Understanding the legal and compliance issues that impact hotel properties begins long before acquisition. Indeed, reviewing local real estate regulations, in-place contracts, and other legal documents is a critical part of the initial due diligence process. Knowing what to review, and what red flags to look for, can ultimately make or break the success of a hotel investment.
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Pre-Acquisition Legal Reviews
Significant legal resources are needed prior to acquisition of a hotel property. The legal team, which can be either in-house or outside counsel (or both), will start by either drafting or reviewing an initial letter of intent (“LOI”), which will document the deal points upon which the offering party is willing to consummate a sale. Although the LOI is not binding, care must be taken in its drafting. Critical points that a party must have in a future purchase and sale agreement, including the certain early deliverables—such as insurance information and due diligence documents—should be identified. The legal team will then either draft or review the terms of the proposed purchase and sale agreement, prepare the private placement memoranda, and subscription agreements and otherwise review documents for SEC compliance.
An initial review of all existing contracts related to hotel operations is also necessary. This helps the prospective buyer decipher what the vendors’ deliverables will be, which contracts are assumable or assignable, and what warranties and representations are stated. More on contract review is discussed below.
The legal team will also review and help navigate any potential title issues, looking for covert liens, encumbrances, tax dues, or restrictions attached to the property, and otherwise ensuring there is no cloud on the title prior to acquisition.
A thorough review of the physical property is also necessary. For instance, the hotel operator will want to know whether the property is ADA compliant. ADA accessibility is something regulated at the federal level; it is not something that local or state building inspectors will enforce at the property-level. ADA lawsuits are very common in certain jurisdictions such as California, Florida, and New York. Understanding the state of ADA compliance can be relevant to pricing, valuation and exposure.
Other property-level inspections usually include a walk-through of every space on the property, including places like the property’s mechanical room, to ascertain the life left on major pieces of equipment, such as the HVAC systems. Aging systems can be costly to repair, so if a repair or replacement is in the near future, that should be negotiated into the purchase price or otherwise accounted for in the pro forma.
Auditing Financial Statements
At Wolfgramm Capital, we spend significant time reviewing all the financial statements of the current hotel operator. We look for these to be certified by a CPA, which ensures the numbers have been audited and are credible.
We take it one step further, however.
We take the financial statements, audited or otherwise, and reconcile them with the numbers reflected in the operator’s booking platform and/or other financial software. We look at how the information was extrapolated and then examine the profit and loss statement that fed into the financial statements. This analysis can be very telling as it pertains to the integrity of the current operator’s financial bookkeeping.
It is a major red flag if we find any underreporting, overreporting, or otherwise sloppy reporting during this process. Having said that, sometimes poor bookkeeping is a sign of a poorly run operation, signaling an opportunity to promptly boost efficiencies and, therefore, NOI and the value of the hotel soon after acquisition.
Examining the Property Improvement Plan (PIP)
Another thing we look at very carefully is the property improvement plan (PIP). Any franchisee of a major hotel brand will be required to maintain the property to certain standards and whenever there is a “change of ownership,” the major flags require a change-of-ownership “refresh” with PIP commitments. The PIP that is part of the franchise agreement will also ensure that the property is being refreshed every five to seven years in accordance with the brand’s standards.
The legal team works closely with the operations team to understand where the current owner is in the PIP cycle. When was the last refresh and what did that entail? What are the next chores on the current cycle and what will need to be replaced in terms of both soft and hard goods? What is the estimated cost-per-key for that work? It is important to understand, per the franchise agreement, what improvements must be made upon a change in ownership. These upgrades can be costly and can also impact the property value. A hotel with a newly completed PIP is typically worth more than a like property that is facing the end of its PIP cycle.
If we feel that the current hotel owner is not transparent with information about their PIP, we will reach out to the brand directly. We will notify them that we are planning to put in an application for a franchise agreement and, after signing a franchise disclosure document, we will receive copies of all information pertaining to where the owner is in their current PIP cycle. Armed with this data, we can better negotiate the terms of the purchase and sale agreement.
