How does a management agreement work?

A hotel management agreement is an agreement under which the owner of the hotel appoints a hotel operator to manage the hotel business on the owner’s behalf. The operator provides management services and gives the owner a right to use its brand name and access to the operator’s central reservation system, loyalty programmes and sales and marketing programmes. In return, the hotel owner pays the operator fees.

This can be distinguished from a franchise, which is mostly a brand licensing arrangement. Under a management agreement, the business owner outsources day-to-day control of the business to a specialist hotel operator. Under a franchise, the owner continues to operate the hotel itself.

It is possible to combine a franchise and a management agreement and license a brand from one branded hotel operator under a franchise and also appoint another “white label” operator to manage the hotel on a day-to-day basis.

Real estate investors and managed hotels

Most real estate investors who have not invested in managed hotel before will be used to receiving their income in the form of rent. However managed hotels are one of the few passive real estate investments where the owner receives trading income, rather than rental income.

As a result, real estate investors new to managed hotels have to get used to a number of factors:

  • Business risk – the owner assumes primary business risk and liabilities, in exchange for receiving all of the profits after management fees.
  • Tax treatment of trading income.
  • Employment of staff –the owner is typically the employer of the hotel staff.
  • Capital expenditure – the owner has to fund capital expenditure on the furniture, fittings and equipment (FF&E) as well as the property.
  • Working capital – the owner is responsible for ensuring that the hotel has sufficient cash to cover operating expenses as and when they arise.

These types of operational management agreements used to be unique to the hotel industry, but we are now seeing very similar arrangements used in other operational real estate investments such as student accommodation, serviced apartments, data centres and restaurants.

Typical management agreement terms

A branded hotel management agreement is usually a long term arrangement – anything from 15-40 years or more in length. Operators will seek to restrict any termination by the owner. Owners will seek to retain some termination rights, but to do so often comes at the expense of an agreed termination fee or other terms that may be more onerous than if there were no termination rights.

In good locations, operators are keen to get long-term contracts and will often pay the owner a premium, known as key money, to secure an agreement with minimal termination rights.

Unbranded management agreements are typically much shorter and often have more flexible termination rights.

The fees are usually expressed as a percentage of hotel revenue, plus a percentage of profit. The percentages may change over time or may change depending upon the profit margin achieved by the hotel. The key for an owner is to ensure that the overall fee arrangements are structured so as to ensure that the interests of the operator and the owner are aligned and if the hotel is successful, both parties will share in that success. This incentivises the operator to deliver outperformance.

Managing underperformance

From an owner’s perspective, it is important to ensure that not only is an operator rewarded when the investment outperforms, but also that the operator is penalised when the investment underperforms. This can be achieved through a number of levers, such as ratcheted fees (fee rates change with margin), owner’s priority return (profit threshold for payment of certain fees) and performance test (the right to terminate without compensation if the operator underperforms against defined key performance indicators (KPIs)).

Optimising the structure

The exact structure of the hotel management agreement on each hotel will depend upon the particular requirements of the owner/investor, its lender, the operator (and the brand owner if different) and whether the management agreement is being put in place for a new development, a conversion or an existing hotel that is re-branding. Experienced advisers can advise on the optimum structure for any given circumstances.

 

CMS

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