An introduction to OWNER & OPERATOR HOTEL AGREEMENTS (Management - Lease – Franchise & Others)

By G. Angelini

September 2020

An introduction to OWNER & OPERATOR HOTEL AGREEMENTS

 

An introduction to

OWNER & OPERATOR HOTEL AGREEMENTS

(Management - Lease – Franchise & Others)

 

Aligning hotel owners' and operators' goals

 

 

MANAGEMENT – LEASE – FRANCHISE & OTHER AGREEMENTS

Between Hotel Owners and Operators

Executive Summary

 

A: Introduction   ………………..... P. 02 – 09

B: Management Agreements   … P. 10 – 26

C: Lease Agreements   ………….. P. 27 – 32

D: Franchise Agreements   …….. P. 33 – 36

E. Other Types of Agreements   .. P. 37 – 39

  • Affiliation/Marketing Agreements
  • Soft Brand Concept Agreements
  • Digital Disruptors – OTAs Agreements

(a new out-of-the-box alternative)

 

There is a saying within the industry; "Hotels Need Brands, and Brands Need Hotels".

Brands and owners need each other, while tension always exists in the relationship, if they both share the same vision, they have a better chance of a successful rapport.

A: INTRODUCTION

This paper examines the way in which hotel management, lease, franchised and other agreements have evolved over recent years. It looks mainly at the commercial terms of contractual agreements and should not be construed as a legal document.

Motivated by their insatiable appetite to continually expand, and forced by institutional investors and hotel owners to change, operators have become very flexible in their approach to structuring hotel transactions and asides from actually owning the asset. There are now several ways (agreements) for hotel operators to expand their groups/chains without using their own funds.

Hotel managing companies date back to the early 1900s. Back then, the normal method to supply management services was through total property lease by which the operator leased the hotel from the owner. It was only between 1950 and 1960, following the global hotel expansion, that management agreements were created to provide a buffer against the financial risks by bringing professional operating expertise to new and existing hotels, expecially given uncertainties involved in expansion, in various countries around the world.

At present, around 70% of all rated hotels around the world are branded/operated by hotel companies, (STR survey). More independent hotels are joining/entering into agreements with professional operators/brands with the objective to tap into their marketing power distribution channels and operating efficiency, given the growing challenges of operating as an independent hotel.

Of course, independent hotels with strong established positions in their respective markets are the most likely to reject offers to join a large group/chain.

Before entering into any agreements, it is strongly recommended that appropriate legal advice is taken from counsel experienced in such matters and with knowledge of the local countries laws, as well as the law which the contract is subject to. “It is recommend that prior to contacting a lawyer, the Term Sheet (primary business terms) should be drafted to cover most business terms, even if they aren’t defined and detailed out. This saves time and money when getting to the legal documents.”

Most of the large operators offer several agreement schemes/models;

Management agreement
Lease agreement
Franchise agreement
Manchise agreement
Royalty or brand License agreement
Affiliation/Marketing Agreements
Soft Brand Concept Agreements
Digital Disruptors – OTAs Agreements (new alternative)
And others

This document addresses the 3 most popular agreements: Management, Lease and Franchise. And briefly touching on the Affiliation/Marketing Agreements, on the Soft Brand Concept Agreements and to a possible new Digital Disruptors-OTAs Agreements.

The hotel industry needs to honestly ask itself whether sufficient attention is being given to research and development to explore what improvements can be made to hotel agreements. This is certainly a challenge for the operating companies with the enhanced importance that hotel agreements now have on their intrinsic value. But it is not just the operating companies. At no stage in the evolution of the hotel industry has hotel ownership been so concentrated. Many owners hold substantial portfolios of hotels spiraling in value into the billions of dollars often in far-away and diverse locations.

When one party wishes to engage in an agreement with a management company it must be aware that this is a complex legal-commercial relationship, which requires understanding the material differences and priorities between the two parties.

Hotel agreement negotiation can be a long and complex process. This negotiation must satisfy both the operator and the owner to help ensure an effective and trustful relationship is established between the two parties, while taking into consideration the medium to long-term financial ramifications for both. The only period of true leverage and negotiation is during this period; “like dating prior to a marriage, it doesn’t get any better”.

While owners have become far more knowledgeable in recent years, global operators have also become larger and more powerful, particularly given the recent consolidation, mergers and acquisitions by the major hotel operators in the industry. Accordingly, the reduction in competition has made it more difficult to negotiate with them. “The reduction in competition has resulted in the major brands being much less flexible or interested in negotiating” Despite the consolidation, the industry is still relative to other industries highly fragmented and the numbers of small and medium size operators are increasing very fast and some of them are successful at competing in the market.

In some areas/countries, there is a move towards agreements with third-party operators. As the hotel is becoming a more mainstream asset and owners are gaining a better understanding and insight, third-party operators (TPO) are on the rise as they are usually more focused on the Owner’s individual asset(s) in comparison to the broad range and number corporately managed properties. Well established in the US market, this model which is relatively new in Europe and Asia, is now growing rapidly, bringing more flexibility to owners and allowing them in some instances to the responsibilities of the staff to the TPO’s balance sheets. A hotel managed by a TPO is very often combined with a franchise from a major hotel brand.

As more management companies have/are entering the market place, competition for agreements has increased with direct impact on lower base fees, higher incentive fees, performance clauses and often, shorter terms.

Looking at the future – recap:

The main operating models offer a range of choice for both owners and management companies. Each comes with its own set of advantages and disadvantages that make them more or less favourable depending on the requirements and priorities of the owner. The lease provides more predictable cash-flow to the owner, but removes the owner from taking part in the operations and upside of the business (in the case of a fixed lease). Management contracts allow owners to enter the industry with little experience required and enjoy greater profits when business is good, but at the cost of assuming greater operating and market risk. Franchises provide the owner with the right to operate the hotel themselves under a recognized brand name; plus have access to the franchisor's distribution and marketing systems covered by royalty and related fees. However they must also have significant management expertise or make use of a third-party operator to qualify as a franchisee.

In the coming years, franchising will likely continue to gain ground as the preferred operating model for a number of reasons: major chains have placed increasing emphasis on franchising to meet their desired expansion pace; TPOs have proven competent in bridging the gap between owners and brand companies; and small independent hotels in secondary locations turn to flexible, less-standardized franchisors (often via “soft-brands”) to remain competitive.

With that said, there will never be a one-size-fits-all operating model. The experience and risk appetite of the owner, the size and desired standard of the property, and the suitability plus availability of high-potential brands are but a few of the components that factor into which model is most suitable.

Concluding a hotel management agreement, along with related pre-opening technical services agreement, IT design agreement and brand/royalty agreement related to residential components (if any), takes time and normally as the first step, both parties may sign a simple MOU or Term Sheet (2-5 pages), terms of which will be incorporated into the definitive agreements. (Note; the technical service agreement must address potential development delays and fees related to the delay)

Impact of the COVID-19 and foreseeable future

The pandemic's impact on global travel, hospitality and the economy, in general, has been broad and deep. Travel and tourism as we knew it may not return for some time to come. At present, the industry is scrambling to sort out ways to convince guests that it can deliver safe, clean accommodation, value, and bolster consumer confidence but there is a long road to recovery as travel has been reduced to the minimum levels.

Navigating the tough times ahead, every group/brand is trying to assess what must be done to be competitive and survive. Traditional hotel brand standards are temporarily suspended -and likely to be upturned as hotel groups cope with massive changes to the operating landscape. Most likely, traditional standards may have to be relaxed and/or replaced with the objective to support struggling operators and landlords. Of course, brand standards remain important but “OUT” with the non-essentials and “IN” with operating efficiency and financial returns. Unprecedented times call for unprecedented action and must look at all opportunities; is this an opportunity to better realign owners’ and brands’ interests?

Most new projects under development, or at the planning stage, will be delayed while some may be canceled. In most cases, ROI is the main objective to develop new hotel projects but the present situation is not ideal to venture into new projects nor obtain financing. Flexibility will be key for hotel groups/operators in order for them to grow their portfolio. It will be interesting to see who will come up with the best innovation in deal-making and who will look at this crisis as an opportunity to grow and expand faster. (At time of writing this article, some owners have put their hotel assets onto the market, in advance of their borrowing coming up for renewal – as values have materially dropped).

