In this issue
Terminating Hotel Management Contracts During Periods of High Inflation
KEY TAKE: Hotel owners considering terminating their long-term management contracts should be aware of the role high interest rates and inflation can play in the calculation of wrongful termination damages.
The significant and sustained increase in interests rates, coupled with high inflation have caused uncertainty throughout the economy, including the hospitality industry. While a recent survey of hotel asset managers spreads hope that revenue per available room (RevPAR) for U.S.-based hotels will return to 2019 levels by 2025, hotel owners still face significant headwinds resulting from the COVID-19 pandemic, high periods of inflation, and sustained increases in interest rates.[1]
Rates of high inflation and interest rates present myriad challenges for hotel owners. While much has been written about high inflation and interest rates making credit difficult to access and reducing hotel owners’ ability to leverage their current assets, high inflation also presents other pitfalls that may be less apparent to hotel owners. This includes the decision to, and ultimately the potential cost of, terminating long-term management contracts.
We have previously written about the effect of the pandemic on the termination of hotel management agreements, observing that the damages for the wrongful termination of such agreements by an owner during the pandemic could be lower than in an average year.[2] And as the hospitality environment remains uncertain, certain hotel owners may still decide that the best business solution for them is to terminate their management agreements with their hotel operators, even though such a wrongful termination would entitle the operator to damages.
But hotel owners should be aware that periods of high inflation could affect the cost of terminating hotel management agreements. This is because the commonly applied damages calculation associated with wrongful termination of hotel management agreements can be influenced by long-term periods of increased inflation.
As such, before considering whether to terminate a hotel management agreement, hotel owners should understand how inflation affects the damages analysis.
Terminating a Hotel Management Agreement and Calculating Damages
Hotel owners that wish to terminate their hotel operators and hotel operators that face the threat of termination should evaluate their respective rights and obligations under all applicable agreements and consult with counsel before taking such actions.
As we have previously written, hotel owners have the right under common law to terminate hotel management agreements, and thus their hotel operators, at any time and without cause. Because such agreements are generally classified as agency agreements or personal services contracts, they remain unenforceable by specific performance or injunctive relief. The termination of hotel management agreements will, therefore, inevitably result in a calculation of the damages to be awarded to the terminated operator in the event the operator is to prevail on a claim for wrongful termination.
Generally, hotel operators that prevail on such claims are entitled to the present-day value of the management fees that they would have earned for the remaining duration of the agreement, had the parties continued under it. Also, hotel management agreements typically calculate management fees as a percentage of the hotel’s gross revenue. As such, hotel operators will generally claim damages for their lost profits or the presumed loss of their future stream of management fees for the remaining duration of the hotel management agreement.
In calculating these lost profits, one first reviews the amount of management fees generated in the most recent years and then extrapolates from that data to project the amount of fees that would have been generated over the remainder of the contract. After doing this, a growth rate is applied to this projected amount. Finally, a discount rate is applied to the projected amount of fees. Sustained inflation can play a role in these damages calculations.
The Impact of High Inflation on Damages for Terminating Hotel Management Agreements
Because inflationary factors are often considered as part of the analysis in a wrongful termination damages analysis, it is important to understand how sustained periods of high inflation may influence the amount of damages available to hotel operators that prevail on such claims.
In particular, inflation is often considered when analyzing the amount of projected fees over the remainder of the contract term and the appropriate discount rate to value any lost management fees in present dollars.
First, when projecting management fees over the duration of the remaining term of any management agreement, a growth rate is commonly applied year-over-year. As a general matter, the growth rate is typically meant to reflect ordinary inflation, such as 2-3 percent. After years of sustained high inflation, there is a risk that the growth rates will be higher than has historically been the case, which would result in higher gross operating revenues projected over time and thus higher projected management fees. However, a hotel owner may be able to demonstrate that long-term assumptions of high inflation are speculative and that a constant inflation rate is a better indicator of future performance.
Second, periods of high inflation and high interest rates may also have an impact on the discount rate that is applied. The higher the discount rate, the lower any wrongful termination damages, and vice versa. Often, experts begin their discount analysis by considering a hotel operator’s weighted average cost of capital (WACC), at the time the contract was entered into, at the time of any alleged wrongful termination, and/or at the time of any damages award.
WACC itself represents the average cost of acquiring capital from both sources of equity and sources of debt, and is thus also susceptible to inflationary effects. Specifically, during high inflation, the cost of debt goes up as the value of capital declines, and, in turn, lenders raise interest rates. In addition, high inflation causes the cost of equity to increase the future value of capital decreases and markets seek higher returns to compensate.
