More than ever, off-plan hotel leases[1] are making headlines in the leisure real estate industry. Stemming from real estate law professional practices, off-plan hotel leases reconcile the legal and financial interests of three distinct actors: the developer (seller), the investor (owner) and the operator (tenant).

In a nutshell, it is the owner who is at the hub of an off-plan lease agreement. The owner holds the land/ premises or negotiates an off-plan sale, and deals with the developer constructing the hotel or carrying out renovation work on its behalf. At the same time, the owner rents the premises under an off-plan lease to its tenant who will start creating the hotel business once the work has been completed.

Off-plan leases are usually divided into two sections; the first covering the construction or renovation phase, and the second, the general and specific conditions of the agreement concluded with the hotel operator.

The use of civil leases. Off-plan leases are generally commercial leases, although nothing prevents the conclusion of an off-plan lease agreement governed by the French Civil Code. This is the case, especially, when owners hold limited rights only over the building to be leased (for example, under an emphyteutic lease which prohibits commercial subletting).

In the hospitality sector, owners should pay special attention to five key points in these complex and risky lease contracts that tie them to tenants over the long term.

The importance of formalising the owner-tenant relationship from the beginning of the transaction

In general, it is the hotel owner who is at the origin of the term sheet/ Letter of Intent (LOI) and who then presents the draft off-plan lease document to the tenant. The term sheet is prepared early on in the transaction and sets out the key points that must be agreed between the parties in the draft lease document and its appendices (in particular: plans, forecast accounts, the FF&E budget, guarantees, technical assistance, etc.). From this first stage onwards, the parties should try to be as clear-cut as possible with regard to a) the hotel project itself (e.g. number of rooms, category, F&B facilities, other amenities, etc.), b) the material, technical and financial investments required, and c) the expectations and contributions (financial, in particular) of each party involved in the project. Given the high financial stakes, owners must also ensure that the building permit is filed free of all claims.

It is also in the interest of the parties to include in the term sheet a timetable for negotiating and/ or concluding, in parallel, a technical assistance agreement allowing the tenant (and, if applicable, its hotel franchisor with its own technical specifications) to oversee the construction and fitting-out of the hotel.

The crucial issues to be negotiated – adjusted rent calculation, charges, capex and guarantee amounts

The issue of rent negotiation. Off-plan lease agreements must include a clause covering the rental amount. Indeed, one of the main concerns for a hotel tenant is being able to adapt its finances to the anticipated rental amount and associated charges, and in this respect the owner and tenant will jointly agree on the level of rent (straight-line or not, fixed and/ or variable, to be negotiated). In practice, the two parties will compare the tenant’s operating forecasts with those produced by the owner’s advisors, ensuring a reasonable rent to hotel income ratio is respected.

Rent to income criteria:

should this ratio be overlooked when the rent is set, the owner may well find itself faced with a defaulting tenant. The tenant will no longer be able to pay the contractually fixed rent, on the basis of which the owner has determined its own financial obligations (bank loan or property finance lease) and potential profitability.

Negotiations also focus on capex and how the cost of the renovation work, various expenses and any hotel upgrading [1] should be split between the parties. Consequently, the rental amount is not only determined on the basis of factors such as index-based evolutions (e.g. commercial rent index) and building depreciation rates, but also on the nature of the various points of sale (Rooms, F&B, Spa) and the proportion of rent applicable to each in accordance with forecast margins.

It is also prudent for the owner to specify at the term sheet stage that the rent will be reduced from the date on which the lease is signed to the date on which the lease takes effect, since the period between the two may exceed two or three years, when allowing for the completion of construction or renovation work.

Lastly, the owner may be required to grant a temporary reduction in the contractual rent over the first two or three years of the lease (in the form of a grace period) to help the hotel operator build up the hotel business.

In the case of a major refurb of a hotel that has already been successfully operating for a while, the rent may be set purely on a variable basis, especially if the tenant is operating under an international franchise. However, the variable rent calculation method is not especially compatible with owners’ financial obligations with regard to the fixed depreciation of their investments. The current practice is to insist on a Minimum Guaranteed Rent (MGR) aimed at securing the profitability of the investment, coupled with a variable rent component indexed to revenues.

