Managing the hotel sector - getting the operator in
One of the key elements for the owner of any new hotel is getting the right operator in place. More than just a covenant strength concern, the right operator is essential for ensuring the parties get the most out of the hotel from a financial perspective.
But once you have found your operator, on what basis do you bring them in? There are various ways of doing this, but generally speaking most hotels will be operated under either a lease, management contract or franchise arrangement – or in some cases, a combination of these.
Which option the parties choose will depend on a number of factors, including the nature of the hotel asset the level of knowledge and experience which the owner possesses in respect of the hotel sector, the liquidity of the particular hotel in question and the risk/reward appetites of the respective parties.
Under a lease structure the operator will be responsible for maintaining the property as well as performing all operating responsibilities. The operator will also take a greater degree of risk (and reward) in respect of the financial performance of the hotel since it will receive all of the profits after rents have been paid. Rental structures can vary depending on the amount of risk the parties are willing to take, but potential options include:
- Fixed rent – This may be index linked or subject to open market reviews. Here the risk on hotel performance sits with the operator as the rent will not change however the hotel performs.
- Share of revenue – The rent is calculated as a percentage of the gross revenue of the hotel. Sometimes the owner will have the benefit of a fixed base rent with scope for an uplift where revenue exceeds a given threshold.
- Share of the profit/net income – Similar to a share of revenue, but here the owner will be taking a greater degree of risk since the cost of operating the hotel (which it has little control over) will also come into play.
Hotel Management Agreements
A hotel management agreement (or HMA) allows the owner to engage the operator to run the hotel for them in exchange for a management fee. The owner continues to own both the property and the business, whilst the operator manages the business on behalf of the owner. The risk and reward profile is greater in this arrangement as the owner bears all the costs and liabilities in the usual way of a business owner but also receives the profits after paying the operator its management and other fees under the agreement. A HMA is particularly attractive to owners who are interested in investing in hotels but do not want to operate it on a day-to-day basis, as well as allowing an owner to bring in a well-established manager and benefit from the manager's expertise, efficiencies and reputation.
The fee structure under a hotel management structure generally comprise both a base fee and an incentive fee. A base fee will be payable based on a percentage of the total revenue and an incentive fee usually be a percentage of the adjusted gross operating profit (i.e. profit less base fee and, in some cases, FF&E reserve, property taxes and insurance). In addition to the base fee, there will be other fees payable such as a sales and marketing fee, licencing fee and fees for centrally provided services such reservations.
Hotel management agreements can be used alongside franchise agreements or can include the right for a management agreement to flip into a franchise arrangement after a period of time. A franchise agreement allows the owner to make use of a franchisor’s established business operations, intellectual and reputation for a franchise fee. The owner may either operate the hotel itself or appoint a manager on a white label basis who will operate the hotel under a management agreement that will require the manager to comply with the franchise agreement.
How to choose?
Many factors will impact on which arrangement the parties choose. Commonly budget and mid-market hotels which are considered more liquid will be operated under a lease, whereas upscale and luxury hotels are more likely to be subject to HMAs as they are more illiquid and it is harder to dispose of them.
An owner which prefers a lower risk profile or one with less experience of the hotel sector will typically lean towards a lease. This moves the transaction closer to a standard real estate transaction and the operator, as tenant, can be made fully responsible for the upkeep and outgoings of the property, leaving the owner to collect the rent. From the operator’s point of view, this structure generally leaves it with the greatest level of autonomy.
That being said, hybrid-type arrangements are becoming more common – leases which have a greater degree of owner oversight over the operator together with greater flexibility to reduce the risk of unsustainable rental levels, versus HMAs with guaranteed returns for the owner.
Of course this is only the start, a transaction may also involve technical services agreements (if the hotel is being developed), asset management agreements (if the owner is employing a separate asset manager to oversee the performance of the operator) and non-disturbance agreements (if there is finance in place) to name a few.
The Covid-19 pandemic created a perfect storm for the hotels sector and, despite ever improving signs of recovery, the resulting devastation will take time and innovation to repair. Unprecedented economic life-support provided by the UK government over the last two years has kept the gathering clouds at bay, but there could well be casualties in 2022 and beyond. This was the conclusion of a roundtable discussion hosted by Forsters on 10 November 2021.