As an industry there is an urgent need to make hotels much more viable. This pandemic has taught us to rethink in this direction and develop interesting and innovative hotel assets with facilities that can drive higher profitability. This can only be done with a new mindset and thinking out of the box, starting with an open-mind to making changes and improvements throughout the whole process, including location, design, facilities, technology, marketing, services and operations. People/customers have become much more savvy and conscious about real value offered by hotels in particular, their safety and well-being.

Eventually, the industry will emerge from this dark period, travel will gradually return and business will start to grow again but in the interim the circumstances bring the opportunity to rethink and revisit each property - and a lot of work remains to be done.

In order to secure new agreements during this period of uncertainty, operators must shift their models to support the goals of hotel owners, clients/investors, and the change in travel demand. The criteria for the selection of a management company has become multi-layered as owners and lenders are basing their decision on the operator past performance, structure, potentials, and strategy for attracting new business and maintaining market share. Securing new agreements may not be as challenging as retaining existing ones as the financial performance/market share/RGI and the sharing of risk, between manager and owner, will be the deciding factor.

Now more than ever, hotel owners need the reassurance that they are associated with the right brand and operator -that is focused on driving the top line, operational efficiency including cost containment and operating profit. Reassurance that the brand has an effective distribution platform plus successful loyalty program to generate business is critical to the relationship for the hotel owner manager and lender.

Owners want to know what the differentiators of each brand is, their effectiveness, and what those differentiators would bring to lift each hotel’s operating performance. Both owners and asset managers have acquired good skills that measure operating costs related to revenue/performance, and understanding customer concerns on the implementation of product and service protocols related to those concerns.

Post COVID-19 Agreements (Facing reality & necessary adjustments)

As we are still in the middle of the pandemic, it is too early to predict permanent changes to the owner-operator relationship which may reflect in future agreements but as this virus has severely affected both parties in the contest of cash flow and fees, some modifications are necessary. In the cases of HMA's, the principle that the operator manages the hotel on behalf of the owner is expected to remain but both parties have to be prepared for adjustments in particular on the handling of future crises and of the impact on the business finances.

Indications are that a number of new projects may be delayed or shelved, therefore the competition for new agreements will increase substantially and brands will have to be more flexible with their fees and demands. Base and incentive management fees paid to the operator are normally contingent on the success of the hotel and in all probability, post COVID-19, the industry may see a shift from top-line based fees to operating-profit based incentive fees tailored to a performance "ramp-up" based on the level of profitability of the operation. Owners will see the increasing benefit of giving operators stronger incentive fees.

This is a time to "think out of the box" and we may see a total change in the calculation of the operator fees. As an example, a recent proposal consists of;

  1. Introduction of a minimum operator fee per year that consists of one flat amount replacing the base fee, the incentive fees, and the centralised charges/reimbursable. The amount can be based on the number of rooms/facilities or on the potentials of the hotel. This minimum amount can be "topped-up" based on the operator delivering on actual results/profitability (GOP) of the property.
  2. Reservation fee based on the actual room nights produced by the brand, a flat fee per reservation, or a percentage of the room revenue produced by the brand.
  3. Loyalty fees also based on production, a flat fee per materialized reservation, or a percentage of the member's folio. (Both the reservation and loyalty fees can also be scaled-up based on production). Note that there is increasing concern amongst Owners who feel that loyalty programme fees based on Rooms Revenue, or total revenue, are not reflective of the actual contribution of incremental room nights from the programme.

In this scenario, only 3 fees are payable by the hotel/owner to the brand/operator, and all are performance-related. This is a very clear incentive for the operator to produce business and profitability for the hotel. (Note that other important clauses like the performance test, territorial restrictions, termination rights, brand standards-SOP's and others are expected to remain).

  1. Owner’s Priority Return is becoming seen more widely as Owners carry the majority of risk. By including a base or threshold of what the Owner needs to cover the borrowing -and insurance, the management company is put on record from the outset that such cash-flow from operations is the minimal accepted return for the Owner. This clause is very much favoured by lenders, who feel the risk is more balanced.

Other scenarios are being contemplated as well by both the owners and the operators and, as previously mentioned, it will be interesting to see who the innovators will be in this very important area. All brands/operators want and need to grow, but with fewer deals available in the short-medium term/future, the competition to secure new deals will strengthen significantly.

The allocation of risk is a key element relationship between the two parties and it is anticipated that Force Majeure takes a more prominent place/importance in the agreement and it will also address epidemic-pandemic-quarantine-natural disasters and similar situations. Clarity on insurance coverages and who pays for what in the event of crises/incidents must also be agreed/documented. This has to include all aspects of the business/operation; employees-guests-property-loss of business-closure/suspension/ reopening of business and other related provisions.

Consumers will view quality brands/operators as a safer place to stay, compared with independent/white label hotels. While from the owner/developer side, it is anticipated that the strength of the brand's distribution platform and the loyalty program (business generation) will be the primary deciding factors when searching/negotiating with operators.

This crisis has reminded us that both owners and operators have to seriously address the fundamental tectonic shift that will emerge out of this crisis in particular the efficiency-automation-technology-safety and the urgent need to come up with an ideal mix of personalized services and artificial intelligence that will contribute to maximizing guest satisfaction and business results.

B: HOTEL MANAGEMENT AGREEMENTS (past decade & present trends)

B: HOTEL MANAGEMENT AGREEMENTS (past decade & present trends)

Definitions: A hotel management agreement is defined as a deal/contract between a management company (operator) and a property owner, whereby the operator assumes responsibility for managing the property by providing direction, supervision, and expertise through established methods and procedures. The operator runs the hotel on behalf of the owner, for a fee, according to specified terms negotiated with the owner.

Hotel management agreements have come a long way in seeking to align risk and reward between owners and operators. In the 1960's & 70's, the common fee structure was colloquially known as "5 plus 10" where the operator takes was five percent of the revenue and ten percent of the gross profit. Then in the 1980's this came down to "3 plus 10"

With such a fee structure, owner and operator risk and reward was totally unaligned and unsustainable. Since that time, we have witnessed a gradual reduction in the quantum of fees and in the method of calculation.

In the framework of creating the sensitive balance, the author of the management agreement must assimilate mechanisms in the agreement, which will balance the risks and interests of both parties.

Today's hotel owners seek contracts in which incentive fees based on profitability make up (if not all) the majority of fees to the operator. Base fees, if any, play a much smaller part. Operator remuneration is mainly based on GOP. Owners today have a much deeper understanding of hotel operations and are far more discerning when selecting their operator. There is simply no space left for the ego-driven operators who load their hotels with additional/unnecessary services, amenities, and facilities at the expenses of the owners.

Negotiating the terms of a hotel management agreement should not be approached lightly as there is a lot at stake for both parties. A well-negotiated management agreement will recognize this, and align the interests of all involved. Maximizing profitability and increase the value of the asset is normally the final objective of the owner and operators must stay tuned to those objectives.

Failure to perform or meet the Owner’s Priority Return calls for top-ups by the operator and potentially termination. Put simply, hotel management agreements have swung in favor of the owners. Agreements are now shorter in duration and with much shorter notice period of termination. Performance guarantees have become a critical part of the agreements, and they are implemented more strictly. Professional consultants and/or asset management companies are in many cases used by the owners to motivate and monitor peak performance from the operator and/or brand.

Management agreements allow investors with relatively little knowledge and experience in the hotel industry, or who cannot directly manage hotels for a variety of reasons, to invest in hotels. At times, investors may also have a modestly easier time obtaining financing as brand operators are generally perceived by lenders to result in a somewhat less risky investment. Also with a top management firm operating the hotel, under a high-profile brand, the value of the asset may increase as well as deliver a reasonable annual ROI.

Establish a mutual understanding and empathy. Perspective-taking helps the owner and the operator to be reasonably aligned in their understanding of their roles regarding the hotel/property. Having an aligned interest it does help the relationship, the operation, and the performance. Both owner and operator must recognize the efforts resources and pride that each places on the success of the agreement and of the property and their reputation.

