Hotel management agreements

Most branded hotels are operated under either a lease, management contract or franchise, or a combination of these options. Each of these models creates a separation of some sort between the investment in the real estate element of the hotel and the operation and/or branding of the business element. Over the past few decades hotel brands and operators have increasingly pursued more capital light growth and used these models to drive expansion in partnership with real estate investors.

In this article we focus on hotel management contracts and, as an introduction, discuss some of the main terms that they cover. Large parts of these agreements cover issues over which the owner and management company are not aligned, and a balanced contract usually requires robust negotiation.

What is a hotel management contract?

Under a hotel management contract, the owner of the hotel real estate and business appoints a management company to operate the hotel business on the owner's behalf. Some management companies are also brand owners, in which case the hotel will be operated under the management company's brand. The owner remains the owner of the real estate and the business and retains the majority of the risk and reward from operation, but pays a fee to the management company, which is responsible for the day-to-day management of the hotel.

Term and renewal

Management contracts can be very long term contracts. Larger, branded management companies are particularly concerned to secure flags for their brands that will be there for decades. To some extent the value of their businesses relies on holding long term contracts. With those types of management company a typical term may be around 20 years, but in some cases substantially longer once renewal rights are taken into account. The management contract is likely to be structured so that the management company stays in place on a sale of the hotel, which can be particularly relevant for investors that have a specific intention to dispose of an asset within a certain period of their investment.

Smaller management companies will offer more flexibility and shorter terms to owners, and some will work on a very short term basis in turnaround type scenarios. They will often allow 'break rights' of some kind in the event of a sale of the hotel, most likely for a fee. The level of that fee will vary and often be dependent on remaining term of the management contract.

Performance-based termination

Most management contracts will contain some kind of right for the owner to terminate based on poor financial performance by the hotel. The most common forms of performance test look at either how the hotel’s revenue generation is performing against a peer group or how the hotel is performing against budget, or a combination of these.

However, overall these are normally fairly weak tests, based over several years, and with various carve outs and cure rights for the management company that can make them essentially toothless.

Management company fees

Management companies will typically be paid a 'base fee' which is a percentage of revenue, and an 'incentive fee' that is a percentage of operating profit. Clearly, from an owner's point of view, a greater emphasis on the incentive fee will align the management company more with the owner's commercial position.

There are many ways to structure the fees to alter the balance between the parties. For example, in some cases a management company might go further and guarantee minimum levels of profit, usually subject to some sort of cap on exposure; or alternatively agree not to take or defer its fees until minimum levels of profit are being earned for the owner.

In addition to the headline fees, management companies will often charge a large number of additional fees for centralised system services covering areas such as marketing, reservations, HR and accounting. Some of these can be in place of a service that the hotel would otherwise have to undertake, and staff, in-house which may result in a cost saving for the owner. However, in general, owners should try to obtain as much clarity on these charges as possible and they should not represent another way for management companies to make profits from the arrangement.

Working capital and bank accounts

As the hotel business remains the owner's under the management contract, and the owner retains most of the risk from the operation of the business, the owner provides the working capital required for continued operation of the hotel as and when it is needed. The management company then operates the bank accounts of the hotel on behalf of the owner, collecting revenues and paying operating costs.

At the end of each month the owner is then transferred from the bank accounts any cash in excess of that needed for working capital and payment of operating costs.

Asset management

Day-to-day control of the hotel is undertaken by the management company, but there should always be certain important matters that require the consent of the owner. The management contract should also include detailed reporting and regular asset management meetings between the management company and representatives of the owner.

Matters over which the owner would typically have approval rights include:

• the appointment of key staff;
• the annual budget;
• high value and or long term contracts;
• high value litigation.

Capital expenditure

The furniture, fittings and equipment (FF&E) in a hotel are often exposed to heavy use and must be replaced or renewed on a regular cycle to avoid a deterioration in the hotel product/brand and its ability to generate income. The owner will be responsible for funding this expenditure. Often the management contract will require a percentage of revenue (typically 3-5%) to be put into a separate reserve each month to ensure that funding for such expenditures is available when needed. If the amount required at any time exceeds that available in the reserve, then the owner will typically be required to fund the shortfall.

In addition, particularly in management contracts for branded hotels that are required to meet evolving brand standards, owners are required to provide capital to invest in improvements to the hotel from time to time. This can be a particularly problematic area in the management contract and owners will often wish to obtain concessions to protect against unreasonable calls for further investment.