The fact that a hotel is near the end of its PIP cycle is certainly not a deal-breaker. Instead, we will simply ensure we understand what will be required to refresh the property in accordance with the franchise agreement and will then budget for that accordingly, so we are not forced to tap into reserves set aside for truly unexpected expenses. In fact, because we have developed some excellent lines of sourcing for hotel goods and we have a fantastic head of construction, we can often source and complete a PIP at a price point lower than our competition. It provides another opportunity to squeeze additional profit out of an acquisition.
Reviewing Vendor Contracts
As noted above, examining in-place vendor contracts is essential. There are some critical vendors that a hotel simply cannot do without. For example, a property without on-site laundry will need to outsource this to a third party; they cannot have any gap in service when ownership changes hands. Additionally, one of the big challenges that businesses—especially within the hospitality sector—has faced since the pandemic flows from the “great resignation.” The labor force is not as robust as it once was. Keeping a quality group of house cleaners on tap is challenging. Hotel operators often have third-party contracts with temp labor to fill gaps in housekeeping. We want to examine those relationships.
During the purchase and sale negotiation, we will specify who owns what goods that are on site and who is responsible for what prorated portion of vendor invoices if the closing occurs mid-month or mid-cycle. These seem like small details, but they can add up, in terms of cost, and must be carefully reconciled.
At Wolfgramm Capital, we will look at each contract to understand the details of each agreement. We want to know whether contracts are assignable or assumable. Ideally, we will create a break in liability by ending a current contract and initiating a new contract with the same vendor if and where possible. For example, when we take over ownership of a new hotel, we will typically fire every single staff member and then rehire them on the spot. This is a risk-mitigation strategy that we use to ensure we are not held liable for anything under the contracts of the prior owner or have ongoing ERISA obligations.
After taking ownership of the property, we will also look at whether some vendor contracts can be renegotiated, consolidated, or transferred to other vendors. For example, we can usually achieve economies of scale in markets where we have multiple hotels and vendors who work across several properties at a lower rate on a per-key basis.
Of course, we review contracts carefully before terminating or otherwise modifying the agreement. The last thing a hotel operator wants or needs is a mechanic’s lien placed on the property, which can have negative consequences from their lender.
All contracts continued to be reviewed by the hotel’s GM on a monthly or quarterly basis. At the limited-service end of the business, there may only be a dozen or so vendor contracts in place at any given point in time. Luxury and resort properties can have significantly more – two, three, or even four times as many – given that these properties require more maintenance, service, and usually have more robust amenities that require routine upkeep.
This detailed contract review also applies to lease agreements. At some of our larger properties, we have lease agreements with third-party vendors, such as spa or restaurant operators. We regularly review the financial statements of these lessees to ensure we are maximizing the value of that lease, whether that means incorporating new language around rent escalation or gross revenue sharing, or otherwise.
Insurance Policies and Claims
In addition to reviewing in-place insurance policies, we will also conduct a look back to determine whether there have been any claims filed against that policy. One of the items that we expressly identify as early as the LOI as a due diligence deliverable is the loss-run report on the in-place insurance for the hotel. That gives a sense as to how the property was operated and whether (and at what cost) the insurance policy will be renewed.
Insurance is something hotel operators must navigate quickly in their acquisition process.
If they cannot get insurance, or if it is going to be very expensive due to either prior claims or as a result of changing regulations/market conditions, then the deal may no longer be financially feasible. For example, insurance premiums have escalated in California because of the wildfires. Properties located in coastal regions are also more expensive to insure given concerns over flooding. There are entire insurance companies that have pulled out gulf-coast Texas, for example, limiting the supply (and increasing the cost).