Should get away from unhealthy habits when, in general, owners prefers to minimize spending while operators prefer to increase it. It has proven successful when both parties agree on the type of reports provided to the owners on a monthly or weekly basis, and this may consist of; market position/RGI, results of guests and employees surveys, social media reports, quality control reports, accounts receivable aging reports, business and cash-flow forecasting for the month-quarter-year, legal cases, and others as appropriate. Return on investment of all capital expenditures needs to be evaluated in all cases apart from safety, security or preservation of the asset.

A well-negotiated management agreement that satisfies both the owner and operator will help ensure an effective relationship between the two parties in the long-term. If the objectives of both parties are not effectively negotiated and met prior to execution of the agreements(s), disputes may result.

A lesson that we as an industry are relearning from the COVID-19 pandemic is that the only constant is change. It is increasingly obvious that the owner's and the operator's objectives must reflect the priorities that were laid out when the management agreement was executed. In a pandemic and/or in other natural disasters situations, both the owner and the operator have to discuss and agree on the best ways to handle the safety aspect, as well as the business, employees, and customers underscored by the projected cash-flow.

Management agreements can be complex, longer in term and binding. They can also be the choice model for both the owners and operators, when entered into with expert advice and careful negotiation to ensure the interest of all parties are as aligned.

The most important elements of a management agreement consist of;

  1. Term (initial and extension/s)
  2. Management fees
  3. Operator performance test
  4. Approval rights
  5. FF&E and capital expenditure
  6. Territorial restrictions for the brand(s)
  7. Non-Disturbance agreements with the bank(s)
  8. Operator guarantees (if any)
  9. Brand Standards SOP's and imposed changes
  10. Operator key money (if any)
  11. Termination rights
  12. Operator centralized services
  13. Language and jurisdiction of the agreement
  14. Agreement Contents/Clauses
  15. Dispute resolution

1. Term

The term of a management contract is the duration the agreement is to remain in effect, generally calculated from the opening/effective date until the expiration of a specified number of years. Initial terms typically last between 10 and 25 years, depending on the brand and the positioning of the hotel as well as on the negotiating power between the owner and the operator.

Renewal terms are usually based on either the operator having further extension rights, or upon the (preferred) mutual consent of the owner and the operator. Renewal terms tend to occur in multiples of either five or ten years. Most contracts offer two extension terms (sometimes more) on the condition that six months’ written notice is given prior to the end of the current term.

For commercial reasons, brand operators prefer longer contract terms with renewal options in their favour, whereas flexibility is likely to be more important for owners and thus there is a preference for a shorter initial term and renewal options ideally only by mutual consent.

There has been a noticeable decrease in the average length of initial terms in most markets/continents which can be attributed to the following factors:

  1. The proliferation of private equity vehicles in the hotel investment market in recent years has placed pressure on operators to offer more competitive, shorter initial terms, although these are generally coupled with weaker performance conditions and more renewal options;
  2. The increasing competition amongst hotel operators seeking to broaden their distribution network at little to no investment on their part;
  3. An increase in hotel investment in emerging markets along with the associated risks in such markets have led both operators and owners to negotiate contracts with shorter terms, to provide the opportunity to exit in the event of disappointing market conditions or also for quick profit.

2. Management Fees

Operators are remunerated with fees for the performance of their duties detailed in the agreement. These management fees should be structured in such a way that they encourage the operator to maximize the financial performance of the hotel. Fees can be calculated by reference to various formulas. Typically, the operator's fee will be split as follows:

  1. A base fee, generally calculated as a percentage of gross operating revenue (ranging typically from 1% to 3%). While many owners would argue that an operator should ideally only receive fees based on the profit, not revenue, that the hotel generates. Operators have successfully argued that they need to be protected with a certain amount of virtually ‘guaranteed’ income in order for them to be able to subsidize the costs of operating their organizations even during a severe market downturn when hotels' operating profits may be significantly reduced or even, in the worst cases, non-existent for a period of time. COVID-19 crisis has underpinned this argument as the operators would have virtually had no income during this period if there was no base fee.

Note:

At times the base fee is replaced by a license fee. In this case, a license agreement may be necessary to comply with both the needs of the operator and also in compliance with the local/tax laws. There are also cases when it is necessary to have both; the base fee and the license fee. Important to note that regardless of one or two agreements, the total cost to the owner remains the same.

  1. An incentive fee based on a percentage of the hotel's operating profit. While the base fee encourages the operator to focus on the top line, the incentive fee ensures that there is also an incentive to control operating costs. Incentive fee structures have a wide variety of forms in practice. These incentive fees are generally based on a percentage of either the gross operating profit (GOP) before the deduction of base management fee or, more usually, the adjusted GOP (AGOP), calculated by deducting the base fee from the GOP. The incentive fee can be structured differently, with examples including:

-   A flat fee structure, where the incentive fee is calculated as a percentage of GOP/ AGOP. This percentage may be constant or scaled upwards throughout the term of the contract (usually by way of a ‘build-up’ in the first few years until the hotel's expected year of stabilization).

-   A scaled fee based on the increasing amount of the GOP or AGOP margin that is achieved. This fee structure certainly rewards the operator for a more efficient performance and is becoming increasingly common.

-   A fee linked to the available cash flow after an Owner’s priority return (operators normally not favorable with this but lenders are becoming increasingly so as not in control of a priority return calculation).

There is a rising trend observed in the industry where operators are accepting lower base fees (or no base fee) in return for higher incentive fees of up to 15% of GOP, which are designed to more closely align the operator's interests with that of the owner – to maximize the operating profit of the hotel, regardless of the revenue.

While a fixed incentive fee percentage ranging from 5% to 10% of AGOP was typical, it is becoming increasingly common to have scaled incentive fees. The tendency towards higher or scaled incentive fees versus higher base fees, rewards effective operators but also provides some protection for the owner's cash flow/return in the event of poor operator performance or a market downturn.

  1. Other fees and charges can be claimed by the operator, and are related to items such as centralized reservations, sales and marketing, loyalty programmes, training fees, purchasing costs, accounting or other costs. These fees are often defined as a percentage – between 2% and 5% – of total revenue or rooms revenue (as applicable, and varying between different operators and as negotiated). A prevalent trend is to lump all these fees together into a pot that is capped at 3.5 to 4% of the room revenue.

Those fees (2c.) can also be referred to as “centralized services” or as "system fund contribution" or as "brand corporate charges and fees" and normally it includes;

  1. Reservation fee: Different operators have different ways to calculate and charges for reservation fee; some charges a fixed amount for each room generated by the brand system. Others charge a fixed amount per room per year. While others charge a small percentage of the room revenue generated by the brand distribution channels. (Clarity on the business provided/generated by the brand system is very important and there should not be confusion).
  2. Loyalty program fee: This is an important program for the hotel to participate and all operators request compliance, not much space to negotiate in this one. Normally fees charged to the hotels are standard throughout the operator system and are based on a percentage of total revenue (excluding taxes and service charge) generated by a program member/guest staying at the hotel. Fees can range from 2.0% of gross rooms revenue for the small-medium size operators/recognition programs to 5.0%-6.0% of total folio revenue for the large global operators/points system. The payment of this fee is typically based on the business received by the hotel, usually excluding group and contract room revenues. Also, the hotel has to participate in the point system program/benefit by providing rooms at an established rate (not free) and sometimes, a discount on F&B. (Important to keep a record on the business generated by the loyalty program and also total business generated by the operator systems). A current trend in high-redemption markets (major cities and upscale resorts is for Owners to cap the number of award room nights that can be reserved in peak season and demand period.
  3. Others/Miscellaneous fee: Normally those are cost-reimbursable to the operator covering in most cases the IT expenses, Training program/expenses, combined (group-wide) sales and marketing activities, annual conferences, and others related. Those charges are in many cases hot topics of discussions and arguments between owners and operators and the new trend is to put a yearly cap on those charges. The base of those fees and the amount is normally provided by the operator on yearly basis prior to finalizing the hotel's annual budget/financial plan as the amount can vary from year to year and it reflects the inflation. (IT expenses have become a real area of contention for Owners, especially when they are fixed and equate to a high proportion of hotel income.)

Important to clarify/agree and document the responsibility of the withholding taxes on all fees and reimbursable from the hotel/owner to the operator. Who absorbs those? Note that in some countries the amount is higher than the traditional 10%.

