Over the upcoming months, we will run a 10-part series discussing particular provisions and concepts within hotel management agreements.
The purpose of this series is to discuss common hotel management agreement provisions and concepts. Hopefully we will touch upon one or more topics which sparks a "I've always wondered why that is the way it is but nobody has taken the time to explain it" reaction with you. We trust the discussion goes some way to demystify the topic.
Our 10-part series will cover the following topics:
- Why is the manager's fee based on hotel's revenue and profit and not some other basis?
- Why do some agreements provide that the manager is the owner's agent and some do not?
- Why does the owner employ most or all of the hotel employees (and not the manager)?
- What is the risk/reward relationship between an owner and manager?
- Why does the owner indemnify the manager?
- Why do we need a non-disturbance deed between the owner, manager and financier?
- Why the need for an area of protection?
- Why is the owner usually prevented from selling the hotel to one of the manager's competitors?
- Why does the manager impose restrictions on the owner's ability to finance the hotel?
- What is the importance of brand standards?
Today, we will kick off with the first topic.
Why is the manager's fee based on hotel's revenue and profit and not some other basis?
It is difficult to identify another service provider who calculates its fees this way. Many service providers traditionally charge on a time cost basis but these days, fixed fees, retainers and incentivised arrangements are increasingly the norm. From a manager’s perspective, apart from their services and expertise in hotel operations, the brand it brings to the hotel is also at stake and therefore linking their fees to the revenue and profit of the hotel under its management is an effective way to align the business interests of parties.
In the hotel industry, simply put, the manager's fee is based on the hotel's revenue and profit and not some other basis because it has always been calculated this way.
The manager's fee is typically split up into two revenue streams: (a) base fee; and (b) incentive fee. The base fee is typically a percentage of the hotel's gross operating revenue whilst the incentive fee is typically a percentage of the hotel's gross operating profit.
It is important to pay attention to the calibration of the base fee in particular. Where the base fee is high enough to provide an adequate internal rate of return to the manager such that the arrangement generates an acceptable profit for the manager earning only this stream of revenue (without requiring the addition of an incentive fee), a misalignment is apparent between the financial interests of the owner and the manager. If this transpires, the manager is not properly incentivised to try to maximise profit for the hotel.
Forty years ago, base fees were typically three (3)% of the hotel's gross operating revenue which generally provided a more than adequate return for the manager regardless of whether the hotel was making a profit. Over time, in recognition of the dynamic discussed here, we have seen a push towards lower base fees and higher incentive fees to provide the financial incentives to engender financial alignment between the parties.
Whilst the manager's fees have always been based on the hotel's revenue and profit, there is no reason why alternative ways in which a manager may be remunerated for its services (for example a fixed fee arrangement) cannot be used. What is surprising is that there is comparatively little inclination by either owners or managers to explore alternate fee arrangements. It is not entirely clear why this is the case. Perhaps it will take somebody who enters the industry from an entirely different field and feels strongly that there is a more creative arrangement for any alternatives to be considered.
We wish to stress that what we are talking about here is a quest for alignment of the manager's fee and not minimisation thereof. We support the view that a manager should be entitled to a fee which is commensurate with effort and in our view it is not in the owner's interest for the manager to be under-remunerated. The expression "pay peanuts get monkeys" is totally applicable. If the owner wishes to minimise fees then our advice usually is to operate the hotel yourself. However if you feel that there is a necessary skill set which you do not possess then you should pay reasonable compensation to acquire it.
Hotels rarely trade in an environment where there is no competition. To expect a manager who is under-remunerated to compete effectively with one who is (especially if the financial arrangement is properly aligned) is folly.