Understanding insurance premiums is essential. What is reflected in the current owner’s profit and loss statement (P&L) may no longer hold if the insurance premium is going to skyrocket with the change of ownership. A hotel that costs three times as much to insure will be a red flag on the overall return profile of the deal, as this goes right to the bottom line.
Too often, hotel operators fail to realize that their insurance premiums can be negotiated. In our experience, insurance companies rely heavily on data during their underwriting process. To the extent we can provide information and data that shows how well we manage our properties, we do that. For example, we use relatively inexpensive water monitoring systems that will notify us of excess water use or leaks prior to the water causing a flood. Having sensors that monitor water intrusion or certain moisture levels not only save us on repair and maintenance costs, but can also lower our insurance premiums by an amount well over the cost of installing the sensors.
Compliance with Employment Laws
There are several laws that govern the labor relationships between ownership and their employees. In addition to federal regulations (like OSHA), there are laws that vary from state to state. Hotel owners must be cognizant of all applicable laws and follow those carefully. It is generally considered best practice to hire a General Manager who is well-versed in local regulations to ensure compliance. Sometimes that GM is already in place upon acquisition; other times, we will bring in someone new or train-up an Assistant GM who is eager to take on the role and responsibility.
We utilize various checklists to ensure compliance with employment laws. Some states provide these checklists; in other instances, we use checklists provided by the corporate hotel entity. These will outline who is responsible for issuing employees with warnings, under what circumstances, what disclosures need to be posted, what must be handled directly by the payroll department, and more.
Moreover, our employees are generally hired on an at-will basis, meaning that either party can terminate employment at any time. Prior to signing an employment contract, we provide new hires with our employee manual or handbook that specifies all rights, obligations, and expectations of staff.
One of these expectations is that our staff undergo very specific and often, ongoing training modules. Many of these are hosted by the corporate brand. Marriott and Hilton, for example, have fantastic training programs. They offer courses for both hotel management as well as employees. Some of these courses are very specific, such as training for those who use the revenue management system, or those who conduct night audits.
Not only does this training help our business operate more efficiently, but advanced training also helps us from a liability perspective. For example, there is a training course for hotel managers to look for signs of human trafficking. This is a big deal in the industry, as hotels are often used as a place for human and/or sex trafficking. This liability is covered by most insurance premiums, as it is not the hotel operator doing anything wrong, but rather, the third parties who are utilizing the hotels for these purposes. Nevertheless, hotels can be seen as negligent and liable if they are not proactive and well trained in how to spot signs of human trafficking and then act accordingly.
Advanced trainings like these are part of a risk mitigation strategy that we use this to negotiate better rates on our insurance premiums. More advanced training means that we are less likely to face an adverse situation where someone makes a claim on our insurance or gets injured. Cost savings like these can have a dramatic impact on our bottom line.
All staff receive advanced notice about the trainings, including our expectations regarding who should attend and the timeline for completing the modules. Given that our employees operate on an at-will basis, those who do not want to participate in the trainings can be terminated without recourse.
Workplace Health and Safety
As noted above, hotels must abide by all federal OSHA regulations. That is the bare minimum. However, we use detailed checklists to ensure we are maintaining a healthy and safe work environment for our staff and guests to mitigate the risk of litigation.
We also have written policies in place for handling staff complaints and/or other workplace issues. For example, if someone complains about sexual harassment, we have a policy in place to promptly address the situation. We separate the staff involved, collect statements from all parties, and then address how best to proceed if there is indeed a valid concern. Instances that are reported to management that are not sufficiently addressed create significant liability for the hotel ownership team. The hotel operator can be found negligent in protecting its employee or handling an adverse workplace condition.
One of the ways we monitor our performance is by using employee surveys.
We ask employees to report whether there are any problems that the ownership team needs to be made aware of, and if so, we look to address those concerns immediately. We take it very seriously. We log these surveys in our personnel files which we can go back to in the event of an employee grievance.
Protecting Intellectual Property and Brand Collateral
Many hotels, particularly those associated with a franchise, will have their own intellectual property or brand. Protecting the integrity of this IP or brand collateral is essential.
