Investing decision: How to on buying hotels
Major events such as Expo 2020 Dubai and the 2022 FIFA World Cup in Qatar are helping to fuel the continued growth of the Middle East hotel sector. During this exciting period of expansion in the region, there is likely to be an increasing amount of hotel acquisitions.
Whether you are expanding your portfolio or entering the hotel industry for the first time, purchasing a hotel can be a complex and time consuming process. We set out 10 key issues to take into account when buying a hotel:
1. Determine your acquisition criteria
There can be many different reasons for acquiring a hotel. For some buyers, it may be a short-term investment with a view to selling quickly at a higher price. Others may take a more long term view, based on, for example, the potential of the hotel to generate significant cash returns. Ultimately, the criteria will be unique to each buyer but typical factors include:
(a) purchase price and commitments for capital expenditure and working capital immediately and in the medium and long term;
(b) will owner operate the hotel, enter into a franchise agreement, or have the brand manage the hotel;
(c) potential appreciation in asset value;
(d) upside potential from re-branding taking into consideration the cost of any associated property improvement plan (PIP) required by the incoming operator etc;
(e) financial performance including current and potential cash flow yield, revenue per available room (RevPAR), occupancy rates etc;
(f) a hotel as a “trophy asset”;
(g) whether the hotel is sharia-compliant, which includes not only that it is alcohol free but includes other considerations;
(h) location — strategically, a buyer may want an asset in a certain city or part of a city and assessing the competitive set of the hotel and likely future development in the area surrounding the hotel;
(i) if adding to existing portfolio, whether the target hotel is a “good fit”, results in economies of scale, or gives the portfolio geographic scope that it previously did not have; and,
(j) anticipated “hold” period (which will be tied to the strategy).
There is no right or wrong answer but ultimately a buyer needs to be clear on what its reasons are for wishing to purchase a hotel before entering the acquisition process.
2. Identify the right target
Once you have settled on your acquisition criteria, the next step is to contact the right people in the industry to see what opportunities are out there — this may be brokers, asset managers, industry consultants , or even the brands themselves. For those assets that are potentially in line with your acquisition criteria, a site visit should be arranged. Following that, a property and marketing analysis (feasibility study) should be undertaken and then, based on that analysis, you should be in a position to start developing a business plan and bid price.
3. Manage the bid process
It is not uncommon for hotels to be sold by way of an auction process. These processes vary but typically as a buyer you will need to first submit an indicative offer and, if that is successful, a final bid will be required which often needs to be accompanied by a mark-up of the draft sale and purchase agreement (SPA). Offering the highest price is not always a guarantee of success — other factors such as evidence of funds, ability to complete quickly and acceptance of key SPA terms can also be strong influences on a seller’s decision. This process tends to be resource intensive with tight deadlines, and as such it needs to be managed carefully.
4. Determine the right price
As with any acquisition, one of the most important factors when buying a hotel is the price you pay. There are various different hotel valuation methodologies — for example, discounted cash flow analysis, EBITDA multiples, comparable hotel sales, surveyor valuations etc — and you should discuss which one is appropriate with your financial adviser. Bear in mind that in an auction process, where you may be one of many bidders, price will be a key factor.
5. Determine the right structure
As a buyer you will have two main options. One is to buy the shares of the company that owns the hotel property and other assets which make up the business; the other is to buy from the company the hotel property and other assets. If shares in a company are purchased, all its assets, liabilities and obligations are acquired (even those a buyer may not know about).
On an asset deal, only the assets and liabilities which the buyer agrees to acquire and assume, which will be identified in the sale agreement, are transferred. Generally, asset purchases tend to be logistically more complex than share purchases due to the need to transfer each of the separate assets which form the business and to obtain approvals of third parties (counterparties to contracts, licencing authorities etc), although change in control issues also arise in share purchases. In Dubai, there are other structural issues which arise as a result of foreign ownership restrictions and local authorities’ requirements in terms of which types of entities can own property and hold a hotel licence. Off shore entities will also need to consider potential tax implications based on their specific circumstances. Your lawyers will be able to advise you on all structuring matters.