3. Operator Performance Test

Performance tests allow an owner to terminate the management agreement should the operator fail to meet the agreed performance criteria after the ramp-up to stabilization (test periods typically commence in the third or fourth year).

Two types of performance tests are typically used, often jointly:

Room revenue per available room (RevPAR) as a percentage of a mutually agreed upon competitive set (the test is generally set somewhere between 80% and 95% of the weighted average RevPAR of the competitive set);

The GOP level for an operating year should not be less than the mutually agreed annual budgeted GOP level (usually starts at 80%, up to 90% of the budgeted GOP, depending on the negotiation strength of both parties).

A performance test usually starts from year three or four, after stabilization of the new hotel, generally known as the commencement year. The performance test is usually deemed to be failed if both the RevPAR and the GOP tests have been failed for two years in a row or two out of three years.

It can also be challenging to agree on the most appropriate competitive set and sometimes to find reliable RevPAR data for the competitive set. Furthermore, in case of a force majeure event or any peculiar event that is beyond the operator's scope, then the performance test would not be applicable and the right of termination of the owner is not exercisable. Good performance tests are the ones that are measurable and enforceable, sensible and that truly reflect the relative position of the hotel. Note, with new competitors in the hotel’s territory, it is quite appropriate to change the competitive set in future years, based on discussion.

Operators usually negotiate a clause with a ‘right to cure’ (with a claw-back) in the event of a failed performance test, allowing the operator to make a compensation payment of the shortfall to the owner. The typical right to cure usually includes a specific/limited number of times that the operator has the right to cure during the term of the agreement and often the opportunity for the operator to ‘claw back’ the funds they advanced in a weak year(s).

4. Approval Rights

Approval rights define the extent to which the owner’s consent is required for decisions impacting the hotel’s operation. This allows the owner to remain involved in key decisions regarding cash flow. In addition, if stipulated, an owner can place restrictions on expenditure (that is, purchasing systems, concessions or leases). These owner approval rights generally comprise:

  • Opening and closing of bank accounts – and handling of cash/debts.
  • Insurances and liability coverages – all insurances.
  • Working capital – amount and replenishments.
  • Auditors – internal and external.
  • Licenses and permits – all licenses and permits as required by local laws.
  • Legal cases – appointment of lawyers and review major cases.
  • Budget – the operator should submit an annual budget for the owner's approval, usually 30 to 90 days prior to the start of the fiscal year. Owner approval of the annual budget is usually negotiated, but such approval may depend on the conditions of the performance test, and may therefore exclude certain line items. If both parties do not come to a consensus, an independent expert to be appointed to adjudicate and provide a determination. The annual budgeting exercise is one of the most collaborative activities between the owner and the operator during the life of a management agreement.
  • Employment of key senior management positions – the management contract will specify whether the hotel's employees are employed by the owner or the operator. Generally, each party prefers to pass the responsibility of employment to the other, because of liability issues. For most cases, the staffs are officially employed by the owner. However, generally the operator has the responsibility of hiring and training the staff. In a significant proportion of management agreements, owner approval is required for the hiring of certain key management positions (that is, general manager, financial controller, director of sales and marketing and director of food and beverage).
  • Facilities changes – F&B concepts, room mix/inventory and others.
  • Renovations – purpose, objective/s, timing, budget, interior designer, contractor, pay-back, and others related.
  • Remuneration and benefits – owner will also approves the incentive scheme/bonus, the percentage of the annual salary adjustment/increase, salary scale, pension schemes, loans and other long term financial commitments.
  • Outsourcing – this clause affects the decisions involving the appointment of an external service provider in relation to the hotel’s operations, such as engineering services or housekeeping or others.
  • Capital expenditure – reallocation of approved funds for different projects and timing.
  • Leases and concessions - such clauses relate to the leasing out of hotel space to third parties, such as restaurants, spas, gift shops, beauty salons or retail outlets.
  • Disposal of fixed assets – all assets due to renovation, change of concepts, oversupply etc.
  • Delegation of authority – for clarity and consistency purpose, there should be a formal document signed by both side stating the authorities of the operator including payments, purchases and others.

The purpose of the delegation of authority is to define "who authorize/approve what" in the operation of the hotel and as an indication, it normally includes matters and monetary controls such as; purchases above X dollars, contracts longer than X months, litigations above X dollars, delinquent accounts above X dollars, termination/lay-off of long-serving employees over X years of service, any type of loans to/from, donations to/from above X dollars, sponsorships to/from above X dollars, and similars. The list can be extended, or reduced, based on the local situation and owner's structure/request.

  • Others – as mutually agreed by both parties.

5. FF&E and Capital Expenditure

To maintain the asset in a marketable condition and replace the furniture, fixtures and equipment (FF&E) of a hotel at regular intervals, a ‘sinking/reserve’ fund is created to raise capital for this periodic FF&E replacement, which is usually a percentage of gross revenue and somewhat dependent on the positioning/level of the hotel. Included in this category are all non-real-estate items that are typically capitalized rather than expensed, which means they are not included in the operating statement, but nevertheless affect an owner's cash flow. Generally, management agreements include a reserve for replacement of FF&E of between 3% and 5% of gross revenue per month, with the lower percentage more likely to relate to budget hotels and the higher percentage to upper upscale and luxury hotels.

In some cases, the amount to be reserved may be dictated by the lenders financing the hotel. Typically, capital improvements are split into two categories:

  • Routine capital improvements: funded through the FF&E reserve account and required to maintain revenue and profit at present levels;
  • Discretionary capital improvements (also called ROI capital improvements): investments that are undertaken to generate more revenue and profit, such as the conversion of offices into meeting rooms. These require owner approval and are in addition to the funds expended from the reserve account. In general, soft goods for a typical full-service hotel should be replaced every 8-9 years, and case goods should be replaced every 14-15 years.

Within a management contract, the owner is responsible for providing funds to maintain the hotel according to the relevant brand standards.

6. Territorial Restrictions for the brand(s)

By including a territorial restriction (also sometimes referred to as an ‘area of protection’) in a management contract, an owner is assured that no other property with the same brand, or type of hotel (e.g. 4-star), is allowed to open within a certain radius of the subject hotel, for a certain period of time (ideally being for the whole duration of the agreement) in order to minimize or even pre-empt any form of cannibalization from the same brand, or sometimes also from another brand of the same company. Beware of whether the restriction applies to ‘brand-extensions’ or all brands of the operator.

Depending on the location, the city size and the type of brand, this clause may vary significantly. Upscale/luxury hotels tend to have a territorial restriction area for a larger radius and for a longer period of time than budget/mid-market hotels. Operators will inevitably seek for a more flexible scheme, so that such a constraint does not interfere with the development of the operators’ other brands which are not direct competitors (for example, upscale brands compared to budget brands).

Therefore, to define the territorial restriction, the negotiations should be centered around the area of the exclusion clause, the brands that will be included in the clause, the period of time and also the provision of an independent impact study of the development of a similar brand on the subject property’s performance.

7. Non-Disturbance Agreement with the bank(s)

Hotel management contracts often include a non-disturbance agreement. This is an agreement between the hotel operator, the owner and the owner’s lender. In the event of default or the owner’s insolvency, the lender takes over the ownership of the hotel and recognizes that the operator has an existing agreement in place, and commits to terminate the hotel management contract. At the same time, the hotel operator agrees to stay and operate the hotel for the lender in case of insolvency or enforcement.

The hotel operator can be confident in keeping the value of the management contract, and in having a direct contractual relationship with the lender. On the other hand, the lender knows the operator can’t leave the contract immediately on insolvency or a default, which is potentially disruptive to the business and/or the lender’s ability to liquidate the asset.

8. Operator Guarantees (only for specific cases)

An operator guarantee ensures that the owner will receive a certain level of profit or net operating income. If this level of profit is not achieved by the operator, the operator guarantees to make up the difference to the owner through their own funds. For example, if the contract states a guarantee of 1,000,000 per annum, and the operator only achieves 800,000, the operator will then make up the remaining 200,000 from their own resources.