The tough negotiation surrounding guarantees in off-plan hotel lease agreements. The owner will require the tenant to provide guarantees concerning the regular payment of rent. Here, we refer to our article « The tough negotiation surrounding guarantees in off-plan hotel lease agreements ».[2] In short, to guarantee the proper execution of the lease, the owner will request that the tenant provide a security deposit – often covering six months’ rent or more – as well as a bank guarantee or a significant « first demand guarantee » to cover any default in the payment of rent and charges. These are standard guarantees in lease contracts.

It is not uncommon for the parties to agree on a gradual decrease of guarantees during the term of the lease, even though the risk of default by the hotel tenant is generally greater in the first years of operation, since the tenant is building up its business with no real assurance as to the hotel’s success.

This round of negotiations also focuses on when the guarantees will be issued: the owner will seek their issuance on the date the lease agreement is signed, while the tenant’s obligations covered by these guarantees will only take effect once the construction or renovation work has been completed and the hotel premises delivered. As specified in the article « The tough negotiation surrounding guarantees in off-plan hotel lease agreements », the so-called « good arrival » guarantee aims to cover the risk to the owner of a breach of contract by the future operator prior to the lease taking effect. Yet it is when the lease is signed and it is certain that the tenant will take over the hotel’s operations that the owner incurs significant construction or renovation costs. The owner will thus be paid a « good arrival » guarantee if the tenant does not follow through with the lease once the construction or renovation work has been completed.

The amount to be paid under this guarantee is all the more justified since it reflects the actual loss suffered by the owner, primarily due to having to find a new tenant, to not receiving any rent during this period and to having to carry out any readjustments and refurbishments requested by the new tenant.

Owners are often seen to take a principled stance on requested guarantees, but pragmatic negotiations should prevail. As the subject is delicate, owners often postpone any discussion on this matter until the end of the negotiation process.

The financial and practical issues concerning clauses covering FF&E and its financing

FF&E refers to a hotel’s furniture, fixtures and equipment, or the portable elements independent of the property itself that can be removed without damage. FF&E represents a significant expense in fitting out a hotel and is normally the responsibility of the tenant (to whom the hotel business belongs), whose job it is to furnish and equip the property. However, FF&E costs can be negotiated between the owner and tenant.

The organisation and installation of FF&E by the tenant on completion of the construction or renovation work can be tricky, since the building has been finished but the lease cannot take effect until the premises have been fitted out and furnished. [3] Often, any finishing works falling under the responsibility of the owner (constructor) can only be carried out once the FF&E have been installed. Consequently, it is in the interest of both parties to specifically plan how the installation of FF&E will fit into the overall construction or renovation work. This necessitates the complex legal definition of the alternative or cumulative responsibilities of the various service providers that are working on the building site.

To simplify this phase, some hotel owners prefer to take FF&E in hand from the outset, in consultation with the tenant. In this way, they are able to incorporate the installation of FF&E into the services that they have to provide, in order for the hotel lease to take effect as soon as the premises are completed. Of course, any services provided by the owner instead of and/ or for the tenant may be later reimbursed by the tenant, or incorporated into the rental amount. In any case, the owner will ensure that the lease contract clearly states that the renewal and maintenance of FF&E fall exclusively under the tenant’s responsibility.

The off-plan hotel lease contract is a long-term business arrangement that is based on a number of stages, including the execution, completion and acceptance of the construction or renovation work, as well as the delivery of the hotel premises and its authorisation to open to the public. The owner should thus provide in the appendix to the lease contract a schedule specifying each of these stages. It may also be worth attaching plans and providing for late penalties, so that each party involved in the transaction is kept accountable. That said, the future landlord (owner) should not be too unyielding when it comes to constructing the hotel. Updates should be incorporated into the schedule, as should the opportunity to apply for any amended building permits in consultation with the tenant (and/ or its franchisor).