As high inflation increases the cost of equity and the cost of debt, when inflation goes up it tends to cause increases in WACC as well. This in turn could result in a higher discount rate being applied to the amount of projected fees determined in a damages calculation, which could offset the application of high inflationary factors applied in the growth factor analysis. Additionally, periods of high inflation may also make the future performance of the hotel riskier, which an expert may consider as a reason for adding bases points to the discount rate calculation, reducing any wrongful termination damages.
Thus, it is possible that high rates of inflation will result in higher growth rates being applied to the projection of gross revenues, resulting in higher projections of future management fees. However, because inflation may also result in a higher discount rate being applied to these projected fees, an increased discount rate may counteract the increases in the overall fee projections generated from the application of higher growth rates.
Therefore, while inflation can affect both the growth rate and discount rate used in damages calculations, how these elements may interact in a particular damages calculation will depend on the specific circumstances pertinent to a particular hotel. For example, hotels that are currently performing well may be less incentivized to terminate their hotel management agreements, as their future performance may be viewed as less risky and subject to a lower discount rate, while also potentially absorbing the cost of future projected inflation. By contrast, hotels that are significantly underperforming, may be incentivized by the same inflationary factors to make a business decision to terminate a management agreement.
Given these competing effects, and the potential for wrongful termination suits to result in increased damages awards, hotel owners should carefully weigh their options and consult with knowledgeable legal counsel before considering whether to terminate any management agreements with their hotel operators.
[1] https://app.box.com/s/ia7uk2r8kh3hsld50zcu46xe0okbtwpj
[2] https://www.law360.com/articles/1370411/terminating-hotel-management-contracts-amid-covid-19
Updates on SB 264 – Florida Law Restricting Persons From Foreign Countries of Concern From Owning, Having a Controlling Interest in, or Acquiring Certain Real Estate, Including Hotels and Condominium Hotel Units
KEY TAKE: New restrictions on land ownership in Florida by non-U.S. nationals is being challenged in court and pending resolution
Owners, purchasers, and sellers of real estate located in Florida, including hotels and condominium hotel units, should be aware of recent legislation and pending court challenges affecting the implementation of such legislation.
The U.S. Court of Appeals for the Eleventh Circuit heard oral arguments on the merits of the Florida law restricting persons from “foreign countries of concern” from owning, having a controlling interest in, or acquiring an interest in certain Florida real property. The court of appeals halted the enforcement of Senate Bill 264, which introduced Chapter 692, Florida Statutes (the Bill), against two individual Chinese plaintiffs/appellants who were in the process of buying property in Florida when the Florida governor signed the Bill. The plaintiffs allege that SB 264 violates the Fourteenth Amendment’s Equal Protection and Due Process Clauses, the Supremacy Clause, and the Fair Housing Act. The court previously held that those Chinese plaintiffs/appellants showed a substantial likelihood of success on their claim that the state statute is preempted by federal law, specifically the Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA), and we anticipate the court will be issuing its decision on the issues presented at oral arguments shortly.
Overview of Florida Senate Bill 264
Florida enacted Senate Bill 264 in May 2023, creating Chapter 692, Florida Statutes, that restricts select persons and entities from “foreign countries of concern”[1] from owning, having a controlling interest[2] in or acquiring by purchase, grant, devise, or descent an interest in certain Florida real property. The Bill generally prohibits, inter alia, foreign principals[3] of a foreign country of concern from owning, having a controlling interest in, or acquiring real property within 10 miles of any military installation[4] or critical infrastructure[5] in the state. An exception permits foreign principals who are “natural person[s]” with a valid non-tourist visa or who have been granted asylum to purchase one residential real property, as long as the property is less than two acres in size and not within five miles of a military installation. Current owners and prospective buyers identified as “foreign principal[s]” under the Bill must register real property located on or within 10 miles of any military installation or critical infrastructure facility with Florida’s Department of Economic Opportunity. The Bill also generally prohibits the real property ownership by any foreign principal.
The second group of restrictions are China-specific restrictions, which prohibit China, Chinese Communist Party or other Chinese political party officials or members, Chinese business organizations, and persons domiciled in China but who are not citizens or lawful permanent residents of the U.S., from directly or indirectly owning, having a controlling interest in, or acquiring by purchase, grant, devise, or descent any interests, except a de minimis indirect interest[6], in real property in Florida. This prohibition includes the same two-acre residential property exception described above for “natural person[s]” with a valid non-tourist visa or who have been granted asylum, and the same requirement to register property with the state.
