In Q3 2024, market participants surveyed by CREFC expressed a positive outlook for the UK real estate market in 2025 with the prevailing expectation of a sustained recovery in investor demand for commercial real estate in the UK.

The UK election was out of the way, interest rate cuts appeared to be on the horizon and, in some sectors at least, commercial property values appeared to be stabilising. The outlook in Q1 2025 is arguably different; interest rate cuts are no longer a near term reality, the UK and certain other European economies are flatlining and the impact of the US election on the UK and global economy remains uncertain.

Nevertheless, real estate investors continue to expect increased revenues and sustained returns[1], capitalising on (albeit fewer) market opportunities. Consequently, we are seeing an increased interest in and focus on the operational real estate sector, namely real estate assets that are operational in nature with income and value linked to the performance of an underlying operator of the asset (for example, hotels, build-to-rent and datacentres) rather than the underlying tenant. Investment in operational assets located in the UK reached an average quarterly investment of £1.5bn in 2024 and we expect that to increase over the foreseeable future[2].  

While 2024 saw the welcome return to the real estate debt market of some of the bank lenders who had previously retrenched from it, we expect 2025 to be another strong year for private credit fund lenders. Lagging asset valuations and the on-going retrenchment of “traditional” bank lenders continues to cause financing challenges resulting in funding gaps which often suit private credit fund lenders who are also willing to support sponsor’s “value-add” business plans. Their relative flexibility, speed of execution, relationship-based approach, customised financing solutions and freedom from regulatory constraints provides private credit fund lenders with a distinctive advantage over bank lenders. The challenges that 2025 is likely bring for real estate investors are likely to suit private credit fund lenders whose footprint in the market we expect to increase relative to bank lenders.

These challenging but stabilising market conditions have driven an increased focus on operational real estate (and, in particular “living” and residential assets) and the continuing demand for private credit to finance those assets, it is perhaps not surprising to see that the hospitality sector is experiencing particular attention as an asset class. European hotel investment volume was up 55% in the first three quarters of 2024[3] showing that European hotels are experiencing a notable resurgence - and private credit fund lenders are at the forefront of the financings of these deals as evidenced by the £310m refinancing of Shiva’s BoTree Hotel in London by private credit funds BlueWater Capital and NorthWall Capital (February 2025) and the £152m refinancing of MUI Group’s Corus Hyde Park Hotel by ESR Europe (July 2024). Both financings included a capex line to finance upgrades.

It is against this backdrop that in this article we discuss six considerations, and associated issues and mitigants, for lenders in the hotel sector, with a particular focus on their impact on private credit funds.

Type and nature of hotel

What is the type and nature of the hotel being financed? Is it branded or an independent, owner operated hotel? A full-service or a limited-service offering? 

These characteristics are likely to have an impact on the value ascribed to the bricks and mortar of a hotel, and the anticipated cash flows. Branded hotels may offer advantages such as reputation, marketing and loyalty programs, however they will be subject to strict standards (and prescribed fee arrangements for use of brand), typically set out in a franchise agreement between the brand owner and the owner/operator, which establishes minimum standards for a brand and related service levels. These arrangements may limit flexibility in dealing with the hotel, particularly if a major hotel brand is incumbent at the hotel. The removal of that brand is likely to have a negative impact on the value of the property. 

A lender will need to carry out careful diligence on branding arrangements to understand their full extent and practical operation, including the impact such arrangements may have on the ability of a lender to enforce transaction security, and the circumstances in which the branding arrangements can be terminated. For private credit fund lenders new to the space and/or with a limited portfolio of hotel assets, such rigorous diligence requirements may prove more challenging as they establish an experienced team and, fundamentally, until such point as they have built a sufficiently diversified portfolio able to absorb some of the associated risk. 

Relationship between the owner/borrower, operator and others 

Although there are some owner-operated hotels, the owner and the operator are often separate, and not always affiliated, entities. In an effort to regulate these relationships and align interests to ensure the operator maximises the value of the hotel asset, an operating agreement between the owner and the operator that sets out how the hotel is to be operated will typically be put in place. These arrangements can be complex and are often bespoke. This is particularly true when a hotel is comprised of rooms, hotel-branded residences and/or stand-alone villas, each of which may have separate terms and arrangements in place. Alternatively (but along the same lines) a hotel management agreement between the owner and the operator appointing a specific hotel manager that sets out how the hotel is to be managed may be utilised. This is an important diligence point: who is the operator, the hotel manager, the franchisee? What are the terms of their appointments and how do these interlink? To maintain visibility over these relationships, lenders will commonly seek to agree consent rights over changes to the operator, manager and perhaps franchisor of the hotel.

Similarly, in order to provide the operator with some protection from issues arising in the owner’s relationship with its lender, operators often require a non-disturbance agreement to be entered into between a lender, an owner and an operator. This will dictate what happens in the event that the owner defaults under its finance documents and will ensure that any enforcement action taken by the lender will not automatically terminate the operating agreement and the rights of the owner thereunder.   

Non-disturbance agreements are often on terms prescribed by the operator, and in such cases operators have little appetite for negotiation by a lender. They do, however, offer some reassurance to the lender that, notwithstanding an owner’s issues under the financing arrangements, the income produced by the hotel will be protected by the continued operation of the hotel by the operator. It is usual for a non-disturbance agreement to include the ability for a lender to “step-in” and remedy a default on the part of the owner under an operating agreement to ensure the hotel remains operational (and cash generative). It should, however, be noted that such agreements do not always grant the lender the opportunity to terminate the appointment of an operator. 

For private credit fund lenders intending to foster a long-term relationship with an owner and its hotel asset, understanding the nature of these relationships is key.

