often bespoke or based on the hotel franchisor’s standard forms and negotiations are limited, but we would always look to ensure that the lender’s key continuity concerns are catered for.
For example, hotel management/franchise agreements very often contain change of control rights for the hotel manager/franchisor, allowing the hotel manager/franchisor to terminate its management or franchise if the ultimate ownership of the owner of the hotel changes. We would ask the hotel manager/franchisor to specifically agree that its change of control rights will not be triggered as a result of the lender taking control of the hotel upon a share enforcement (usually subject to certain requirements such as the new owner not being a competitor of the hotel manager/franchisor), and that the new lender-owned controller of the hotel can take over the benefit of the hotel management/franchise agreement upon enforcement (usually provided that the hotel manager/franchisor’s brand standards continue to be met).
If the loan is to be securitised, we would also look to ensure that the hotel manager/franchisor pre-consents to disclosure of the key terms of the management or franchise agreement in any offering circular. Hotel managers/franchisors will typically agree to this provided that they can review those terms in advance, and sometimes on the basis of a fee. It is also worth noting that if the asset in question is a leisure park, it may be more appropriate for it to be financed by way of a whole business securitisation structure rather than by way of loan, as this preserves the operating nature of the asset and ensures that the whole business can be financed in an uninterrupted manner.
Lenders will also typically require certain controls in relation to the hotel and its operations – for example, an event of default if the hotel management/franchise agreement is terminated or assigned. We often see an immediate event of default if the hotel closes for a certain period, although carve outs may be negotiated for seasonal repairs and/or for a closure resulting from legislative requirements as was seen during the pandemic (possibly with an obligation for the sponsor to top up income from equity during any period of closure). There may be additional bespoke covenants around any services ancillary to the hotel such as a golf course, beach or marina. Fixtures, fittings and equipment (FF&E) will be fundamental, as this is a major factor in the upkeep and reputation of any hotel – poor customer reviews about hotels tend to focus on poor FF&E. A certain amount will be earmarked for FF&E each year, usually in line with the hotel management agreement and the franchisor’s brand standards, and this amount is to be paid into a separate FF&E account senior to many other expenses.
The other key differentiating factor in a hotel facility agreement will be the fact that the asset is operational in nature. Financial covenants will typically look at debt yield rather than interest cover, and leverage is more likely to be measured. Revenue will be based on operating income rather than rental income, though any retail premises at the hotel such as hairdressers and kiosks should not be forgotten. Cashflow might be more lumpy or seasonal than on another type of real estate financing and so a finance costs facility, PIK (pay-in-kind) loan or seasonality reserve account may be required. Income will be paid into an operating account over which the hotel manager usually has signing rights, and the hotel manager will be able to deduct its fees at source and operating expenses from that account. Unlike on other financings, the lender will not be able to block the operating account upon an event of default, as this would be terminal for the hotel – instead, typically post-event of default any profit after payment of the hotel’s expenses and the hotel manager’s profit and fees is redirected to a blocked account.
Because of the operating nature of a hotel, employment issues become more relevant. The lender will need to consider who the employer of the hotel employees is (typically this is an obligor rather than a manager) and what happens to their employment contracts upon an enforcement (typically, they will TUPE over to the new owner but this should be checked). Representations, covenants and obligor rights around pensions and intellectual property will be more relevant than usual, and if security is taken over IP it should be registered with the Intellectual Property Office as well as with Companies House. Carve outs from covenants may also be required for time share arrangements. Depending on the location of the hotel, terrorism insurance cover may also be particularly important.
Lastly, as on any financing, the link to ESG should be considered. Often, hotels are not particularly environmentally friendly as they can comprise older buildings and have heavy running costs. However, even in these circumstances it is advisable for the lender to consider whether the environmental credentials of the hotel can be improved at all during the life of the loan, and to take into account any other ESG considerations. Modern slavery can be a particular issue in the running of hotels and so lenders would be well advised to be able to show investors that they have looked into any such issues before lending.
Industrial assets
A facility agreement for an industrial asset will not be markedly different to that for any other type of real estate asset, though there is likely to be less lender focus on maintenance covenants and property management arrangements if the relevant assets are purely industrial. It will be important to consider access to the relevant assets – if there are any easements or rights of way, the lenders will need to ensure that these are due diligence properly prior to lending, and if there are any shuttle services to the assets, we would need to consider who runs these services and how they factor into rental income.
If the industrial asset is a cold storage site, an additional consideration will be the trading contracts under which the obligors provide the cold storage services to the users of the site. The facility agreement will likely contain restrictions around those trading contracts, such as the occurrence of an event of default if there has been a material breach of a material trading contract, and any proceeds arising from the termination of a trading contract would need to be paid into a blocked account of the lender in the same way as lease surrender proceeds would. The lender may want to enter into direct agreements with anchor customers of key trading contracts to prevent their termination. Maintenance and repair covenants will also be more important for cold storage properties to prevent any loss of their value, and the lender may want to consider an immediate event of default if there is a prolonged power outage. The lender and borrower should also keep in mind that a cold storage financing may qualify as a green loan due to its environmentally friendly nature, potentially widening investor access to the financing and improving its pricing.
If the industrial asset is a data centre, arrangements with the data centre operator will be key in order to ensure smooth running of the site. We would effectively treat the data centre operator in a similar manner to a property manager, asset manager or hotel manager, requiring it to enter into a duty of care agreement with the lender, and for any termination of or material amendment to the data centre operating agreement to require lender consent. Insolvency of the data centre operator should also result in an immediate event of default, possibly subject to a permitted replacement mechanic provided that a contingency plan is in place. The borrower may also be required to sign up to covenants regarding the minimum total connected capacity of the site. We would also typically include covenants around customer contracts relating to the provision of telecommunications infrastructure, equipment, data centre disaster recovery services, secure housing of data and similar managed services, in a similar manner to trading contracts for cold storage facilities.
