The current environment allows parties to implement creative structures under Hotel Management and Operating Agreements, with enough flexibility to take advantage of the market when it inevitably turns.
It’s a catchphrase most of us are no doubt thoroughly sick of hearing, but flick through any newspaper, industry magazine or publication such as this and it is hard to escape those three words: global financial crisis. The GFC, as it is affectionately known, has affected every industry one way or another, and Australia’s hotel industry is no exception.
But it’s not all doom and gloom. The word on the street is that the hotel industry is picking up pace as cashed-up international and domestic investors trickle back into the market, while at the same time, hotel owners (particularly owners of mid-range hotels and motels) are seeking experienced and well-branded operators to steer their investments through these choppy times.
Negotiating Hotel Management and Operating Agreements – trying to get the upper hand
It is fair to say that the hotel industry has undergone significant change over the last 12 months, particularly in the way hotel owners and hotel operators approach the negotiating table. While each party’s respective agenda is not dissimilar to that which they brought to past deals, it is clear the market has forced them to take a more silo-like approach to protecting their position.
While each party’s aim, understandably, is to negotiate the best possible deal, it is important both parties appreciate that they have a common goal – seeing the hotel succeed. Financially, both parties receive a share of the profits, but separately the hotel owner will endeavour to increase the value of its asset while the hotel operator will aim to increase its brand recognition and reputation. Therefore, more than ever, it is important the parties put in place a balanced Hotel Management and Operating Agreement that represents a “win-win” for both.
Hotel Management and Operating Agreements are never straightforward. We have set out below our understanding of the current key negotiation points in Hotel Management and Operating Agreements.
Term of the agreement
While Hotel Management and Operating Agreements historically have contained long terms with options for renewal, especially at the top end of town, we are now seeing shorter terms being entered into to allow both parties to reassess their respective positions much sooner – and if required, walk away from the arrangements. For global brands, a 10 year term with one or two five year options is common in the current environment.
Previously, Hotel Management and Operating Agreements were also usually drafted in favour of hotel operators, especially the well-known and reputable operators who could throw their weight around. This included options to renew the term of the Hotel Management and Operating Agreement at the sole discretion of the hotel operator. More recently however, there has been an increasing shift towards renewals being:
- mutually agreed by the hotel owner and hotel operator; or
- exercised at the option of the hotel owner rather than the hotel operator.
This shift in power illustrates that the parties’ bargaining positions are now generally even.
There are two main components to management fees, namely:
- a base fee, and;
- an incentive fee.
The base fee is usually a percentage of the audited gross revenue while the incentive fee is a percentage of the audited gross operating profit.
Base and incentive
We are currently seeing that hotel owners are seeking to remove or reduce any base fee in exchange for a higher incentive fee. The percentage of the incentive fee largely depends on:
- whether a base fee is paid and if so, the amount; and
- the reputation of the hotel operator and the market standing of the hotel and the hotel operator.
The main reason for hotel owners seeking to remove or reduce the base fee is (1) to ensure that the hotel owner is not paying a high base fee when operating costs are high or where the hotel is running at a loss; and (2) to incentivise the hotel operator to achieve a higher gross operating profit. While this is also beneficial to the hotel operator as it receives a higher incentive fee, nervousness and unpredictability in the current market have resulted in hotel operators being reluctant to agree to this payment structure.
In today’s market, it would not be surprising if hotel operators started seeking higher base fees but maintained a reasonable incentive fee. It is unlikely this would be well received by hotel owners unless this payment structure was to operate for a short period of time or unless there was a mechanism where the payment structure would change (for the benefit of the hotel owner) if certain milestones were reached (for example, there was a percentage increase in the gross operating profit).
Recently we have witnessed tension between hotel owners and hotel operators over room rate charges. Both would like the hotel to be at full occupancy, but the question is, at what cost? In today’s market, hotels are facing an uphill battle when trying to fill rooms, with fewer people travelling and other hotels slashing their prices to get what business there is. While reducing rates will attract visitors and may increase market share, hotel operators face an increasing dilemma. They face pressure from hotel owners to fill rooms, but in slashing rates they may:
tarnish the hotel operator’s image and brand (especially hotels at the top end of the market), and;
make it difficult for the hotel operator to charge the standard rate once the economy turns around and demand picks up.
To remove this tension, hotel operators are usually given the right to set the room rate charge but subject to the overall budget setting, an approval process and various financial performance targets as set out below.
Financial performance protection
Due to the GFC, hotel owners are increasingly seeking from hotel operators income guarantees for an agreed amount and period. Where the hotel operator has agreed (usually reluctantly) to an income guarantee, the hotel owner usually has to offer something in return. This may include offering the hotel operator more control over the operation of the hotel to ensure it is not restricted in achieving its target.
Financial performance termination provision
A financial performance termination provision gives the hotel owner the right to terminate the Hotel Management and Operating Agreement if the hotel operator fails to achieve the financial performance targets for the hotel over a specified period of time. There are a number of tests that the parties can apply (these will normally not apply in the early years of the Hotel Management and Operating Agreement while the business or the hotel operator’s management of the hotel is being established).
We are seeing an increasing number of such clauses to enable the hotel owner to terminate the agreement and walk away if the hotel is not meeting its financial performance targets. This may also be in the interests of the hotel operator, as not meeting such targets will affect the hotel operator’s total fees and may also damage its reputation.
Lessons for hotel operators and owners
There is little doubt the global financial crisis has significantly affected the hotel industry. While there are some positive signs that the industry is emerging from the crisis, players in the market are taking a very cautious approach to negotiations. However, the current environment has also allowed parties to implement creative structures under Hotel Management and Operating Agreements, with enough flexibility to take advantage of the market when it inevitably turns.
In the meantime, it is important for both hotel owners and hotel operators to remember that negotiating and agreeing a Hotel Management and Operating Agreement requires an equal investment on both sides. Such agreements will not work unless the parties are prepared to work together to achieve their common goal – being able to put up the “No Vacancy” sign.