Operator guarantees are not to be confused with an owner’s priority return, which reflects the hurdle of a particular performance (such as GOP) before receiving the incentive fee. For example, if the owner’s priority return is equal to 1,000,000 and the GOP achieved in a particular year is 800,000, then the operator will not receive an incentive fee. If the GOP in a particular year is 1,200,000, then the incentive fee will be payable.

It is typical when such guarantees exist that there is a provision for the operator to ‘claw back’ any payments made under a guarantee out of future surplus profits. Equally typical is the tendency for the operator to place a limit (‘cap’) on the total guaranteed funds within a specified number of years. When the operator fails to receive an incentive fee, this is sometimes referred to as a 'stand aside'. Some contracts allow for this to be paid once future profits are earned to cover the shortfall.

The current trend is for a shift away from operator guarantees. Over the past several years, operators have been placing limits on guarantees to exclude force majeure factors in order to cover their future liability. As such, operators will generally require higher fees in return for an operator guarantee and this may not always be cost-effective for the owner. In addition, most contracts will include a cap on the level of operator guarantee, as noted above.

9. Brand Standards SOP's and imposed changes

The operator has the responsibility to provide the appropriate brand standards (SOP's) and provide adequate training on those standards to all people in the hotel. Both the owner and operator accept that the full implementation of the brand standards is an integral part of a successful quality system and it guides all concerned in maintaining the quality and consistency of service necessary to compete. The manager is to ensure that the hotel is operated and managed in a manner consistent with hotels of a similar standard, quality, and brand. The owner acknowledges that the brand standards shall continue to change to reflect the intended qualities and competitiveness of the brand -as well as trends/demands in market conditions, technology, etc and that it shall have a continuing obligation to ensure the hotel continues to comply with brand standards throughout the term of the agreement.

10. Operator Key Money

A more prevalent way to incentivize owners in high-demand markets and secure contracts when operators use their balance sheet to offer either key money or “silver equity”.

Key money, in the context of management contracts, can be defined as a financial contribution from the operator to the owner's investment cost related to the development of the hotel. Often regarded as an evidence of the operator's genuine interest in the engagement. Key money can be a valuable resource to help a brand expand into new markets without the high development costs and to seal the deal for trophy assets.

Many operators offer the key money as a ‘loan’ to the owner, which could be either towards the hotel's development or its preopening, or to cover part or all of a renovation in the case of the re-branding of an existing hotel. However, key money comes at the expense of something else, usually higher fees and/or a longer term.

Moreover, almost all operators require the owner to repay a prorated unamortised amount of the outstanding key money, with or without interest, if the contract is terminated prior to the end of the term or an agreed part thereof.

For existing properties, key money may be offered at the time of signing or after the capital improvements (recommended by the operator) have been completed. Conversely, for new hotels, key money is mostly offered as the last funding available to the owner, paid on the opening of the hotel.

However, key money does not entitle the operator to an actual equity share in the investment. In today's highly competitive market, some operators now assume an actual ownership position in the hotel. An increasingly common tool is minority equity stake where the operator makes a financial contribution in return of a stake (from less than 5% to 20%) in the ownership of the hotel. Under such an arrangement, if the hotel performs well the operator directly realizes a return for the investment. Equity contributions by management companies may help to align the interests of the owner with the management company.

The benefit of reducing an owner's need to use their own cash is a powerful incentive. However, owners should also be aware of the potential risks or trade-offs associated with forming equity partnerships with management companies. More partners imply more parties to split the profits, and less owner equity means a higher chance of losing control of the property. In addition, the relationship with the management company as an equity contributor may limit the owner’s ability to terminate the management agreement.

11. Termination Rights

Each party may choose to terminate the hotel management agreement for a variety of reasons: bankruptcy, fraud, condemnation, unmet performance standards, sale. As hotels are becoming more mainstream assets, owners are getting more mature and vigilant on the conditions for termination and the associated operator fees. While the initial signatories to an agreement may have had all good intent and spirit of co-operation.  That can change!

Owners can negotiate the right to terminate the contract upon the sale of the hotel to a third party. This clause gives flexibility to the owner or to any potential investor as it allows the owner to realize the investment and sell the hotel unencumbered. The operator is compensated with a termination fee from the owner. The termination fee is usually an amount equal to the average management fees earned by the operator in the preceding two-three years (24 to 36 months) prior to the date of termination, 'multiplied by' either the remainder of the term (years/months) or a multiple of three–five or any other as agreed.

Termination without cause allows the owner to terminate the contract without any justification. The termination fee under this provision is normally calculated in a similar method as for the termination upon sale. Termination without cause, or on sale, is more common in contracts with independent operators.

The operator performance test mentioned earlier allows the owner to terminate the contract if the operator fails to meet the performance expectations and does not use its cure rights. The testing periods for most performance termination clauses begin three–four years after the opening of the hotel or the inception of the contract to allow the hotel to reach stabilized operating levels, and the performance failure usually has to persist for two consecutive years as a minimum.

Other causes for termination consist of operator misconduct, condemnation, bankruptcy and default and reputation. Important to stress here that management contracts without termination on sale provisions obviously reduce flexibility on exit. It is usually worse when the operator has an equity stake in the property. An owner should always look for the most flexible management contract terms that can be negotiated. Neither Owner nor operator want to be held to a relationship where one or the other’s reputation impacts the value and/or profitability of the asset.

12. Operator Centralized Services

As hotel operations have become more sophisticated, so have the Operators and the offering of centralized services. This concept provides support services, or muscle, to the hotel on a shared basis by spreading the cost of delivering the service across participating hotels.

Two commonly provided centralized services are accounting and revenue management services. Other services an Operator may offer include recruiting and training, technology and systems support, engineering and risk management, legal support, and special purchasing.

Hotel Owners should be mindful of the size and support of the Operator. As an example, a 100-room limited-service hotel may not require all the bells and whistles, whereas, a 500-room conference hotel requires more support to place heads in beds.

The nature of these services is to enable the Operator to manage the hotel more effectively. The benefit received from these services should be earned through the enhancement of value created and not through their existence. Therefore, the Owner's cost of using the services should be such that it offsets the Operator's costs to provide the service.

Amount of centralized service is normally based on percentage of the GOR or room revenue based on services provided by the Operator. The amount has to be negotiated and specified if it includes marketing and reservation contribution, (production from brand website). See section 2 “other fees and charges”.

Contribution/participation to Operator’s customer loyalty program is required for the hotel and payment is based on a percentage of the actual folio of the customer (no production – no payment) see 2c–B.

13. Language and jurisdiction of the Agreement

How does the language of the HMA impact the Operator's ability to provide exceptional returns to a hotel Owner? Language is the heart of the agreement since it gives purpose and utility to the body of a contract. Too much favoritism to one side of the table can set the wrong tone during negotiations or even throughout the operating term.

Some crucial questions that an Owner should ask regarding an HMA:

  • Are the roles and responsibilities of the Owner(s) and Operator explained clearly without making the HMA inflexible?
  • As market conditions change, does the HMA allow the right amount of flexibility given the length of the term?
  • Does the agreement provide the Operator with enough authority to operate the property without interruption or disruption from the Owner?
  • Does the agreement provide the Owner with enough power to terminate the Operator rightfully?

The language within an agreement should reflect the business plan and be the building blocks of how the relationship should function. That is to say that the Operator will run a successful business operation for the Owner. It is worth noting that the business plan should also represent the intent of the relationship. That means a business plan that includes an involved Owner should include language in the agreement, that is clear in duties and sets reasonable expectations plus delegation of authority/approval rights.