Some “soft brands” are associated with major hotel chains but have their own independent brand as well. This is the case with the Sam Houston, for example, a hotel that is 100+ years old and is widely recognized but is technically a part of the Hotel Curio collection. But Sam Houston has its own brand and their own IP. When acquiring a hotel like this, it is important that all IP, including any trademarks, is transferred to the new ownership group as part of the sale.
We often find this to come up when purchasing luxury hotels and resorts.
Many of these properties have a long-standing history in their community and host various events that are unique to the hotel. The Gaylord Hotel in Grapevine, TX, for instance, has a Christmas wonderland event that they host. There is a lot of IP associated with this program that would need to be included and/or addressed in any acquisition or disposition.
One of the first things we will look at in situations like this is how the IP is managed, how it has been maintained, whether there are renewals coming up, and the conditions by which the renewals can be obtained.
Maintaining brand standards is also critical for any hotel franchisee. The franchisor will often send someone out, unannounced, to conduct a property inspection to ensure the property is protecting the brand and any of its associated collateral. Hotel operators that are not in compliance with the brand standards are at risk of losing their flag altogether. The brand platform, through loyalty programs or otherwise, helps to drive significant business to a hotel and losing the flag devalues the property.
Consumer Protection and Data Privacy
The realm of consumer protection and data privacy is becoming increasingly important to hotel operators. While many people book their stays online via closed-system technology, we still have several people who walk-in off the street and pay in cash or with their credit cards. Our staff are trained in how to handle these transactions, including how to spot a stolen credit card.
We take data privacy very seriously. To that end, we have a VPN system in place that requires two-factor authentication. Only those who need to have guests’ private information are able to obtain it. We also have a full-time IT person on staff who monitors data transmission and ensures we have appropriate systems in place.
In addition to proper handling, destruction of personal data is also important. For our properties where it make sense, we have a third-party vendor who comes in once per week to shred or otherwise destroy any written information that includes personal data.
Compartmentalizing Liability
One of the best ways to limit liability is to compartmentalize our hotel properties and businesses.
Each hotel property is held in its own special purpose entity, typically as a newly formed LLC that only has one asset. That could mean there are two LLCs for each hotel, one that holds the real estate and one that holds the business operating out of that real estate. Therefore, if someone sues the business they cannot also go after the real estate—nor can they go after the other assets that we might own. From a protection perspective, this compartmentalization is essential.
Also, as noted earlier, we like to enter into new contracts upon taking over ownership rather than assuming existing contracts. This helps break the chain of liability. Someone who has a claim against the prior owner, under that prior contract or LLC, cannot come after us. We look to start fresh with all contracts (with vendors, employees, etc.) whenever possible.
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Conclusion
In the dynamic world of the hospitality industry, where guest experiences are paramount and operations are multifaceted, the importance of a robust legal review process cannot be overstated. Hotel properties, serving as the epicenter of countless interactions and transactions, must navigate a complex legal landscape to ensure not only the seamless functioning of their operations, but also the protection of their guests, staff, and overall reputation.
The legal intricacies surrounding hospitality encompass a wide area of areas, from employment laws and safety regulations to contractual obligations and intellectual property considerations. Failing to address these legal dimensions can lead to significant consequences, ranging from financial penalties to damage to the brand’s integrity. The legal framework serves as a crucial safeguard, providing a structured approach to compliance and risk mitigation.
Furthermore, maintaining compliance is not a one-time endeavor; it is an ongoing commitment that requires vigilance and adaptability. As laws evolved and societal expectations shift, hotel properties must proactively engage in legal reviews and stay abreast of changes to ensure that their policies and practices remain aligned with the prevailing legal landscape. By investing in thorough legal reviews and fostering a culture of compliance, hotel properties not only protect themselves from legal liabilities but also demonstrate a commitment to ethical business practices.
