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Is a Profit-Driven Hotel Management Agreement Fairer? Hotel owners and operators jostle for the upper hand in contracts

A hotel is a single asset but often operates within a binary relationship between the property’s owner and its manager. Legally binding them is the hotel management agreement, or HMA, which dictates the terms of their partnership, outlining fiduciary duties and other provisions.

And while the hotel management agreement is standard, its construction oftentimes varies, dependent on myriad variables, chief among them, how the operator is remunerated for its work.

One of the cornerstones of the HMA is the fee conditions, which, traditionally, dictated the hotel’s operator receiving a 3-percent base fee of the property’s gross revenue and a 10-percent incentive fee off its gross operating profit. This common arrangement isn’t entirely equitable: the hotel owner at a disadvantage since the base fee is contingent on maximizing revenues and does not incentive operators to minimize costs. The operator, in order to boost revenue, could spend lavishly, for example, on sales and marketing—costs that the owner oftentimes incur.

In today’s operating environment, profits are under a constant squeeze, as things like labor becomes not even more difficult to find, but more expensive, leading to profit-margin erosion. It begs the question: do hotel management agreements need a makeover? More precise, do they warrant a further shift from revenue-based agreements to ones more inclusive of operator remuneration based off profit?

Depending on whom you ask, the answer is different.

“From the owners’ point of view, you want your operator to be incentivized on profit,” said Felicity Jones, a partner at law firm Watson Farley & Williams, which represents both hotel owners and operators in negotiating management agreements. The main incentive fee is on that—gross operating profit. She goes further; floating the idea of removing the base fee altogether. “If operators are recharging for services—from accounting support to revenue management— what is the base fee for?” she asked.

Others, who own hotels, aren’t as quick to marginalize the operator; if for nothing more that it’s one less thing to worry about. “Look, at the end of day we are ultimately out for profitability, but having someone else operate your asset gives you time to focus on other areas, so it is well worth the fees,” said Heetesh Patel, a principal with Neves Investments, which both owns and operates hotel.

That doesn’t mean he enjoys the volley of fees that come with representation. If an owner engages with a brand franchise and a third-party manager, it’s plausible that it will pay out at least 15 percent of the asset’s gross revenue, in addition to whatever incentive fee the owner pays the manager.

Hotel operators have a place within the hotel industry for a reason: the good ones produce results; many have proven methods to bolster revenue and institute cost-saving measures. If they couldn’t deliver, then there wouldn’t be well over 100 such companies in the U.S.

In fact, according to Chris Green, COO of Chesapeake Hospitality, which manages more than 30 hotels in the U.S., a skillful operator can produce on behalf of an owner, if they are allowed to do their job with minimal interference.

“Owner over-involvement is what can cause performance issues,” he said. “Just because you own a hotel, doesn't mean you know how to run it.”

For Patel, tapping a management company always comes down to arithmetic. They calculate their forecasted ability to drive profitability and “if they can beat us, we'll give them that piece of the pie,” he said.

Patel does acknowledge that HMAs still skew in favor of the operator, but he’s willing to sacrifice that to take one more thing off his plate. “They have the advantage; you as an owner gives up lots of rights and decision-making and holding them accountable is difficult,” he said. “But as you move to larger portfolios, you focus on one or the other. We are focusing on development.”

Kristie Dickinson, an EVP with asset manager CHMWarnick, finds third-party operators to be more flexible on HMAs than their branded counterparts, in particular as it relates to fee structure—”often a lower base fee and more incentive weighted,” she said—shorter term lengths and provisions that more readily allow for selling the asset unencumbered, “which has a real value for owners on disposition,” Dickinson said.

The Beginnings

The hotel management agreement dates back more than 50 years as a method for asset-light growth of hotel companies, the likes of Hilton and Marriott. These companies realized that they could excel, prosper and grow on the back of their names rather than their balance sheets. Instead of owning real estate, they could earn fees by managing hotels that carried their flags, and later franchise those names, creating a whole new dynamic.

Hotel management agreements have historically skewed in favor of operators, though have been challenged in the past. Cases like Woolley v. Embassy Suites, Inc. (Cal App 1st Dist 1991) nullified the dominate position of hotel operators within management agreements by deciding that the hotel operator was beholden to an owner, the principal-agent relationship.

Meanwhile, brand managers have successfully petitioned to swing the HMA back in their favor. Consider Marriott International, when in 2005 the Maryland legislature passed a law that became part of the Commercial Law of the Code of Maryland. The statute provides that if a conflict arises between the agent and principal, “the express terms and conditions of the operating agreement shall govern.”

The statute acceded control back in the hands of the operator and is why, regardless of where a hotel is situated, many companies seek to have contracts governed by Maryland law.