14. Agreement Contents/Clauses;

Different operators/brands have different agreement formats and clauses. As a guideline (indication only), the various agreement clauses to be negotiated between the two parties can be divided as follows;

  1. Executive Recap of the Agreement
  2. Definitions and Interpretations
  3. Scope of Agreement and Property
  4. Term and Effective Dates
  5. Rights and Obligations of Owner and Manager
  6. Bank Account/s
  7. Annual Budget
  8. Accounting Matters (books & records)
  9. Capital Replacements
  10. Personnel 
  11. Fees; Licence-Base-Incentive & Withholding Taxes
  12. System Fund Contribution and Other Fees
  13. Brand and Trade Marks
  14. Insurances; by Owner and by Manager
  1. Indemnity and Related Matters
  2. Damage/Destruction of Hotel & Compulsory Acquisition
  3. Termination of agreement
  4. Notices
  5. Relationship and Authority
  6. Applicable Law & Dispute Resolution
  7. Assignment
  8. Confidential Information
  9. Development Restriction
  10. General Provision
  11. Warranties, Owner & Manager
  12. Pre-Opening & Working Capital Budgets and Provision of Funds
  13. Place of Arbitration
  14. Others/Miscellaneous

 

Useful attachments to the Agreement

  1. Hotel/Property Description/Facilities
  2. Development of the Hotel, Schedule & Warranties
  3. System Fund Contributions and Other Fees, Details
  4. Loyalty Program Purpose and Details
  5. List of all Insurances and Coverages
  6. IT Systems & Information Technology, Details and Ownership
  7. Handling of Operator Employees/Compensation
  8. Benefits/Participation in the Operator Employees Programs
  9. Intellectual Property Ownership (+List of Operator Manuals)
  10. Delegation of Authority Format/Details

Agreements are getting longer and more complicated than what it used to be (and at times confusing). Definitely there is space for much more simplicity and shorter documents. A question is to be asked, "Do hotel management agreements need a makeover?" Agreements continue to evolve and in the foreseeable future, it is anticipated that most of the fees to the operator will be based on incentive schemes and not on revenue.

Must accept that although both parties, owner and operator, have a vested interest in the hotel's success (like maximizing revenue, minimizing costs and increase profits), their different sources of income, risk profiles, and investment strategies mean they often have different interests, which may lead to misaligned and possibly even conflicting goals.

Despite a strong focus on the relationship between the Owner and the Operator, this relationship is not a marriage; it is a business relationship. Even if the HMA were to be worded perfectly and inclusive of all details, the relationship could still fail due to a simple fact. If the relationship is not working, it would need to be resolved, or it should result in a separation. It provides no benefit to either the Owner or the Operator to persist in a lose-lose scenario. Objective is a “win-win situation”.

15. Dispute Resolution;

Ideally, a dispute between an owner and an operator should be settled amicably but given the complexity and length of the agreements, it is inevitably that disputes will arise. Normally disputes can arise from the approval of the annual budget, from the calculation and payment of fees, from the market positioning/RGI of the hotel as compared with the competitive set, control of expenses, profitability, inexperienced/careless management, lack of operating funds/working capital, unreasonable interference from owners (micromanaging), lack of funds for renovation and up-keep of the property, and others. Both parties have responsibility that most of those matters are dealt with and settled avoiding legal actions and court cases.

A well written agreement should address the mechanism for dispute resolution including the jurisdiction. Those provisions are often multi-tiered working through different methods for solving disputes such as negotiations, mediation (including third party professionals), and eventually/last resource, litigation/arbitration. Must understand and accept that litigation/arbitration is always the worse possible solution as it is expensive, time consuming, image damaging, and often renders decisions neither side agree with, leaving no winners.

The ultimate goal of any dispute resolution process should be to salvage the business relationship of the parties and provide each of the parties with the rights and remedies bargained for in the agreement.

C: HOTEL LEASE AGREEMENTS

C: HOTEL LEASE AGREEMENTS

Definition: An agreement to the use of a property for a period of time on a fixed and/or variable rental fee basis. The agreement does give more control but not provide ownership rights to the lessee; however, the lessor may grant certain allowances to modify, change or otherwise adapt the property to suit the needs of the lessee. During the lease period, the lessee is responsible for the condition of the property.

With a hotel lease agreement, the hotel company rents the property from the property owner and operates the hotel as independent unit, separate from the property owner. This way, the hotel company (the lessee) reserves all incomes from the hotel and pays fixed rent and, in some cases, a certain percentage from the sales revenue to the lessor.

Advantages and Disadvantages of Leases

Owner

Advantages

Disadvantages

The owner retains the title to the property and the residual value created at the end of the lease

The operator has little interest in maintaining the property as the lease comes to expiration

The owner incurs minimal financial risk, especially if the rent is fixed and the hotel company is reliable

The owner is passive and has no control over the hotel’s operations

The owner has no operational responsibilities

The owner does not benefit if/when the property is more profitable than expected

Guaranteed rent/revenue in line with financial obligation and ROI

Leases are more difficult to terminate than management contracts because they create a vested interest in the property for the operator

 

Operator

Advantages

Disadvantages

The operator retains total control over operations

The operator incurs all the operating financial risk

The leasehold value created by the hotel can be realized through a sale (if the lease contract allows it)

When the lease term expires the operator loses its rights on the property

The operational upside is retained solely by the operator

The leasehold loses/decreases its value as the term come to an end

A lease could be a vehicle to enter specific markets / destinations where HMA’s are not possible

Leasehold interests are a liability on the balance sheet that could negatively affect value

Under a lease structure, the hotel company (lessee) holds the entire financial burden. The hotel company in this case is a tenant and assumes all operating responsibilities together with all the financial obligations; therefore, it enjoys the benefits if the property is successful but suffers all of the losses if the property does not perform adequately. The hotel company receives all of the profits, after rents have been paid. Rental structures can vary depending on the amount of risk that the investor is ready to take. Some of the possible options are:

  1. Fixed rent: this is a fixed rent with indexed growth. This form of lease structure has a guaranteed return, which bears the least risks for the property owner;
  2. Combination of fixed rent & share of revenue: in this scenario, 70% - 80% of the expected guaranteed return by the owner is paid as fixed rent and balance based on a percentage (to be agreed) from the revenue. At times there is a percentage on room revenue and a different percentage on F&B revenue
  3. Share of Revenue: in this variable lease scenario, the rent is calculated on the amount of revenue generated (typically ranging from 18-25% of revenue). In this case, the property owner shares some of the risks linked to the level of performance of the hotel. They do, however, have the opportunity to assess the performance of the hotel against market data;
  4. Share of Net Operating Income (NOI): in this variable lease scenario, the rent is linked to the NOI after all the operating expenses have been deducted. This scenario carries the highest risk to the owner, as it also includes the operating risk of running the hotel. Owners are normally staying away from this scenario.

Methods and Principles of Development;

  • At times, the owner builds out the hotel on a turn-key basis to operators’ specifications and provide interior finishes, FF&E’s and OS&E’s..
  • While at times, the owner builds to shell and core and tenant (operator) is responsible for the interior design and the installation of fixtures, fittings and equipment.
  • A 3rd method could also be; the owner builds shell-core-mechanical. All the remaining costs consisting of interior finishes, FF&E’s, OS&E’s split between owner and operator.

Important: the amount of rent is reflected accordingly to the method of development.

Following is the summary of basic terms/guidelines and conditions for a hotel lease:

Note that all terms and conditions are to be negotiated

  1. Lease Term

Within the range of 10 to 40 years, normally 25 years, and in accordance with the Civil Law of the country.

  1. Renewal

Renewable for another several periods of 5-10 years.

  1. Rent

Rent is usually consisted by a mixture of base rent with variable rent, whereas variable rent is linked to either gross sales or GOP and in some case also on NOI. Rent levels are determined based on future forecasts and development costs with a minimum rent typically calculated at in line with future forecasts.

  1. Rent Payment

Base rent is payable quarterly in arrears, or in some case, monthly in advance. Variable rent is paid in arrears reflecting the actual operating results.

  1. Rent Revision

Usually, base rent is escalated on a predetermined schedule.

  1. Deposit Money

(Land-Building-FF&E)

There are no standards for deposit money. This clause will be based on the country/law requirement and negotiations.

  1. Maintenance & Repair

Day-to-day maintenance and repair fee is borne by lessee. Large repairs to structure, heavy equipment and machinery are borne by lessor.

  1. Utilities

Utilities are borne by lessee.

  1. Interior Design

Varies from case to case. If lessor invests in interior, rent will be increased in accordance.

  1. FF&E’s

In some cases, lessor purchases FF&E up to a pre-determined amount before opening and leases it to lessor where rental fee for FF&E is included in total rent. In some cases, lessee purchases the FF&E’s and amortized accordingly.

  1. OS&E’s

Based on negotiations and agreement. If purchased by lessor it will be reflected in the amount of rent. If purchased by the lessee, it is normally amortized within 5 years.