6. Ensure that your financing is in place
You will need to consider at the outset of the transaction how you are going to fund the purchase and, potentially, an initial capital expenditure programme. Will this be from existing cash resources, other investors or bank debt?
If bank debt is going to be required, you should speak to potential lenders at an early stage to find out how much they are willing to lend and what specific requirements they may have in terms of security over the hotel and/or the bank accounts. This will enable you to determine whether the deal is feasible and, if it is not, you can stop work and avoid incurring unnecessary costs. If there is an existing hotel management agreement in place, the operator may have already imposed certain loan to value criteria which would need to be complied with as well as the requirement to obtain a non-disturbance agreement.
7. Carry out proper due diligence
On any hotel deal, due diligence is of critical importance. You will need to appoint a good, experienced team of advisers which will typically include lawyers, financial advisers and property surveyors. Each adviser should conduct a thorough investigation of the part of the business that corresponds to its area of expertise. High quality due diligence should uncover material issues which can then be dealt with up front — for example, by way of contractual protections or deductions to the price (or, in extreme cases, by pulling out of the deal altogether). Bear in mind that you are acquiring more than a real estate asset. A hotel is an operating business so the due diligence process needs to be conducted accordingly.
8. Assess your management options
In most cases it is likely that a third party management company is managing the hotel already. If so, their consent will be required for completion of the deal (which includes approval of the buyer by the management company). Therefore, it is important that you discuss this with the seller with a view to agreeing how best to approach the management company and at what stage in the process to do this. Although you will not want to contact the management company at the outset, you will not want to wait until just before completion either. Most hotel management agreements are for a long duration (often up to 20+ years for luxury brands) and you will need to check if there is any ability to terminate the agreement. If there is a provision for termination upon sale it normally comes with a fairly high termination payment. If there is no incumbent management company or it is run by the current owner, you will need to consider your management options. You should engage with a third party management company at an early stage as they will need to assess the hotel for compliance with their brand standards and assess if a PIP is required. You should appoint a hotel specialist lawyer to assist you negotiate the terms of the hotel management agreement. Franchising is another option pursuant to which the owner obtains the right to use the brand and operate within the brand system (i.e. reservations systems, loyalty programmes, etc), but operates the hotel itself or with an unbranded operator.
9. Negotiate the right price adjustment mechanism in the SPA
One of the key negotiation points in the SPA will be the pricing mechanism. The two most common structures are: (1) a valuation based on the target company’s accounts at completion and adjusted through a completion accounts process (Completion Accounts); and (2) a target valuation based on historic reference accounts, which is fixed as at a historic reference date and where all subsequent economic upside (and downside) in the business since that date is for the account of the buyer (Locked Box). In broad terms, a Completion Accounts mechanism is typically the preferred choice for buyers as it means they only pay for the balance sheet that they actually acquire and they are able to check and verify the financial position when they are in full control of the business. On the other hand, Locked Boxes have traditionally been the mechanism of choice for sellers as they result in certainty of proceeds and no post-completion adjustments nor any of the associated costs. In an auction process it is common for sellers to insist on a Locked Box mechanism and there is unlikely to be any scope to negotiate on this — in such a case you will need to make sure that you carry out sufficient due diligence on the historic reference accounts.
10. Negotiate a robust set of warranties and indemnities in the SPA
Warranties serve two purposes. Firstly, they complement the due diligence exercise by confirming that the information that has been given to the buyer is accurate and by ensuring that the seller discloses any known issues to the buyer prior to signing the SPA. Secondly, warranties apportion risk; in essence, the buyer can sue the sellers for damages for breach of contract if the warranties prove to be untrue or inaccurate and, as a result, the value of the acquired business is reduced. As a buyer you will want warranties on all of the key aspects of the target business — good title to the hotel land, accuracy of accounts, absence of litigation etc. Any known material risks — for example, a court case which is likely to result in the target company having to pay damages after completion — should be dealt with by way of indemnities (which provide dollar for dollar compensation in respect of the specific losses suffered).