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Due Diligence in the Purchase and Sale of a Hotel Property

By Eric Dean, Attorney at Law with the Wolf Firm (P: 949-480-1672 | E: eric.dean@wolffirm.com) and Jenny Redlin, REPA, Principal of Partner Engineering & Science, Inc., (P: 310-765-7243 | E: jenny@partneresi.com)

In the transaction for the sale or purchase of a hotel, both the seller and buyer will usually have divergent due diligence concerns.  The buyer typically wants full disclosure and broad representations and warranties from the seller while the seller wants to limit its risks, convey the property “as is” and make only limited representations or warranties that expire at or a short time after closing.  The overall aim for both parties is to best manage risk while maximizing profits. As such, their respective priorities will in many respects differ in various respects related to the transaction. This article will summarize key due diligence concerns from both a seller and buyer prospective.

SELLER CONCERNS:
The seller typically has two major concerns in a sale transaction. First, the seller does not want to tie up its property and miss other potential sale opportunities with a buyer who does not have a likelihood of timely closing escrow. The Seller also is focused on avoiding liability risks after closing. Key questions that are of concern to a seller can be summarized as follows:

  1. Who Is The Buyer?  Often a seller becomes so focused on the terms of the potential sale without equal focus on the buyer’s representation, financial position, savvy and track record.  Unfortunately, a seller who contracts without due diligence as the potential buyer can become embroiled in protracted litigation and disputes, costly litigation and the seller’s property tied up by a specific performance claim for an extended period of time. To minimize this risk, conducting a reasonable level of due diligence through search engines, public record searches and perhaps conducting a search through a professional company can be done quickly and a limited cost.  Considering the risk factor, conducting such an analysis may be prudent unless the seller is very familiar with the potential buyer. In fact, the seller can include reference to such an analysis in the Letter of Intent and require the buyer to provide documentation and information to the seller to use in such an analysis before proceeding to contract.
  1. Is The Buyer Financially Sound? A risk often exists that the buyer’s sole purpose in contracting is to tie up the hotel property and convince the seller to take it off the market while the buyer searches for potential investors or financial resources.  The potential buyer may have no immediate source of required funds and simply intend to shop the transaction to potential investors, lenders or assignees.  The seller may require receive of various documents before contracting such as (a) a commitment letter provided by the buyer as a source of loan funds to be reviewed and verified by the seller (b) require the buyer provide proof of funds on deposit and set aside for the purchase of the property at closing and provide for the escrowing of such funds (c) mandate that the earnest money deposit be a sufficient amount and deposited and on terms favorable to the seller and (d) if possible, that the buyer provide a financial statement with backup documents before the seller contracts with the buyer.
  1. Does An “As Is” Clause Provide Sufficient Protection? While it is certainly wise for a seller to include an “As Is” provision in the purchase agreement that provision will not generally protect the seller against a concealment of material facts or a negligent or intentional misrepresentation. In fact, the seller’s failure to disclose known conditions in the face of known defects, legal non-compliance or potential impediments to the buyer’s intended use of or anticipated income from the property may create a material risk of  seller liability which will not necessarily be limited contractual provisions limiting the seller’s potential liability.  Such bad acts by the seller may also result in the rescission of the contract by the buyer. This risk may exist even if the buyer was negligent in its failure to discover such concerns. Moreover, the “As Is” provision may be argued by a cleaver lawyer to constitute evidence that the seller intended to hide material information and mislead the buyer thereby increasing the risk of a larger damage award against the seller.
  1. Fund Distribution At Closing; Prepayment Penalties. The seller needs to be careful that the escrow documents and closing statement are consistent with the terms of the seller’s operating agreement or the terms of the loan. As to the operating agreement, this agreement is typically entered into years before the sale escrow closes. A failure to review the operating agreement in detail can result in a distribution of net sale proceeds inconsistent with the operating agreement thereby resulting in adverse claims or litigation. Similarly, the loan documents or service contracts may include prepayment provisions or termination fees not recognized by the seller at the time of contracting with the buyer.
  1. FF&E Concerns.  From the seller’s prospective, there needs to be a defined inventory of items to be conveyed, that references the condition of such items and an “AS IS WITHOUT REPRESENATION OR WARRANTY EXPRESS OR IMPLIED” provision in both the contract and bill of sale.
  1. Form of Conveyance. A Grant Deed by definition includes unstated but implied representations and warranties.  The Seller would prefer a Quit Claim Deed, which by definition includes no representation or warranty. A negotiated Special Warranty Deed (which defines expressly what representations are being made by the seller to the buyer as to the title conveyed) may be negotiated.
  1. Labor/Employment Considerations. Possible labor issues for a seller of a hotel may include unions (if there is a union in place), contracts with individual employees that are for a specified term, tax abatement or development agreements with governmental agencies that require that certain levels and classes of employees be maintained for a set number of years, term notice requirements under local or federal law. Often the Purchase and Sale Agreement will be entered into stating a closing date without considerations of the labor consequences in doing so. These concerns will be further elaborated on in a follow-up article to this article. These potential concerns must be evaluated by the seller before contracting.
  1. Franchise Agreements. Franchise Agreements typically require payment of a stiff penalty for an early termination and both greatly restrict and impose costly requirements as to a possible assumptions. These concerns must be concretely considered, negotiated and documented in the Purchase and Sale Agreement as well as reserved by the Buyer in the due diligence provisions of the Agreement. Often the Purchase and Sale Agreement does not even address these concerns. Not considering these concerns in drafting the Purchase and Sale Agreement can materially complicate or derail the transaction in its entirety or result in substantial costs not anticipated by the seller.
  1. Seller’s Disposition. Although less common, performing physical due diligence to prepare for the sale of an asset has great advantages to the Seller too. Many sellers choose not to perform due diligence at this stage because they don’t see the value, or because they think it could uncover issues that will drop the price of the asset.  However, there many proactive approaches to address red flags uncovered that will create an advantage for the seller and help increase certainty of closure.

