10 Due Diligence Concerns to Consider When Purchasing, Investing

The structure of the investment vehicle, including its financial and management terms, as well as immediate and long-term project concerns, must be considered prior to investing in a hotel project to ensure that the investment is prudent and sound. This article summarizes some of the key considerations to be addressed in that analysis.

  1. The Investment Structure: The investment structure is often a complex and critical factor to consider before investing in a hotel project. Considerations such as the soundness of the management team, development and success fees, disbursement waterfalls and the scope of management discretion can all impact the viability of the project from both a developer and investor prospective, independent of the soundness of the project itself.
  1. Existing Contracts and Licenses: In most instances, purchase and sale contracts provide that existing contracts must be terminated unless the buyer of the hotel agrees to assume same. Existing franchise agreements, liquor licenses, service contracts and equipment leases may be advantageous or detrimental to a hotel buyer. There may be substantial costs and time associated with either the assumption or termination of a contract or license right. These issues often are addressed in negotiating the agreement, but certainly remain key concerns in the due diligence process.
  1. Buyer Employment Concerns: Typically, the buyer does not want to inherit the seller’s liability risks or contract commitments as to employees. Legally, there may be statutory notice requirements imposing stiff penalties for early termination of employees. These concerns are usually the subject of a series of provisions in the purchase agreement and are key concerns to be addressed in both the contract negotiations, as well as during due diligence.
  1. Environmental, Water and Utility Concerns: These concerns are of increasing importance in the valuation, operation and income generation of hotel properties as clean air and water limitation concerns continue to grow in prominence. Site assessment during the due diligence period related to these matters are, therefore, becoming increasingly important in the analysis of project feasibility and financing.
  1. Structural & Retrofit Concerns: Seismic risk analysis has become an increasing concern throughout California and has led to retrofit mandates throughout the state, resulting in certain projects being unfinanceable. These concerns can have substantial impact on the availability of franchise brands and, if available, the costs of meeting mandated property improvement plans imposed by those franchise brands.
  1. SBA Energy Incentives: The Small Business Administration (SBA) 504 lending program encourages for-profit business owners to “go green” via the installation of renewable energy systems or energy efficiency building hardware. Installing renewable energy systems virtually unlocks unlimited borrowing potential with the SBA’s—below market rate—504 lending program.
  1. Title Concerns: Buyers often gloss over exceptions stated in a title commitment (or preliminary title report) or fail to read the underlying documents. If not reviewed carefully, these exceptions to the title will result in unanticipated right of way, easement, and access concerns that are material to the project. Understanding the distinction in coverage between a CLTA and an ALTA Owner’s Policy, as well as available endorsements to the title policy, is key to insuring a successful acquisition.
  1. Location Potential: The long-term economic prospects, culture, projected population, and business changes and potential market competition are all factors that can either enhance or destroy the long-term viability of a hotel. Concretely defining these long-term concerns by a feasibility study or otherwise, is a critical consideration to be explored by a buyer in the current environment of where seeming stability is often replaced by rapid and unanticipated shifts.
  1. Franchise vs. Boutique: Whether a franchise brand is attractive or not depends on several factors including location, competition, costs, and operational and property improvement plan requirements. Depending on the circumstance, some operators have determined that while gross income may be lower operating as a boutique, the net income from operating without the costs associated with the brand results in a lower cost factor and a higher net income.
  1. Timing: Sellers generally prefer a shorter due diligence period, and for the buyer’s earnest money deposit to become non-refundable on the earliest possible date. However, often an extension in time is needed to address the complexity of issues that arise during the due diligence process. It is therefore, prudent to build in a provision for an extension of the due diligence period by adding an additional amount to the earnest money deposit or allowing for a partial release of the funds on the deposit. The same analysis applies to a right to extend the closing date if the necessity arises.

About the Author
Eric Dean, Esq., is an honor graduate of UCLA School of Law. His Firm, Straggas Dean, LLP, has five offices in California providing full service to the Commercial Real Estate, Hospitality and Financial Services Industries. Dean is also a member of the Steering Committee of CRENETEX, a Trade Group of Commercial Real Estate and Hospitality Professionals.

Disclaimer:  This article is solely intended to provide information for consideration only. It is not legal advice and is intended solely to raise broad and general possible topics of concern for further consideration, and therefore, should not be relied on. A reader who has concerns related to the topics addressed in this article should consult his/her own advisors and not act based on the content of this article.