Residential assets
Residential financings can take different forms – the financing may involve a single asset with a build to rent scheme, or could involve a multitude of individual residential assets. If the latter approach is taken, the key differentiating factor will likely be the granularity of the portfolio which will require certain adjustments to the facility.
It will likely be appropriate to adjust some of the events of defaults and covenants to reflect the granularity of the portfolio. For example, it will probably be inappropriate for the borrower to be in default as a result of major damage to or compulsory purchase in respect of one property only within a portfolio of thousands, so a materiality or MAE qualifier will be appropriate. In reality this means that these events of default will likely never be triggered, as it seems unlikely that there could be an issue affecting a material number of individual residential assets within a large portfolio, unless a large scale event happened such as a material weather event or widespread environmental contamination.
Because of the granularity of the portfolio, it may not be appropriate to take mortgage security on all transactions. This renders the transaction more akin to a RMBS (residential mortgage-backed securitisation), and the lender will instead be relying mainly on the servicer or operator of the properties, the appropriateness of its enforcement and collection policies and its compliance with any relevant consumer rights legislation. The lender will of course be keen to avoid association with any negative headlines such as tenant evictions. As on an RMBS, we would also typically due diligence the standard lease templates and other property-related contracts prior to financing and include a requirement that any contracts entered into during the life of the facility follow the form of these due diligenced templates, subject to pre-agreed exceptions giving the borrower appropriate flexibility to conduct its business. We would seek to ensure that any English lease agreement excludes the benefit of the security of tenure provisions of the Landlord and Tenant Act 1954.
For any residential asset, technical due diligence is also essential. New building safety legislation can impose onerous and expensive obligations to remediate defects which could substantially impact upon the value of the asset and the financial position of the borrower. Where financing development or refurbishment of existing multi-storey premises, more stringent building control procedures may apply. Lenders may require receipt of approvals as a condition precedent to drawdown of development facilities. The placing of a homes warranty policy will also be required as the benefit of such a policy is a requirement on the sale of new homes. It is also advisable to diligence any operator’s right to rent checks.
Tenant arrangements should also be considered. In many countries, tenant deposits are now required to be kept separately by a landlord within a designated account or government-controlled account. If this applies, any tenant deposits will need to be dealt with separately from the remainder of rental income. Tenant contributions may also be paid into a sinking fund relating to the building, and these will likely be deducted from rental income at source.
If there is a co-living arrangement in place, shared space is a key element and so maintenance of common parts will likely be important and some upfront refurbishment or development of the properties may be necessary, requiring capital expenditure allowances. The presence of any retail units (such as on the ground floor of flats) or company lets within the building should also be taken account of when structuring the transaction and calculating rental income. If the building consists of affordable housing, there may be a lease to a social housing provider and the insolvency of that social housing provider may result in an event of default. Any social or affordable housing element may permit the financing to be ESG compliant (under the “S” of ESG), potentially widening investor access and publicity for the deal.
Student accommodation
A branch of residential property is student accommodation, which tends to remain resilient during downturns in the real estate finance market. On these transactions, the arrangements with the operator of the asset will be key. There may be a lease or nomination agreement in place with the relevant university, or an operating agreement with a third party operator. There may also be an overseas referral agreement which will need to be reviewed. We would also conduct due diligence on the form of tenancy agreement with students and require that the contracts substantially follow the format of that due diligence agreement. Permitted leasing will be negotiated, the borrower having freedom to lease within certain pre-agreed parameters. If a third party operator is appointed (as is usual) a duty of care should be taken, and in due diligence particular focus should be placed on compliance with the tenancy deposit scheme – we have seen an incident where a manager failed to comply with tenancy deposit scheme obligations and the news spread quickly amongst the students who all sought statutory compensation. As with residential properties, it is also advisable to diligence any operator’s right to rent checks.
On student accommodation deals rental income may be lumpy (as students often pay per term) and there may be no income over summer. As such a cash trap or seasonality reserve may be required for the summer period. That said, some student accommodation properties operate as budget hotels over the summer and Christmas breaks.
Maintenance and repairs will be important considerations for a lender on a student accommodation financing, as students are liable to publicise any issues such as mould or broken showers by immediately posting videos on social media.
Care homes
A key lender consideration on a care home financing will of course be reputational risk on enforcement – because this could theoretically result in the eviction of elderly people. However there will be different levels of risk depending on the asset – for example, financing a standard senior living home is a very different proposition to financing an acute medical facility.
Any care home facility will likely be regulated by the Care Quality Commission. Information undertakings will require the borrower to share any regulatory reports and to notify the lender of any material communications with the regulator. A downgrade by the CQC to a particular level (for example, “requires improvement”) may result in an event of default.
Conclusion
In the current environment, with office and retail assets becoming less popular as financing targets, we are seeing an increasing focus on operational real estate such as industrial assets, data centres and hotels. Meanwhile residential real estate, including student accommodation, continues to be a resilient asset class, benefiting at the moment in particular from higher rents due to inflation. Whilst in general, facility agreements remain broadly consistent across all asset classes, some particular considerations are necessary for lenders depending on the type of asset being financed. This article has given a flavour of some of the key points we would push for as counsel to a lender, or would advise our borrowers to expect. Please contact us if you require any further detail or advice in relation to any real estate finance transactions.