Other cases have helped further solidify the operator’s position, such as Marriott International, Inc. v. Eden Roc, LLLP (N.Y. Sup. Ct. 2013), which found that a hotel management contract was a personal services contract under New York law, and was therefore exempt from injunctive relief.

An Evolution

Termination parameters are only one part of the hotel management agreement, which serves as a blueprint or guide of the parties’ relationship; to know what each party’s obligation is to the other. Today, for instance, the 3-and-10 rule is less uniform.

“Contracts have changed,” said Juie Mobar, Director of Special Projects for consultancy Hotelivate. Prior to joining the company, she, along with colleague Manav Thadani, worked for HVS and collaborated to author the “HVS Guide to Hotel Management Contracts.”

“Operators are becoming more flexible and understanding of owners, who are now more sophisticated. There is further room for negotiation and because of that, they are holding their own at the table. A lot of terms that were standard are now being negotiated.”

At the heart of the HMA are the fees the operator derives off revenue and/or profit. According to Dickinson, this arrangement has gone askew. She contends that more than a decade ago revenue-based fees were more aligned than they are today. “There was a more reliable correlation between RevPAR and profit; so much of the old methodology for calculating fees was more owner friendly or created some semblance of alignment,” she said. But as industry dynamics have evolved, “this methodology is no longer effective.”

As an example, Dickinson said that 15-20 years ago profit margins on rates were much more consistent—"If you got $1 in rate, you generally knew exactly how much you were going to flow to the bottom line. Today, there is so much variability in the cost of a roomnight based on what channel it comes in from, that we have to look at Net RevPAR to even understand the true value of a roomnight, which can look very different than top-line performance,” she said.

Net RevPAR is a KPI calculated by room revenue minus direct customer acquisition costs such as commissions, transaction fees and loyalty expenses. In today’s balkanized, fragmented booking structure, highlighted by a glut of diversified reservation options, understanding costs tied to customer acquisition is paramount.

On a per-available-room basis, Net RevPAR, as a moving average total, has been on a descent since May 2018, according to HotStats data tracking the number. It had been on an incline since October 2015, topping out at $161.48 in April 2018 on a moving average total. It’s fallen since, and faster than the rate of RevPAR, which is also trending down.

As a practice, rewarding operators on the top line is a cautionary tale since top-line fees encourage capturing any type of business, not always the right kind of business, or the most profitable mix of business. “Not all RevPARs are created equal,” Dickinson said.

Some, like Jones, don’t see the typical contract straying too far yet from where it is currently. Where she does see room for change is in the incentive structure—that fee percentage an operator receives for how well it can generate profit, which, for an owner, is what matters most.

“In terms of incentive fees, if the adjusted gross operating profit is a certain level, they’ll get more upside if they create more upside,” she said.

Meanwhile, others who negotiate management agreements do see movement in fees. Richard Bursby, a corporate partner and leader of law firm Taylor Wessing’s Hotels & Leisure group, said fees are reducing specific to management agreements tethered to a brand operator, like Marriott. “We are seeing base fees now much closer to between 1.5 percent and 2.5 percent. Anything above 2.5 percent is unusual,” he said.

That was not the case 20 years ago, when base fees topped out as high as 3.5 percent. Now, though management contracts are still lopsided in favor of the operator, Mobar contends there is wider adoption of profit hurdles, as “owners try to get more for their money.”

According to HVS’ 2017 Guide to Hotel Management Contracts, which had a sample set of 475 hotel management agreements, more than half of which were from the Americas, the stabilized average base fee for the global sample set was 2.81 percent.

While operators still may have the upper hand, the gap is narrowing. Part of that is because of an ever-growing number of hotel management companies competing for a limited number of assets.

As the former VP of Legal at Starwood Hotels & Resorts Worldwide, Daniel Braham has years under his belt working with owners and third-party operators. Years ago, he said, gaining management contracts was akin to shooting fish in a barrel. “The operator could pick and choose whoever they wanted,” he said. Decades ago, the hotel owner wasn’t as savvy or sophisticated, “they didn’t understand the industry fully, so the operators had their say,” Braham said.

This paradigm began to shift in the aftermath of 9/11 as hotels suffered from a large dip in both corporate and leisure travel. And as the financial crisis settled in, financing dried up and deals abated. As a macro event, this hurt the brands. Braham contends that Blackstone’s acquisition of Hilton, in 2007, magnified it.

Post-acquisition, Hilton, in order to push growth, pursued deals at a rampant rate, sometimes conceding on management-agreement terms at the negotiating table. This, Braham said, led to other companies having to also be more flexible. “It flipped the script,” he said. Added Jones: “When the financial crisis hit, some brands agreed to work the figures.”

