Franchise Fees

Definition of Franchise Fees in Commercial Mortgages

In the context of commercial mortgages, franchise fees refer to the mandatory payments made by a property owner (the franchisee) to a brand owner (the franchisor) in exchange for the right to operate under the brand’s name, utilize its proprietary systems, and access its distribution networks. These fees are a primary consideration for lenders because they represent a significant, non-negotiable operating expense that directly reduces the Net Operating Income (NOI) of the collateral property.

Detailed Description and Impact on Financing

When underwriting a commercial loan for a branded asset—most commonly seen in the hospitality, retail, and restaurant sectors—lenders scrutinize franchise fees to determine the true profitability of the business. Because these fees are often calculated as a percentage of gross revenue rather than profit, they must be paid regardless of whether the property is currently operating at a net gain or loss.

From a commercial mortgage perspective, franchise fees typically fall into several categories:

• Initial Franchise Fee: A one-time, upfront payment required when the mortgage is used to acquire a new franchise or when a property is rebranded. Lenders often require proof that this has been paid or budgeted for within the loan proceeds.
• Royalty Fees: Ongoing monthly payments (usually between 4% and 7% of gross sales) for the continued use of the brand. Lenders deduct these from gross revenue to calculate the Debt Service Coverage Ratio (DSCR).
• Marketing and Advertising Fees: Contributions to a national or regional fund used by the franchisor to promote the brand.
• Reservation and Technology Fees: Common in hotel financing, these cover the costs of the brand’s global distribution system (GDS) and central reservation systems.

Lender Security and the "Comfort Letter"

Because the value of a commercial property is often tied directly to its brand (for example, a Marriott-flagged hotel vs. an independent boutique), lenders are highly concerned with the stability of the franchise agreement. If a borrower defaults on their franchise fees, the franchisor may strip the brand from the property, causing an immediate drop in the property's market value.

To mitigate this risk, commercial mortgage lenders usually require a Comfort Letter (also known as a Tri-Party Agreement). This document is an agreement between the lender, the borrower, and the franchisor. It typically grants the lender the right to:

• Receive notice if the borrower defaults on their franchise agreement.
• Step in and cure the default to prevent the loss of the brand.
• Transfer the franchise license to a new owner or receiver in the event of a foreclosure.

Furthermore, lenders will evaluate any Property Improvement Plans (PIP) mandated by the franchisor. A PIP represents a future capital expenditure required to keep the franchise license current. Lenders may require the borrower to escrow funds for these fees to ensure the property remains compliant with brand standards throughout the life of the mortgage.