Finding out and disclosing as much information about an asset to potential buyers up front will help prevent missed deals due to issues discovered by buyers at the 11thhour.  It will also arm the seller against potential buyers’ demands to reduce the sale price to cover the cost of issues uncovered during the buyer’s due diligence process. It can pay to disclose the issue early on to all interested buyers, who will be more likely to consider the issue in a competitive context.

  1. Other Concerns. The seller needs to review service contracts, management contracts, leases, loan documents, advance contracts with invitees, receivable collection, franchise agreements, tax abatement agreement etc. to determine whether such contracts include cancellation provisions or are assignable (if the buyer will assume same) must be done before contracting with a potential buyer. The seller must also carefully review its legal and contractual ability to terminate employees and, if so, what notices are required before doing so.

THE BUYER’S CONCERNS:
The buyer’s due diligence concerns when entering into a sales contract for the purchase of a hotel in some respects parallel those of the seller but in many instances are far broader, because the impact of liability risk and capital costs intensifies once a property is on a buyer’s books.

  1. Timing.  Generally, the buyer wants as broad a due diligence period as possible, or the option to extend the due diligence period for a set period of time either without or with a payment to the seller or an additional deposit in escrow. It is possible that the buyer does not fully understand all due diligence issues until after the sales contract has been executed and the buyer has reviewed a title report or explored other concerns as to the hotel property. This could include: existing or potential governmental requirements or restriction, potential structural issues on the property, lender requirements as a condition of funding, general concerns in the area where the property is located such as the possible closing of a military base or significant private business concern in the area or planned construction of competing hotels in the area. The buyer needs the flexibility and sufficient time to investigate these concerns as they may arise. The buyer may also wish the due diligence period to be stated in business days not calendar days.
  1. Existing Contracts. The buyer is often not provided with existing contracts until after the due diligence period has commenced. These might include such things as service contracts, leases, loan documents, and advance reservations with invitees, franchise agreements, tax abatement agreements, management agreements, employment contracts, warranty agreements etc. The buyer needs to review these contracts in detail to determine (a) which of the contracts are assumable or may be terminated (b) if assumption of a contract is contemplated, the credibility and performance of the service provider (c) which contracts include favorable terms and (d) if the buyer desires to assume any of the existing contracts what requirements must be met to effectuate the assumption, what costs are involved in the assumption process and how long it will take to complete the assumption.
  1. Buyer Employment Concerns. The buyer does not want to inherit the seller’s mistakes as to labor concerns. The buyer therefore needs to include specific representations and warranties in its agreement with the seller as to employment/labor concerns that survive closing and also provide for specific due diligence analysis as to such concerns in the agreement.
  1. Environmental Concerns.  Environmental due diligence is performed to address three critical categories of risk relating to the purchase of an asset:  regulatory risk, liability risk and market risk.  An environmental site assessment is an important step in determining these risks, and the scope of the assessment should match the complexity of the site and the risk tolerance of the buyer.  In determining the feasibility and profitability of a transaction, the presence of environmental concerns should be determined, along with an assessment of regulatory and innocent landowner requirements and the availability of cleanup funds.   If environmental issues are encountered during the due diligence stage, such as vapor intrusion or mold, asbestos or other industrial hygiene concerns, there are a number of approaches to protect the buyer against liabilities and allow for the completion of the deal.  Beside remediation, this may include indemnity, insurance or remedial cost estimates.
  1. Structural Concerns. In order to prevent or quantify significant expenses that would be needed after close to bring a property up to code, a buyer should carefully consider the hotel property’s structural resilience prior to purchase.  To determine collateral loss in case of a major earthquake event and to identify unsafe conditions that could pose a risk to life safety, a buyer is wise to engage a consultant to perform a seismic assessment.  Feasibility of a transaction will be affected by whether the property is subject to an increasing number of local seismic retrofit codes, and whether rebates or incentives are available to implement structural upgrades.  Importantly, the Probable Maximum Loss (PML) report can be a requirement for properties in seismic zones to secure CMBS, SBA and a number of other loans.