  1. Pre-opening Budget &

Working Capital

Normally provided by the lessee and amortized accordingly.

  1. Employees

Normally responsibility of the lessee.

  1. Licenses & Permits

Normally by the lessee.

  1. Early Termination by Lessee

Not allowed unless lessee continues to pay the rent until lessor finds a new hotel tenant.

  1. Renovations
  1. Renovations affecting the structure, heavy equipment and machinery are subject to lessor’s approval, and expenses are borne by lessor. In some cases, base rent will be revised in accordance to the capital expenditures incurred by lessor.
  2. All other renovations by the lessee.
  1. Assignment by Lessee and Sub-lease

Assignment of main lease not allowed except for sub-leases, which are indispensable for the hotel operation, such as florists, beauty salons, photo studios etc.

  1. Disasters & Force Majeure

Both lessor and lessee to be properly insured. Based on the severity, the lease may be suspended without penalty. In case of permanent closure, both parties assume financial obligations.

  1. Insurances

Casualty insurance covering damages to structure, heavy equipment and machinery is borne by lessor. All other insurances borne by the lessee. The Owner should be co-named as a beneficiary on over-all building and liability coverage.

  1. Cancellation

Standard cancellation conditions such as:

  • Default of payment by lessee and not remediable for a certain period of 4 to 6 months.
  • Bankruptcy of lessee or enforcement against lessee.

As penalty, lessee is obliged to pay a pre-determined penalty such as all the rent for the remaining period or an amount equal to several years’ rent.

  1. Taxes

Property taxes are borne by lessor.

  • Sales & operation taxes by lessee.
  • Profit taxes proportionate to income of each parties
  1. Succession of Hotel

Business

In case of termination and the premises will be still used as a hotel, lessee will transfer all permits and licenses necessary to operate the hotel and to assign equipment leases and concession agreements.

Lessor or the new lessee will endeavor to take over the necessary interior & FF&E from the old lessee at the then fair market value and to take over employment of the personal hired by lessee.

  1. Restoration to Original

Condition

In some cases/countries, lessee is obliged to restore the premises to its original condition including removal of all FF&E at its own expense. In some cases, lessor has the option to buy FF&E at the then fair market value if it will continue to use the premises as a hotel.

  1. Capital Reserve

Normally not part of the agreement but advisable that both parties maintain a reserve for this.

  1. Non Competition Area

Normally not as strict as HMA’s & franchises but must be included in the agreement covering both sides.

“Rule of thumb”

  1. Objective of a lease agreement is to benefit both the lessor and the lessee. Both have to accept that with a rent of over 25% of GOR, the lessee will not make any profits.

(Of course all depends on who invests in what. If owner provides FF&E’s and OS&E’s, including replacements, rent can go up to 25% of GOR. If lessee provides for some FF&E’s and OS&E’s, rent could be around 20% - 22% of GOR.)

  1. The agreement must have a “termination clause” and a “force majeure clause”, both are difficult to negotiate and it should cover both sides. Note that there are no precedents on pandemics like the present COVID-19 therefore it takes a bit of negotiations by both parties and both have to take risks.

Notes

  1. In most cases, particularly for listed hotel operators, a fixed lease payments with obligations beyond a number of years, has to be disclosed as a liability on their balance sheets. This is one of the main reason for operators to stay away from leases if they can. Using variable lease payments based of the GOR and NOI may circumvent part of this requirement.

 

  1. Japanese Hotel Leases:

In most case, lease contract is signed between the real estate owner and a local company established for the purpose of leasing and managing the target hotel. It is very rare that the hotel operator signs a direct lease contract with the real estate owner. The local company simultaneously enters into a management agreement with the hotel operator. It is the local company that actually hires personnel and runs the daily hotel operation, and pays management fee to the operator and rent to the owner respectively.

A standard Japanese hotel lease scheme;

A standard Japanese hotel lease scheme;

With respect to the control of the local company, the hotel operator normally holds the majority (or full ownership).

Conclusion (Leases);

The main advantages owners find in leases are the stable, predictable returns and the resulting lower degrees of risk. This makes obtaining financing easier and appeals greatly to institutional investors. However, as leases are generally not the preferred operating model for brands and management companies, it can be difficult to attract capable operators, particularly in the case of smaller and strategically less-important properties. Furthermore, the fixed payments come at the cost to the owner of profiting from the upside of the business when the hotel is performing strongly (in the cased of fixed leases).

From the tenant's perspective, a lease offers a high degree of control over operations, positioning and the product itself. In good times, operators can receive more than they would have under a management contract (depending of course on rent levels), as all profit after expenses and rent go straight to their pocket. In difficult times, however, the obligation of meeting rent payments creates additional risk and a debt-like liability on the balance sheet. As mentioned previously, variable leases might defer this problem, but it does require an owner willing to share the risk of the business.

Lease agreements require lengthy negotiations.

D: FRANCHISE AGREEMENTS

Definition: An agreement between a hotel owner (franchisee) and a hotel company (franchisor) where the franchise company allows a hotel to use its services, brand standards/operations manuals, business model, and trademark in exchange for fees based on services provided and on a percentage of the hotel's turnover/top-line. The overall principle of a franchise agreement is that the franchisee (owner) operates its own hotel, in compliance with the brand standards and retains all risks and liabilities of the business.

A franchise agreement is normally negotiable and can range in duration of 10-20 years to even an undetermined amount of years. In the hotel industry franchises are common in many parts of the world as they allow independent hotels to benefit from the marketing power of international hotel brands or companies. Thereby allowing them a greater reach far beyond anything their own resources could buy. Additional to this the franchisee benefits form professional advice, standards of operation, simple business accounting, sales and marketing support, training programs, and others. On the other hand, being a franchisee means full compliance with the standards of the trademark.

The importance of selecting the appropriate brand for a hotel resides in the impact it will have on the positioning of the hotel within the market, its capacity to maximize the RevPAR, and develop/maintain a healthy business relationship between the two parties. Typically, whether a property is an existing or newly-built hotel is not an issue as long as the brand is a good fit for the type of product and the positioning of the hotel.

Clearly, franchise agreements have become more established in most markets in North America, Europe, and some parts of Asia and are increasing in popularity and acceptance. Overall, the trend of growing interest in franchising is increasing.

Franchise advantages and limitations

Party

Advantages

Limitations

Owner

  • Full operational control within brand standards
  • Instant market presence and access to global distribution systems
  • Access to Development, Design and Operations support from brand
  • Stronger upside potential for profits after fees (5%-6% of rooms revenues)
  • Experienced operating team or third-party operator required plus management effort
  • Operating loss risk + fees payable
  • Lack of control over brand reputation
  • Bound to brand-imposed global initiatives

Brand Company

  • Growth of brand with minimal investment and effort
  • Increased brand fees with minimal investment and effort
  • Low market risk and no operating risk
  • Ability to terminate if non-compliance issue
  • Risk of quality of operation, guest and employee satisfaction, and brand image
  • Fees limited to franchise fees
  • Lack of control over operation, renovations, and owner behaviour/reputation.
  • Less control over late payments.

