Out-Law Legal Update
Individuals advised to check whether they can still claim entrepreneurs' relief
Out-Law Guide | 04 Aug 2011 | 10:42 am | 9 min. read
There are a number of structures available for the ownership and operation of a hotel. Comparatively few modern hotels are operated by their owners. Hotels are frequently operated as franchised businesses, with the franchisee taking on the style and brand reputation of a leading chain under license.
The structure chosen will often depend on the scale of investment by the investor/hotelier, and whether land ownership is an important consideration. If the hotelier would rather minimise the obligations and responsibilities that are associated with land ownership, then a management agreement is a good choice.
Hotel management agreements are usually long-term arrangements. Under such agreements, the hotel operator has almost exclusive control. The hotel owner's role is that of a sleeping partner until problems are encountered.
This guide is a summary of the most commonly encountered features of this type of agreement.
What is a hotel management agreement?
A hotel management agreement records the relationship between the owner and the operator of a hotel.
The nature of the relationship is that the operator is made responsible for the day-to-day running of the hotel, including hiring and firing employees. As well as providing accommodation, and additional functions such as conference facilities, the operator will take reservations and conduct the marketing and promotion of the business. The operator will be responsible for routine maintenance and will procure other capital projects needed for the hotel, although these will typically be authorised and paid for by the owner.
The negotiation of the hotel management agreement, focussing on the respective rights and obligations of the owner and the operator, is critical to the financial success of the hotel business and the return on the owner's investment. The first draft of the agreement will usually be offered by a prospective operator. The operator will usually seek a long-term right to operate the hotel under the operator's brand to standards commonly used across that operator's group of hotels. It will usually be heavily weighted in favour of the operator, such that the owner has little or no input in the business operation but is expected to finance the whole operation.
The owner will want to negotiate the terms of the agreement and introduce some balance, giving the owner rights and remedies if the hotel business experiences financial concerns. The scope to add balance to a hotel management agreement may depend on the allure of the hotel to the operator – if it is a prestigious hotel, in a good location, the operator will be more likely to negotiate.
Hotel management agreements can be long and sometimes complex, but many of the same issues frequently arise.
Avoiding tenancy rights
The owner should be careful not to accidentally create a tenancy under which the operator will enjoy the rights of a business tenant. This risk arises because the management agreement, if incorrectly drafted, can have the two basic features which are required for the grant of a lease: exclusive possession of the premises for a defined period of time.
If the owner's interest is leasehold, care needs to be taken that the inadvertent creation of a tenancy does not breach the terms of the owner's own lease.
The operator's fees
The operator's remuneration for the provision of services under the hotel management agreement is usually provided for as a fee which, in effect, is an operating expense of the hotel business. This fee must encourage the operator to perform well, but the owner's return will be reduced by the deduction of the operator's fee before any profits are distributed.
Fees can be calculated by reference to various formulae. Typically, the operator's fee will be subdivided as follows:
GOP is calculated by deducting operating costs from gross revenue, but there can be debate over what is considered an operating cost for the purpose of ascertaining the operator's fee and what is a financial risk which should be borne by the owner. Other measures of performance can be brought into play, such as RevPAR (revenue per available roo) and ROR (room occupancy rate).
The management agreement should enable the owner to restrict the operator's ability to incur certain types of expenditure that may result in increased revenues, and therefore a higher base fee, but which may not correspond to increased profits - for example, sales promotions. Best practice leans towards the agreement of an operating budget with projected profits which the owner is able to review from time to time.
It should be noted that the relationship between owner and operator is increasingly governed not only by the traditional management agreement but also by parallel arrangements such as licence, royalty or service agreements. To fully assess the value of payments due to the operator, it is necessary to assess the fee requirement of these parallel contracts.
Duration and renewal
Operators typically prefer long initial terms and several long renewal periods exercisable by the operator. The owner may prefer a shorter duration without specific renewal rights – if the hotel is a success, renewal will be in both parties' interests.
Differences have emerged in practice between the terms of management agreements entered into as part of a 'sale and manageback' transaction and those management agreements which are entered into by operators on a standalone basis, for example in relation to a new development. The former tend to be longer term than the latter.
However, there has been a noticeable decrease in the average term of many management contracts recently, for the following reasons in particular:
The owner's obligations to provide working capital or otherwise finance the operation of the hotel should be clearly addressed in the agreement. The furniture, fittings and equipment (FF&E) in a hotel are often exposed to heavy use and must be replaced at regular intervals to maintain its quality, image and income potential. A fund will often be set up to accumulate capital to replace FF&E, typically a percentage of gross revenue.