The Bill imposes both civil and criminal penalties for violations of the statute. Failure to file the required registration by January 31, 2024, for property acquired before July 1, 2023, may result in a civil penalty of $1,000 for each day that the registration is late, a lien against any unregistered real property for the unpaid balance of any penalties assessed, and/or potential forfeiture of any real property owned or acquired in violation of the statute. With respect to criminal penalties, foreign principals or property sellers found in violation of the first set of restrictions may be charged with a second-degree misdemeanor, punishable by up to 60 days’ imprisonment and a $500 fine. The prohibitions aimed at China carry more severe consequences: a person who “ knowingly sells real property” to Chinese persons or entities in violation of the Bill commits a misdemeanor of the first degree, punishable by up to one year of imprisonment and a $1,000 fine. Chinese purchasers of real property in violation of the law commit a third-degree felony, punishable by up to five years in prison and a $5,000 fine.
New Regulations Adopted
The Bill requires three Florida regulatory agencies to promulgate rules in order to implement certain sections of the Bill, specifically registration: the Florida Department of Commerce (Commerce), the Florida Department of Agriculture and Consumer Services (FDACS), and the Florida Real Estate Commission (FREC). On January 4, 2024, Commerce adopted Rule 73C-60, Florida Administrative Code, implementing section 692.203, Fla. Stat., which applies to the purchase of certain real property on or around military installations or critical infrastructure facilities by certain foreign principals, and not to the law applicable to agricultural land or to the ownership of Florida real property pertaining to persons or entities from the People’s Republic of China. Commerce also established the State’s registration system for these applicable properties.
Commerce’s rules add the following example and extends the exception of what qualifies as a de minimis indirect interest: “[a]ny passive ownership interest of a foreign principal in an entity, provided that the foreign principal does not possess, by virtue of that ownership interest or otherwise, the power to direct or cause the direction of the management or policies of the entity with respect to the interest in real property.”
The Commerce’s rules also clarify that individuals approved by the federal government to participate in the EB-5 Program are not prohibited foreign persons. Generally, under the EB-5 Program, investors (and their spouses and unmarried children under 21) are eligible to apply for lawful permanent residence (i.e., become a green card holder) if they make the necessary investment in a commercial enterprise in the United States, and plan to create or preserve 10 permanent full-time jobs for qualified U.S. workers.
During the rule-making process, many companies raised concerns whether the new Bill applied to leasehold interest, considering the Bill contemplates the acquisition of real property by “purchase, grant, devise or descent.” In this regard, Commerce’s rules provide that a lease is not an interest in real property.
Similarly, the FDACS adopted Rule 5J-27 to implement provisions related to foreign ownership of agricultural land in Florida, which became effective on April 4, 2024. The FDACS’ new rules clarify terms used in the statute and the rule, detail the registration requirements that foreign principals must comply with, summarize the enforcement action that FDACS will take for violating the rules, and provide a safe harbor provision to closing agents and sellers of agricultural land when certain conditions are met.
These new rules, however, do not mirror one another, and there are disparities between the agricultural land rules and Commerce’s rules. Most notably are the different definitions of terms. For instance, the new rules defining “controlling interest” in agricultural land differ from those governing controlling interest in certain real property on or around military installations or critical infrastructure facilities. Commerce’s rules narrow the definition of “controlling interest” to an interest giving the prohibited person the “right to improve or develop the real property” and “to attach fixed or immovable structures or objects,” whereas the FDACS’ definition of “controlling interest in agricultural land” adds any interest that gives the foreign principal the right to physically access the agricultural land and to exclude others from physically accessing the agricultural land.
Critical to real estate transactions, on January 17, 2024, the FREC adopted Rule Chapter 61J2-10.200, which contains the form affidavit a buyer must provide under the Bill.
We will continue to closely monitor subsequent developments related to the Bill, both on the regulatory front and as rules are developed and enforcement as the result of the pending litigation in Shen v. Simpson, No. 4:23-cv-208-AW-MAF (N.D. Fla. 2023), appeal docketed, No. 23-12737 (11th Cir. Aug. 23, 2023).
[1] Foreign countries of concern include the People’s Republic of China, the Russian Federation, the Islamic Republic of Iran, the Democratic People’s Republic of Korea, the Republic of Cuba, the Venezuelan regime of Nicolás Maduro, and the Syrian Arab Republic.