Security

The precise security package on a hotel financing is dependent on the specifics and structuring of the transaction. Security over the property is obviously key, as is security over or assignment of cashflows, bank accounts and key contracts including any franchise agreements or operating agreements. As with all operating assets, cashflows are important, and negotiations in respect of what constitutes operating costs can be extensive. 

Non-disturbance agreements must be carefully reviewed and negotiated to ensure there are no bars or delays to enforcement of security, and lenders must understand what impact enforcement of security might have on franchise agreements or operating agreements: whilst the position negotiated by strong lenders may be such that an operator is required to continue in role so long as its fees are being paid, it is not uncommon elsewhere for an operator to have the right to terminate an operating agreement (usually after a set period of time) following the enforcement of security and such rights should be considered by lenders when profiling risk and the potential decrease to value and attractiveness of the asset in an enforcement scenario.

Financial covenants and financial reporting 

As with all real estate financings, financial covenants and regular property monitoring reports are key items in a lender’s toolkit to track the performance of the owner and the property asset. Where appropriate, failure to satisfy the criteria may trigger a cash trap, an event of default or, in the worst-case scenario, enforcement of security and the termination of the relevant financing arrangements. 

Key financial covenants include those linked to the value of the underlying property asset and the loan to value covenant and are tested by regular valuations (at the expense of the owner). Interest cover or debt service cover covenants that examine the ability of the owner to service the debt / interest payments, are also commonly seen. Lenders need to be aware that the income stream in a hotel may fluctuate due to the seasonality of hotels (rather than the more traditional rental income on quarter dates seen in other real estate asset classes). If the lender is providing finance to fund a capex/refurbishment programme, close attention will be needed as to the timing and impact of each part of the programme on room availability and food and beverage outlet closures - and the impact on revenue, the setting of financial covenants and, ultimately, debt service.

Quarterly property monitoring reports, delivered by the owner to the lender, ensure that the lender can keep abreast of the performance and status of the property. It is useful for the parties to agree the form of reporting upfront, to ensure that the lender is provided with all information it requires (within the timeframe it requires it), and that the information is something the owner can deliver, within that period. Hotel monitoring reports typically cover details such as the usual details of tenants and rent arrears (if there are lease arrangements in place), hotel performance (including occupancy rates, revenue per available room, capex, repairs and refurbishments), relevant notices, insurance claims, and planning permissions. Understanding which parties will control the key information required for reporting purposes is key. A lot of key operational data will, in practice, be held by the operator/manager of the hotel. Although the operating or management agreement may contain rights for the hotel owner to obtain this information, difficulties can arise in distressed situations or where relationships between the owner and operator/manager have soured as the operator/manager may be less inclined to be transparent will all required information. Non-disturbance agreements can therefore include direct covenants from the operator/manager to provide information to a lender (although the practical impediments may still arise).

Whilst bank lenders often used standardised covenants that are less tailored but sufficient for their risk management needs, and benefit from robust internal controls necessary for regulatory compliance, private credit fund lenders have both the luxury and disadvantage of flexibility and the bespoke. This may make it a greater challenge for these lenders to ensure that appropriate covenants and financial reporting controls are in place. 

Operational covenants and undertakings

As the operation of a hotel is key to revenue generation (and therefore debt service), lenders will be focussed on ensuring the hotel is operated to the appropriate standard and quality such that the value and income of the hotel are enhanced, or at least maintained. This is particularly relevant where the hotel is positioned within the “luxury” end of the market and where the levels of quality and service expected by guests are high, and where any decline in standards or service could have an impact on income or property value. Lenders need to ensure that operational covenants and restrictions included within the finance documents are clear, reasonable and measurable, and that they align with the terms of any operating agreements.  

Specific undertakings and covenants to address this may include the requirement to maintain the hotel property at a specified level or position in the market (for example, five-star or higher, or “a standard expected of a European luxury hotel”), and include regular capex and refurbishment works to be carried out on a rolling basis. In this respect, brand operators and lenders are likely to be aligned and hotel management agreements and franchise agreements are likely to include maintenance provisions. These agreements, along with any operating agreements will need to be carefully diligenced and an understanding of how the arrangements fit together is key. Ultimately, ensuring standards and values are maintained is in the interest of all parties. 

The higher risk tolerance and higher targeted returns of private credit fund lenders, arguably necessitate more detailed scrutiny and control over the owner's operations and financial health, than required by bank lenders. Bank lenders often rely on their diversified portfolios, regulatory frameworks, and standardised processes to manage risks, making some of these concerns less relevant.

Bank accounts

The bank account structures in hotel financings are often more complex than those for, for example, an office financing. This increased complexity reflects the operating nature of the underlying business and the necessity for the operator to be involved in (and seek control over) the collection and spending of hotel revenue in order to run the hotel efficiently and in accordance with the detailed provisions of the operating agreement (which may have been entered into before any financing is put in place). As such, close attention to, and detailed negotiation of, the accounts provision in the facility agreement will be required particularly on those elements of the collected hotel revenue that are permitted to be spent ahead of debt service (such as the operator’s fees, the owner’s profit, agreed capex costs and budgeted furniture, fixtures and equipment (FF&E) expenditure). 

The Macfarlanes team have a wealth of experience in acting globally for borrowers and lenders (including corporates, banks, and private capital clients) on hotel financings for some of the world’s finest hotels. The team have worked on acquisitions, developments, financings and refinancings of a variety of hotels, working closely with our hand-picked local counsel and our own excellent real estate, finance and commercial specialists to provide an integrated experience from start to finish of a hotel financing transaction. 

[1] Deloitte, 2025 Commercial Real Estate Outlook, 23 September 2024.
[2] For more on operational real estate, see our report, “Fully Operational: the future of real assets”.
[3] MSCI’s Q3 2024 Capital Trends Global report.