This was a start and meant that operators would—exclusive of direct real estate investment—share more in the risk and be more aligned with the owner.

“HMAs have improved significantly for owners so there is a greater alignment of interests,” said Bursby. He added that this is more equitable since the operator normally has no skin (equity) in the game.

One of the ways that hotel operators can show their effectiveness is by how well they can drive profit margin, or the amount by which revenue from sales exceeds costs. Overall, profit margin percentage is a good indicator of a hotel’s financial health and allows easy comparison against other hotels of similar product: If your profit margin is higher than a competitor’s, it confirms that you're operating your hotel with better efficiency. Conversely, if your profit margin is lower, it’s a sign that adjustments are needed.

One way that HMAs can bake in profit margin is by instituting performance hurdles that, if not met, can result in termination of the contract. These are certain thresholds that an operator must satisfy, and if the threshold is reached and surpassed, then the operator is rewarded for it, “so that the greater the margin of conversion of revenue to profit than the higher their fee,” said Bursby. In this example, Bursby noted that the incentive fee might start at 6 percent or 7 percent at a GOP conversion of 40 percent. It could then rise to 9 percent or 10 percent if a 50-percent profit margin is attained. “There are more variations on incentive fees than there used to be,” he said.

Not all performance tests are equal. In a sample of South American hotels in the HVS study, the majority of hotels had performance tests linked to both budget/profit-oriented and RevPAR performance, the so-called “Collective Test.” A smaller percentage are linked to GOP/AGOP/NOI performance versus budget or RevPAR performance versus the competitive set.

As HVS pointed out in the study, and in stark contrast to contracts from North America, only 17 percent of the surveyed contracts that had a budget test required the operator to attain higher than 85 percent of the budgeted GOP/AGOP/NOI, and just 20 percent with a RevPAR test required the operator to record RevPAR exceeding 85 percent of the weighted average RevPAR of the defined competitive set during the test period.

In some cases, management agreements are absent of performance tests altogether. In Patel’s case, the reason his company doesn’t institute them is purely altruistic. “We don’t want to put any undue pressure or anxiety on our partner that could prevent them from performing,” he said.

Along with fees, the length of management agreements has come down. While the 1980s saw the initial term length of a management contract in excess of 30 years, according to HVS’ 2017 Hotel Management Guide, the average length of the initial term of their global sample set was 18 years, with 33 percent of the contracts averaging less than 10 years. In the U.S., the length is lower, 15 years, on account of the glut of third-party operators who tend to be more flexible than branded operators.

Still, it’s no secret that operators prefer longer contracts with less options; owners, conversely, want shorter contract terms with multiple options, the ability to terminate and the option to sell their asset unencumbered by a management company.

“A 30-year contract with a break at 15 is more valuable than a 15-year with an extension because the operator will be worried over termination,” Jones said.

However, according to Jones, operators may assent to shorter terms, but at a price. “If an owner wants a shorter management contract, then the fees will have to go up,” she said.

Negotiating management agreements customarily comes down to leverage, and which side, the owner or operator, has it. In the hotel industry, nothing says leverage like location. If a developer has an A1 site or comes into possession of a trophy property, then more likely he will be able to negotiate favorable terms.

“A lot of it depends on where the hotel is located,” said Bursby, citing the difference between a hotel management agreement covering a London hotel versus another in Northern England.

“Revenue-based fees are coming down, but big operators won’t move exclusively to an incentive-fee model, unless for a really prestige project or location,” Braham said.

A Fairer Arrangement?

The owner-and-operator relationship is ostensibly an equitable partnership, but is oftentimes diametrically opposed. Logically, if an operator’s main source of income comes from fees off of revenue, then it will do its best to maximize revenues, sometimes at the sacrifice of expenses.

Owning anything comes with risk. On a risk-continuum scale, hotel ownership is one of the most precarious; reason, not feeling, should be the steward. Mike Medzigian, CEO of real estate investment trust Carey Watermark Investors, once called hotel ownership “an unemotional analysis. We aren’t doing this for fun; we are doing it to make money. How do you maximize the value of the asset? Who can bring you the most revenue and what happens on the cost side? It’s about maximizing revenues and minimizing costs.”

While removing the base fee altogether from management agreements is not likely to materialize, there are those that advocate for an owner-aligned management structure. This could include varied layers of compensation, but, as Dickinson said, greatest alignment could be achieved through fees based on achieving a GOP hurdle and owner priority return hurdle. “This type of structure is truly the only way owners will ever get alignment on the bottom line,” she said.

Any outcome that better aligns a hotel’s manager and owner is a positive trend and one that can find its basis at the outset of the relationship, through the terms of the management agreement.

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