[2] “Controlling interests” is broadly defined as “possession of the power to direct or cause the direction of the management or policies of a company, whether through ownership of securities, by contract, or otherwise. A person or entity that directly or indirectly has the right to vote 25% or more of the voting interests of the company or is entitled to 25% or more of its profits is presumed to possess a controlling interest.”
[3] The Bill defines “foreign principal” as “(a) the government or any official of the government of a foreign country of concern; (b) a political party or member of a political party or any subdivision of a political party in a foreign country of concern; (c) a partnership, association, corporation, organization, or other combination of persons organized under the laws of or having its principal place of business in a foreign country of concern, or a subsidiary of such entity; or (d) Any person who is domiciled in a foreign country of concern and is not a citizen or lawful permanent resident of the United States. (e) Any person, entity, or collection of persons or entities, described in paragraphs (a) through (d) having a controlling interest in a partnership, association, corporation, organization, trust, or any other legal entity or subsidiary formed for the purpose of owning real property in this state.”
[4] “Military Installation” is defined as “a base, camp, post, station, yard, or center encompassing at least 10 contiguous acres that is under the jurisdiction of the Department of Defense or its affiliates.”
[5] Critical infrastructure facilities include chemical manufacturing facilities, refineries, electrical power plants, water treatment facilities or wastewater treatment plants, liquid natural gas terminals, telecommunications central switching offices, gas (and natural gas) processing plants, seaports, spaceports, and airports.
[6] A person or entity (or foreign principal, as applicable) has a de minimis indirect interest if any ownership is the result of the foreign principal’s ownership of registered equities in a publicly traded company owning the land and if the foreign principal’s ownership interest in the company is either: (a) less than 5 percent of any class of registered equities or less than 5 percent in the aggregate in multiple classes of registered equities; or (b) a noncontrolling interest in an entity controlled by a company that is both registered with the United States Securities and Exchange Commission as an investment adviser under the Investment Advisers Act of 1940, as amended, and is not a foreign entity. (Fla. Stat. §§ 692.201-.205).
Getting Junked? FTC Focuses on Unfair and Deceptive Resort Fees
KEY TAKE:
Hotels that have adopted charging a resort fee should be aware of the changing landscape regarding disclosures to guests.
On October 9, 2023, the Federal Trade Commission published a notice of proposed rulemaking entitled “Rule on Unfair or Deceptive Fees.” The proposed rule prohibits unfair or deceptive practices in the sale of goods or services, and, specifically, prohibits misrepresentations regarding the total cost of goods and services resulting from the failure to disclose fees and the nature and purpose of such fees, which they refer to as “junk fees.” The resort fees, which have become a typical part of the nightly rate of hotel accommodations, are included in these so-called junk fees that will be subject to any such final rule.
What Are Resort Fees?
It is commonplace for a hotel guest to be charged a “resort fee” on top of the base room rate. The resort fee is typically a daily extra charge. It is mandatory and is charged even if the hotel guest does not use any amenities or services which are identified by the hotel as being covered by the resort fee. A resort fee may also be called a destination fee, facility fee, service fee, amenity charge, resort charge, urban fee, or a similar term. The amount of the resort fee varies greatly by hotel, and can be as low as $20 a day and as high as $160 a night.
Consumer complaints arise with respect to resort fees when they are not prominently disclosed in advance with specificity. This often results in the hotel guest being surprised at the amount of the final bill at check out.
Government and Other Responses to Resort Fees
Resort fees have become a point of contention between hotels and consumers in the U.S., and have been and continue to be addressed by consumer advocacy groups, state and federal lawmakers, courts, and attorney generals. Resort fees were even mentioned with specificity in President Biden’s 2023 State of the Union address.
In addition to general laws prohibiting deceptive trade practices and false advertising, legislation specifically addressing resort fees has been adopted or proposed in several states and at the federal level. As discussed above, the Federal Trade Commission final rule addressing resort fees is pending following rounds of public input.
How Should Hotels Respond?
Hotels should be transparent in their disclosure of all resort fees when advertising room pricing. The resort fee should be clearly and conspicuously disclosed such that the average consumer will be able to understand the cost of the stay. To avoid negative outcomes, it is important for consumers to be made aware of their financial responsibility when booking a hotel stay, as well as for the hotel to observe any specific requirements of any applicable legislation or court order.
Hotel Franchise Agreements Can’t Be Negotiated. Is That True?