Owners calculate depreciation over the term of the lease fixed with tenants. The off-plan lease is concluded on the date the contract is signed or on the date, if applicable, the suspensive condition(s) is/ are fulfilled (e.g. obtaining a building permit free of all claims).

It is difficult to predict with certainty how long the construction or renovation work will take, and consequently, the date on which the lease will take effect. The duration of the work can only be estimated in a lease contract, with (if applicable) clauses covering late penalty payments if the hotel premises are not delivered within the contractual timeframe agreed by the parties. Given this, when reference is made to the « term » of the lease, this means, in fact, the duration of the lease that kicks off upon completion of the construction or renovation work.

Pursuant to Article L.145-4 of the French Commercial Code, the term of a commercial lease may not be less than nine years, and parties may also freely agree to a term that exceeds nine years. Since a hotel is considered a single-purpose building, the exceptions provided for by the Pinel Law in this respect are applicable, i.e. it is possible to sign a fixed-term lease, with no option for the tenant to terminate the contract at the end of each three-year period. Conversely, no legislative text governs the term of a civil lease. If a commercial or civil lease is granted for a term of more than 12 years, the lease must be registered with the French Land Registry. [4]

The most sensitive negotiations surrounding the term of the lease are those focusing on when the lease should start. Owners consider it should take effect as soon as the construction or renovation work is finished and the regulatory building handover procedures are completed. However, a hotel is not like other commercial businesses. As a public access building [5] of a specific type, a hotel cannot begin operating until the tenant has obtained the necessary authorisation to open from the authorities. This authorisation is issued on the advice of the Safety Commission, who will visit the property when the work has been completed to ensure compliance with all legal and administrative requirements, especially with regard to fire safety and disabled access.

Since the owner is required to deliver premises to the tenant that comply with the use for which they are intended, the tenant will seek to postpone the date the lease takes effect until official permission to open is granted, as this alone establishes whether the building can be used for a hotel operation. However, the Safety Commission may refuse to deliver this authorisation, either because the work carried out under the responsibility of the owner fails to comply with regulatory standards, or because the building fit-out work carried out by the tenant is unsatisfactory. In addition, the hotel operator is the only party that has the right to apply for authorisation to open the building to the public, and it can only do so if it is already leasing the premises.

With regard to the lease start date, the parties should therefore seek to reconcile their conflicting interests:

• The owner – who has completed the work under its responsibility – wants the lease to take effect immediately, in order to receive rent as quickly as possible.
• The tenant – who does not want to be subject to the obligations of the lease – seeks to postpone the lease start date until such time it can begin operating (when official permission to open has been granted).

These discussions are often time-consuming, and the lease start date is one of the toughest points to negotiate between owners, tenants and their advisors. The obligations and responsibilities of each party with regard to this particularly sensitive issue must be carefully discussed and set out when drafting the off-plan lease agreement.

This article does not aim to provide an exhaustive discussion on the subject of off-plan hotel leases, as these agreements may differ greatly, depending on the context, the legal and financial arrangements being considered (property finance lease, lease-management agreement, management contract, etc.) and the type or category of hotel.

Lastly, it is important not to lose sight of other contractual issues that may appear less important, but are nonetheless challenging to negotiate. These issues – which may be specific to hotels, related to technical issues (e.g. guestroom surface area tolerance) or generally applicable to commercial leases (e.g. allocation of expenses and works, regulatory compliance) – can have significant repercussions, given the long term nature of the majority of lease agreements.

• [1] BEFA: Bail en l’état futur d’achèvement – Lease in a future state of completion.
• [2] See our article on leases and the Pinel Law in the 2017 edition of Hospitality Trends (pages 52 to 57).
• [3] Article can be consulted at: fr.linkedin.com/company/in-extenso-avocats.
• [4] In any case, for the off-plan lease to take effect, official authorisation for the building to open to the public has to be given.
• [5] Services de la Publicité Foncière.
• [6] ERP : Etablissement Recevant du Public.

Cet article est également paru sur Hospitalitynet.