Most important terms to address in a franchise agreement

  1. Fee structure: Type and calculation of fees including initial fees, royalty fees, brand services/marketing fees, loyalty fees, technology fees, and others as necessary (see franchise fees).
  2. Payment of fees: Specify if payments are done on a monthly-bimonthly-quarterly basis and penalties for late payment.
  3. Term: Number of years of the agreement and extension/s. Normally 10 – 20 years.
  4. Owner responsibilities: Develop and maintain the physical product in line with standards as established by the brand and comply with all operational quality standards of the brand. Participation in the reservation system, loyalty program, and other marketing programs as specified. Operate in "high moral and ethical standard" which is subject to brand audits.
  5. Brand responsibilities: Provide all standards manuals including training, operation, signage specifications, etc. Provide access to the reservation system and market the hotel in line with all other hotels within the system. Provide assistance and business leads. Provide access to special/negotiated deals made with travel agent commission (OTA's), bulk purchases and other related.
  6. Brand standards: Update standards in line with brand, market and demand. The objective is to maximize the gross revenue of the hotel.
  7. Indemnification: Owner indemnify the brand, not the other way around.
  8. Transfer and changes in ownership: The franchisor must know who they are doing business and the franchisee to notify the franchisor before a transfer is done. Right of first refusal to be part of this clause as well.
  9. Renovation requirements: Owner is expected to replace soft goods every 6-7 years and case goods every 13-14 years. The property must be in good competitive shape at all times.
  10. Brand inspection rights and quality assurance programs: Regular audit inspection by the franchisor with the objective to ensure compliance with quality standards, security & safety, hygiene, employees and customer satisfaction programs, etc.
  11. Risks and liabilities: Franchisee assumes all risks and liabilities and covered with all necessary insurances including employees, guests, property, and others.
  12. Disasters and force majeure: This must be addressed on the agreement as it may impact the temporary closure of business and how to handle it.
  13. Geographical/non-competition area: This can be addressed by defining a radius where the franchisee will not franchise nor operate a similar brand/product.
  14. Termination: This clause is also a must addressing eventual termination and compensation.
  15. Pre-opening technical services: If the franchisee requires this service from the franchisor a separate agreement is to be made specifying the role-objective-timing-fees. It is advisable that this service is provided with the objective of achieving quality and consistency.
  16. Others: As appropriate/required for each agreement.

FRANCHISE FEES

  1. Initial Fee: The initial fee typically takes the form of an amount based on the hotel's room count. The objective of the initial fee covers the franchisor cost of the site inspection, market assessment, evaluating the plans or existing layouts and facilities, recommendations, and others. This fee is typically paid (either partly or in full) upon the approval of the deal but more often brands are waiving this fee.
  2. Royalty Fee: This is the main source of revenue for the franchisor. The fees are characteristically subject to negotiations between both parties and can vary by brand-location-size of the property. Typically from 2.0% to 5.0% of rooms revenue. In some instances, there is also a small fee for food and beverage revenue in the amount of 0.5% to 1.5% of total food and beverage revenue.
  3. Advertising and marketing Contribution Fee: Those fees normally vary by market/country and cover the franchisor costs to advertise the brand in the various types of media, internet, distribution, and others at times, some of those funds are spent/used in the region where the hotel is located and in the sources of business. The amount is normally based on a percentage of room revenue and it ranges from 1.0% to 2.5% of the room revenue.
  4. Reservation Fee: There are various methods to calculate this fee. In some cases, a fixed amount for each room generated by the brand's distribution channels. In other cases based on a percentage of room revenue generated by the brand's distribution channels. And in some cases based on an amount per room per month. Normally the hotel pays for one of those fees based on negotiations/agreed by both parties.
  5. Loyalty Program Fee: This is more of a reimbursable of the cost incurred by the franchisor to operate the program. Fees are normally based on a percentage, typical between 2.0% and 5.0% of either rooms or total revenue generated by a program member staying at the hotel. The payment of this fee is strictly based on the business received by the hotel.
  6. Miscellaneous Fees: Those are not standards and are based on the needs of the hotel. Typically for third-party suppliers for an additional system and technical support, additional training programs, annual conferences, combined (group-wide) additional sales and marketing activities, purchasing assistance, and others. Normally the amounts of those fees are not specified in the agreement as those are based on needs and costs vary from year to year.

Notes

A number of hotel organizations have not been comfortable on franchising their deluxe top of the line products/brands unless they needed to enter a specific important market or they had a previous relationship with the franchisee. In general, hotel groups have the tendency/preference to franchise their mid-market brands but this is changing rapidly as demand for franchising is growing in most parts of the world and hotel groups must expand their network footprint in order to compete.

A one-size-fits-all approach to franchise agreements is not possible owing to the independent nature of countries and regions around the world. Different countries impose different regulations and disclosure obligations, and hotel groups must be adept at understanding these as well as the expectations of local owners in order to remain competitive and expand their brands.

Important to remember that successful deals/agreements are the ones where there is a Win-Win situation between franchisee and franchisor.

E: OTHER TYPES OF AGREEMENTS

  1. Affiliation/Marketing Agreements

Affiliation Agreements with hotel marketing organizations are becoming more popular and in demand. Most of those Hotel Marketing Organizations (also referred to as Consortia Hotel Companies) are based in Europe and in the USA. Examples; The Leading Hotels of the World, Preferred Hotels & Resorts, Relais & Chateaux, Historic Hotels of America, Small Luxury Hotels of the World, etc.

FYI, note the Hotels Magazine 2020 survey of the top 25 Hotel Marketing/Consortia Companies in the World with Hotusa Hotels (Spain) at the top of the list with 297,430 rooms and 3,032 hotels. While the smallest of the 25 listed marketing hotel group is the Brit Hotel Development (France) with 6,675 rooms and 3,032 hotels. In comparison, the Leading Hotels of the World (USA) group is listed as no. 7 with 61,000 rooms and 406 hotels around the world.

In order for a hotel owner to be part of one of those organizations, the hotel must meet the quality of the physical product, the facilities, the size, the reputation/position in the market, management consistency, and others. Fees are based on a monthly/annual fee, plus a percentage of the room revenue generated by the organization's distribution channel, advertising & marketing contribution fee, and others as per the agreement between the two parties. Normally the territorial restriction, the SOP's, and in some cases the loyalty/recognition programs are part of the agreement.

  1. Soft Brand Concept Agreements

The soft brand concept is designed by the large global hotel groups with the objective to appeal to independent hotel owners who yearn for access to the large brand loyalty program and to its global distribution network without having to sacrifice their properties' own unique branding identities. Those hotels are independently owned and operated with distinct local character, personality, and authentic sense of place.

As the future will bring with it new customers, looking for unique, local and authentic experiences, these new travellers/businesses/demographics, will have higher expectations.  There will always be disruptors and new trends/competitors; hence the owners of individual (unbranded, unaffiliated) hotels can grow their business with the distribution and loyalty programmes of well-known global brands while maintaining their individual local style and entrepreneurial business approach.

The most active hotel groups promoting the soft brands are;

  • Marriott Group with its Autograph Collection and Tribute Portfolio.
  • Hilton Group with its Curio and Tapestry Collections.
  • Hyatt Group with the Unbound Collection.

There are others as well in operation and/or in the pipeline.

Fees normally are based on a monthly/annual charge per room, plus a percentage of the room revenue generated by the brand’s distribution channel. The cost of their respective loyalty programs is additional and based on a percentage of the revenue generated by members staying at the hotel. In addition, a contractual contribution for group-wide Sales & Marketing initiatives should be expected.  Some optional buy-ins are offered for specific markets and segments relevant to each hotel.

  1. Digital Disruptors – OTAs Agreements (a new out-of-the-box alternative)

While relatively new, an alternative to the traditional hotel marketing agreements mentioned in this document, is a dedicated affiliation with one or more of the OTA conglomerates (ie Expedia Group, Bookings.com Group, etc.) whereby a hotel in a high-demand market agrees to contract out their entire rooms inventory to one of these OTAs in lieu of soft-brand or independent affiliation. This implies contracting out the marketing and sales department, loyalty program, revenue management, etc.  We should expect to see more of these approaches in the near to medium term, first in North America then gradually in other parts of the world, Europe, Asia, etc.

Yes, a new approach but it has its own merits. The hospitality industry has to accept that OTA's organizations are here to stay as they have been recognized as key agents in the travel distribution. And most importantly, they do generate a substantial volume of business for all sectors of the travel and tourism industry, hotels in particular. In most cases, OTAs have been able to convince a high percentage of travelers that they have the best deals.

Originally considered disruptors by the hotel industry, OTAs have been successful at what they do. With their reliable and effective platform, their worldwide presence/activities, their deeper marketing pockets, their capability of offering a one-stop-shop to travelers, OTAs are in general more active and engaged during the whole booking process. In addition, they have developed their own loyalty programs, and are able to share information about the traveler's experiences.

Definitely worth exploring further. Perhaps not for the luxury-top of the line products but definitely for all other hotel categories. Assessing the pluses and minuses of the business formula-process-logistics and ultimately the financial benefits of this alternative agreement could be an interesting study and an "out of the box" approach for both sides.

Digital Disruptors – OTAs Agreements (a new out-of-the-box alternative)

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