The Tough Negotiation Surrounding Guarantees In Off-Plan Hotel Lease Agreements

Off-plan hotel leases are often complex and lengthy contracts to negotiate. The parties involved generally engage in several rounds of negotiations, and both the owner and tenant must bitterly debate the guarantees imposed by the former, whose financial stakes are high.

During these discussions, the parties commonly debate three types of key guarantees in favour of the owner, enabling them to cover their financial risk during the different off-plan hotel lease drafting and execution phases.

The negotiation of traditional guarantees related to the execution of the lease

The free setting of the security deposit in off-plan hotel leases

Reminder: The security deposit is freely set by the parties for leases subject to commercial lease status. In the case of off-plan hotel leases, the security deposit (when it exists) is generally set at one quarter’s rent. When the off-plan rent is tiered, similar increments tend to be applied to the security deposit.

Usual practice: When the security deposit exceeds six month’s rent, it is often replaced by an FDG (“first demand guarantee”), and the two are then merged.

The tough negotiation on when the security deposit should be released: Owners seek to be in possession of the security deposit on the day the off-plan lease is signed, i.e. even before the construction or renovation works have started. However, given the very nature of the security deposit (intended to cover a potential rent default during the lease), it is in the tenant’s interest to argue that the payment of the security deposit before the lease takes effect is neither economically nor legally justified.

The widespread use by owners of the deposit or FDG to cover the operating period

Owners strive to cover their financial risk as much as possible should the tenant default on rent, given the limited visibility they have with regard to the creation of hotel funds. Indeed, the owner has no real assurance that the tenant will meet forecast profit and loss targets (which are not contractual under off-plan lease agreements) and pay the rent on time.

Usual practice: If a security deposit already exists, it is in the tenant’s interest to negotiate the reduction of this bank guarantee at the end of a three or four-year period.

Note: The owner may request that a tenant’s parent company act as guarantor for the execution of the lease. This is advantageous for the tenant in that it is less expensive than a bank guarantee.

The tough negotiation on when the FDG should be released: Logically, the FDG should be handed over on the effective date of the lease and not before, since it is not intended for covering the hotel construction or renovation works phase. Indeed, releasing the FDG early would have a serious negative impact on the tenant’s cash flows.

**The stakes surrounding the guarantee to enter into the lease agreement* specific to off-plan hotel leases**

In short, this guarantee serves as compensation to offset the owner’s risk in the event the tenant decides to relinquish the lease and hotel operation, but the hotel constructed by the owner has been delivered in accordance with the terms of the off-plan lease, at significant expense and financed through equity or a property finance lease.

Evaluating this compensation is tricky for the owner as it has to cover a) the cost of financing the construction, b) any works undertaken to modify the layout and the premises should the tenant unexpectedly change, c) the time needed to find a new tenant, and d) the broker’s fees (bearing in mind the owner has already paid a broker for introducing the defaulting initial tenant, whose fees are due on the date of signature of the off-plan lease).

Note: this lump-sum indemnity is legally considered as a penalty clause, governed by Article 1231-5 of the French Civil Code which stipulates, in particular, that the courts may reduce it, if they consider it noticeably excessive.

Usual practice: Owners can request a lump sum equivalent to up to 18 months’ rent as an indemnity, without having to justify the amount.

If in reality this 18 month rent indemnity turns out to be excessive, in the opinion of the tenant, they may obtain from the courts a legal ruling obliging the owner to reduce the amount. To counter this, owners thus tend to request, in addition to the penalty clause, a guarantee to enter into the lease agreement which takes the form of an FDG-type bank guarantee.

Since payment of the guarantee to enter into the lease agreement is made through a bank guarantee, without the need for the courts to get involved, any debate surrounding the excessive amount of this indemnity can be considered superfluous. Tenants who still wish to avail themselves of this would therefore have to initiate proceedings which, understandably, does not swing the balance of power in their favour.

The tough negotiation on when the guarantee to enter into the lease agreement should be released: Future tenants may consider the position of owners who seek to impose the handing over of the entire guarantee to enter into the lease agreement FDG as soon as the off-plan lease is signed as unjustified. Indeed, the tenant would in this case have to bear significant bank and financial expenses (which could be better put towards the operation of the hotel or used as working capital). Further, the risk of the hotel real estate project not being carried out is often remote, and the risk of it not being completed is out of the tenant’s hands at this stage.

Off-plan lease agreements are often subject to several condition precedents (purged building permit, etc.) which must be completed within a fairly long timeframe, ranging from 10 to 25 months, for instance. As long as at least one of these conditions is not met, the tenant has no certainty that the hotel project will actually be completed and delivered on time.

At this early stage of the lease, owners are often uncomfortable justifying a bank guarantee to cover the risk of the non-payment of rent during the term of the lease. To cover the owner’s risk in the form of a guarantee to enter into the lease agreement, it would thus appear reasonable to provide under the off-plan lease the payment of this guarantee in two or three installments, the first to be released at the earliest on the day the first condition precedent is fulfilled.

Note that the guarantee to enter into the lease agreement should not be extended over the duration of the lease, once the tenant has taken possession of the premises.

Yet is the practice of guarantee to enter into the lease agreement widespread? The guarantee to enter into the lease agreement is in fact far from given in off-plan hotel leases. According to our statistics, this specific guarantee is only included in around a third of contracts, with amounts ranging from 12 to 18 months.

The method of off-plan lease guarantee negotiations that should be favoured: Negotiating guarantees should be done pragmatically, in order to reconcile the contradictory business and financial interests of the parties involved. Negotiations should begin at the Letter of Intent stage, alongside the other key points that will condition the success of the hotel project within the off-plan lease framework.

The negotiation of guarantees in off-plan hotel leases, although highly specific, also depends on the discussions surrounding all the other financial aspects of these agreements – the cost of financing FF&E and OS&E, the taking in charge of pre-opening costs, works, upgrading and expenses, or the introduction of a tiered rent structure, to name just a few.

* BEFA: a lease in a future state of completion
* The so called « bonne venue » guarantee

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Written by Christopher Boinet Partner

Anne Epinat, avocat en droit des affaires et hospitality à Paris

Written by Anne Epinat Partner

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