Capital improvements will usually be divided into:
If management elects to postpone a required repair, this will not eliminate or save the expenditure but merely defer the payment until a later date. If a hotel has operated with a lower than normal maintenance budget, it is likely to have accumulated a considerable amount of deferred maintenance. An insufficient FF&E reserve will eventually negatively impact the standard or grading of a property, and may also lead to a decline in the hotel's performance and its value.
Division of responsibility
The management agreement should clearly distinguish between the responsibilities to be assumed by each of the owner and operator, and should specify what each party needs to provide to enable the other to perform its part of the agreement. Tension can arise as to where the residual risk lies – if action is required which is not assigned under the agreement, who should perform this task and at whose cost and expense?
Owners can fall into the trap of making assumptions as to the scope of the operator's responsibility. The operator will be eager to minimise its responsibilities and to charge extra for ancillary services which the owner may have wrongly assumed to be part of the overall package offered by the operator. The management agreement may allow the operator to charge the owner additional fees for these 'chain services', but this should be limited to only those services that can be provided more efficiently for the entire group of hotels maintained by the management company rather than on a hotel-by-hotel basis. The owner should satisfy itself that all hotels benefitting from these services are paying for them equitably.
Participation in loyalty reward schemes, central reservation systems and other brand-drive offerings provided by the operator should be considered by the owner – these can make or break the financial viability of the hotel.
One mechanism for sharing risk is for the operator to guarantee minimum levels of profit or a certain percentage return on the owner's investment, requiring the operator to fund any shortfall. There has, however, been a trend away from this type of guarantee.
The owner would prefer the hotel's employees to be employed by the operator, but this is rarely achievable. Operators take the contrary position, other than in relation to the General Manager. If the hotel's employees are employed by the owner, the owner should extract appropriate indemnities from the operator to guard against any liability to employees arising through mismanagement of the employer-employee relationship.
The owner should limit the operator's ability to be involved in other hotels which will compete for the same business as the owner's hotel. If this limitation is included, the operator will seek to limit this to hotels within a defined area.
The owner will not want to micro-manage the hotel operation but should have the ability to oversee and, in appropriate circumstances, manage the incurrence of costs and expenses so as to preserve the return on its investment. The operator should prepare, deliver and keep to operating, capital expenditure and FF&E budgets approved by the owner. Flexibility to adjust these budgets to meet changing circumstances should be considered.
Operators who run the hotel under their own brand will likely demand the right to incur expenditure so as to preserve the brand reputation associated with its goodwill and common operating standards. Care must be taken to ensure that this does not turn into a 'blank cheque' – if the operator's group decides to introduce a swimming pool in all of its branded hotels, the owner should not be forced to agree to the building of a new pool complex at its hotel.
The operator should provide complete, detailed and accurate financial data to the owner, who may reserve the right to audit the books from time to time. Maintenance of books of account should be in accordance with accepted accounting standards.
If the hotel is a new-build, the owner should have the right to terminate the management agreement if the hotel is not completed for any reason without payment of compensation to the operator.
The owner should have the right to terminate if the operator defaults under the agreement, without incurring any liability. It may reserve the right to terminate without cause, but should expect the operator to require payment of a termination fee equivalent to its anticipated return over the unexpired duration of the contract.
The owner may also extract a right to terminate if the operator fails to meet defined performance measures detailed in the management agreement, or if the operator experiences change such as being acquired by a competitor.
Business continuity on termination is important, and the management agreement should provide for a smooth transition on termination or expiry.
Even though the operator is managing the hotel on a day-to-day basis, the owner's residual liability should be addressed. If the operator acts as agent for the owner, the owner should obtain indemnities to provide for the situation where the operator exceeds its authority or otherwise incurs liability for the owner without justification.
Who owns the intellectual property rights in the hotel's processes, computer systems and branded materials should be addressed in the management agreement. If the operator retains these rights, there should be adequate protection for the owner in terms of business continuity in the event of termination or expiry of the agreement.
A fair contract for both the owner and the operator is one that balances the needs of both parties and gets the job done for the best available return. The interests of the owner and operator are not always aligned, and a balanced contract is usually dependent on robust negotiation.
Out-Law Legal Update
Individuals advised to check whether they can still claim entrepreneurs' relief