  1. SBA Energy Incentives. The Small Business Administration (SBA) 504 lending program encourages for-profit small business owners to “go green” via the installation of renewable energy systems or energy efficiency building hardware. A traditional 504 program borrower is allowed to borrow up to $5 million, either on a single large project or spread across multiple projects. If the borrower goes green by satisfying the SBA’s energy public policy goals the borrower is now free to borrow up to $5.5 million on that specific project regardless of their current loan exposure with the SBA.  Installing renewable energy systems, like solar photovoltaic, or improving a building’s efficiency, through lighting or HVAC upgrades, unlocks virtually unlimited borrowing power with the SBA’s – below market rate – 504 lending program.
  1. Title Concerns. The buyer has the same concerns as to the form of conveyance as addressed above as to the Seller. Often, buyers gloss over exceptions stated in the title commitment, survey concerns, whether the coverage is sufficient under the title policy, whether an ALTA Owner’s Policy or a CLTA Owner’s Policy are sufficient and as to what endorsement to the title policy might be prudent to consider. The buyer needs to review not only the Title Commitment (or Preliminary Title Report) but available surveys (or commission its own survey) and all documents related to any exceptions to coverage.
  1. Lender Requirements and Ground Leases. In the author’s experience, where the transaction involves a ground lease,  negotiations of the ground lease terms by the buyer and seller without the concurrent input of the lender and equity partner both slows the process down and creates significant otherwise unnecessary costs and expense. The input of the lenders(s) and significant equity participants will ultimately result in required provisions of the Ground Lease independent of what the seller and buyer would consider as material. Since the lender(s) and large equity participants are ultimately going to independently negotiate and demand the language and terms they require, it is far more efficient to bring them into the discussion of the ground lease provisions as early as practical.
  1. The Surrounding Area. Noting is status quo in this fast passed and ever changing environment we live in. The buyer needs to consider potential changes in the government and economic environment that could dramatically change the future projections of the project under consideration. These could conclude anything from a plant closing being considered to street widening, competing hotels on the drawing board, consideration of change in local ordinances and the imposition of prevailing wage requirements to future major infrastructure improvements being projected to commence in the immediate area of the project. Feasibility must be included as one of the Due Diligence concerns in the Purchase and Sale Agreements and must be seriously considered.  There are professionals who for a fee will issue feasibility reports as to these types of concerns and it is generally wise to have such a study conducted.
  1. Liquor and Business Licenses. The closing date of the transaction may be set for a time period sooner than a transfer of the liquor license or required business licenses can be obtained.  These considerations need to be addressed in the Purchase and Sale Agreement rather than on the eve of closing. There are multiple solutions to this concern that might be considered and reached by the buyer and seller.  However, in the author’s opinion waiting until the eve of closing is ill advised since the buyer and seller may have different views on what is a fair and practical resolution of the concern.
  1. Franchise Agreements. See discussion above on this topic above as to Seller concerns.
  1. Equity Participants. Outside of the financial terms reached with the equity participant the major issue is control of the project, flexibility in the budget and time line and the rights of the equity participant to veto the desired direction of management or to replace management. Often the buyer’s focus is solely on raising the funds necessary for the project and these other material concerns are ignored until the equity participant exercises its contractual clout and either materially restricts or replaces management.
  1. The Merger Doctrine. In a typical real estate transaction, upon closing, the terms and conditions of the Purchase and Sale Agreement are of no further force or effect. There are typically terms such as representations and warranties, liquidated damage provisions and limitations on liability that the buyer may desire to survive the closing. The seller may have similar concerns as to certain provisions of the Agreement.  As a general rule, these terms can only survive the closing if they are expressly stated to survive the closing.

DISCLAIMER: This article is a general overview and is simply authored to raise awareness of issues and concerns to be considered by a potential buyer or seller before contracting and is not otherwise disseminated for purpose of reliance as to any specific transactions. The authors recommend that buyers and sellers consult with professionals as to specific transactions.

ABOUT THE AUTHORS: Eric Dean,Attorney at Law, is a highly experienced and sophisticated attorney with the Wolf Firm, serving clients throughout the State of California. Mr. Dean represents clients in all aspects of hospitality, secured lending, creditors rights and commercial real estate. He can be reached at 949-480-1672 (direct line) or 949-244-8634 (cell) or at eric.dean@wolffirm.com.

Jenny Redlin, REPA is a Principal of Partner Engineering & Science, Inc., a national environmental, engineering and energy consulting and design firm providing services in support of commercial real estate transactions, management and development projects throughout the United States, in Canada and the United Kingdom. She can be reached at 310-765-7243 or at jenny@partneresi.com

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