Cash Management in Hotel Financing

The financing of hotels and resorts requires balancing the borrower’s need for flexibility to successfully operate the hotel against the lender’s desire to prevent cash leakage should conditions related to the borrower’s payment of debt service and compliance with the loan documents deteriorate. No one size fits all circumstances, and different lenders will pick different points on the spectrum of control based on factors such as the identity of the owner and operator, the type of hotel (i.e., how much seasonality could impact performance), and the performance history of the hotel.

In the typical hotel operating structure, all hotel revenue is directly deposited daily into a hotel operating account, which is controlled by the hotel operator or jointly by the owner and operator. Various operating expenses are paid from this hotel operating account, with the balance transferred by the hotel operator to the owner’s account on a monthly basis. The hotel operator may or may not be permitted to deduct management fees and working capital reserves before the monthly remittance to the owner. The question is at which point in this cash-flow stream should the lender exercise control without unnecessarily restraining the operations of the hotel.

In the most borrower-favorable structure, the lender allows the operator to pay all operating expenses from the hotel operating account and takes only a pledge over the account into which monthly owner remittances are made. This structure allows for flexibility on the ownership side to pay all expenses without lender control or discretion, but for the lender means higher risk of cash leakage should performance issues arise. This structure is likely to be seen in cases where the owner and operator have the strongest of track records or a relationship with the lender or, more often, where the hotel is operated by a brand manager like Hilton, Hyatt, IHG, or Marriott, and such brand operators require such control as a condition to management.

More often, the lender will require all hotel revenue to be directly deposited into a single clearing account over which the lender has a pledge through a control agreement. As long as the hotel is meeting its financial covenants, cash in the clearing account will be swept periodically (often daily or weekly) to an unpledged operating account from which hotel operating expenses can be paid without further oversight from the lender.

If the hotel fails certain financial covenants, however, cash will be swept to a lender-controlled cash management account from which payments (usually monthly) will be made in accordance with a negotiated waterfall. Here, unlike with non-operating assets, the lender may agree, so long as the loan is not in default, to allow essential operating expenses such as taxes, insurance, employee expenses, and third-party franchise and management fees to be paid before debt service, as the continued operation of the hotel is critical to maintaining the value of the collateral. The remaining cash is typically held by the lender as additional collateral for the loan while a loan is in a “cash management” period, but the lender may agree to allow the owner to draw on excess cash for operating shortfalls. This arrangement is commonly known as a “cash trap.” In the event the loan goes into default, the waterfall is typically superseded and the lender can utilize all cash as it sees fit, including by applying such amounts towards the debt and lender’s fees.

In the strictest cash control structure, the lender may require that all hotel revenue be swept into a lender-controlled cash management account even while the hotel is performing.

Where the lender’s cash control is rigid, the owner and operator should consider providing for a robust working capital reserve in the budget to provide a sufficient buffer to guard against fluctuations in cash needs.

Given the need for frequent capital outlays required by hotel assets, the lender will also often require a capital reserve to be funded for fixtures, furniture, and equipment, with the required reserve amount increasing over time. The owner should ensure that any management agreement or franchise agreement, which may also require a capital reserve, allows for lender control over such reserves.

Finally, given the cyclical nature of many hotels, the lender may require a seasonality reserve or debt service reserve to ensure sufficient cash flow to pay necessary operating expenses and debt service during low-revenue months.

Given the wide range of approaches to cash management in the hotel context, the scope of cash management should be negotiated by hotel owners and lenders at the term-sheet stage of any financing. In all instances, the negotiation of a deposit account control agreement (which grants the “control” of the account to the lender for UCC perfection purposes) and a cash management agreement (which governs payments via the negotiated waterfall) should be started as early as possible in the loan process. As these accounts are typically held by third-party financial institutions, their incentives to move quickly diverge from those of the underlying lender, and their willingness to negotiate changes to their forms to account for unique aspects of a hotel’s operating structure has markedly diminished in recent years.