KEY TAKE: Brands themselves and industry participants describe hotel franchise agreements as non-negotiable, though in reality, with experienced legal counsel and strategic/financial advisors, there are several key terms that can be negotiated.
Negotiation of Hotel Franchise Agreements
The form hotel franchise agreement comes directly from the brand’s lengthy Franchise Disclosure Document (FDD). Brands are reluctant to make changes to their form. With legal counsel, JF Capital has successfully negotiated over 125 hotel franchise agreements, and in each, we received concessions beyond the basic form. This was a function of knowing what is achievable in negotiations, and when those negotiations must take place. It is also driven by location, size, and profile of the hotel and the strategic and financial importance to the brand. We will examine some of the negotiated deal points that we regularly achieve, which differ from the franchise forms.
Royalty Fees on Rooms and on Food and Beverage Revenue for Selected Brands
It is usually possible to achieve what is referred to as a ramp up in the percentage of royalty fee percentages paid over the first few years of the franchise agreement, reducing the burden as the hotel is launching and stabilizing. For those brands that also charge a royalty on food and beverage revenue, it is sometimes possible to receive an annual dollar amount cap on that specific fee.
Radius Restriction/Area of Protection
Franchise agreements will often have a defined Area of Protection (AOP) specifying that for a certain number of years, the franchisor will not open another branded hotel within a specified radius or geographic area. The radius will vary greatly as the radius or distance in Midtown Manhattan will be substantially smaller than in suburban New Jersey. It is critically important to understand that the AOP offered will almost always be specific to the sub-brand, such that if negotiated for a Sheraton hotel, part of the Marriott brand family, the AOP would not apply to Marriott, Westin, Residence Inn, Le Meridien, Renaissance, or other Marriott brands.
Guaranty
The franchise agreement is guaranteed. If the specific guarantor is not negotiated upfront, the franchisor will generally assume and take the position that it is the sponsor or their affiliate, essentially a warm body with liquidity and net worth. If structured upfront, it is generally possible to have the property owner LLC or LP as the guarantor such that it is effectively non-recourse.
Loan to Value Limitations on Debt Financing
Some form franchise agreements have a limitation on the LTV on debt financing (often 75 percent LTV). It is possible to increase this or to remove the requirement entirely.
Right of First Offer/Right of First Refusal
Some franchisors have introduced Rights of First Offer (ROFO) or Rights of First Refusal (ROFR) on a proposed asset sale, benefitting the franchisor. It is sometimes possible to remove these encumbrances and simply provide a notice of any marketing or sales process.
Specific Window for Termination With Reduced or Minimal Fees
While rarer to negotiate, for newer brand launches and rollouts there is greater uncertainty in how successful the brand will be. With newer brands, it is sometimes possible to negotiate a “free” or discounted termination with minimal liquidated damages, after or during a certain window.
Select Situation Specific Transfer/Assignment Provisions
Each form license agreement has several pages on transfers. Often, they fail to address deal structures commonly utilized for hotel ownership and development. It is possible to insert specific transfer provisions that would facilitate a joint venture buy/sell or put/call provision, or readjustments of equity within the franchisee ownership.
Key Money
Key Money is widely misunderstood. Usually, Key Money is advanced as an unsecured loan with a franchisee guaranty. The Key Money loan has no interest rate and is coterminous with the franchise agreement. The franchisor will generally forgive a ratable portion of the Key Money loan each year so that by the end of the franchise term it is fully forgiven. Many are surprised that the funds are generally not advanced until after opening of the property, or completion of the detailed capex work. On sale or agreement termination, the balance of the Key Money loan must be repaid.
PIP — Property Improvement Plan
For an existing hotel, each franchise agreement will require a Property Improvement Plan (PIP). The PIP is issued as a scope document of work to be done and related timing, but without any financial estimates. The PIP is an exhibit to the franchise agreement and is guaranteed. The PIP can be up to 25 pages of scope items, including some which simply say “Replace” or “Make like new.” It is important to heavily negotiate the PIP prior to signing the Franchise Agreement. Working with an experienced operator, project manager, and contractor can facilitate an efficient negotiation of the PIP and can lead to large financial savings and minimize future challenges.
Conclusion
Working closely with experienced legal counsel and strategic advisors that regularly negotiate with the hotel brands, and doing so early in the process — at the term sheet stage, prior to submitting a franchise application — can yield surprisingly good results. While 95 percent of the text of the franchise agreement shown in the FDD doesn’t change, the few items that may are material and can drive substantial value.
*JF Capital Advisors
