Understanding Contracts and Commitments Associated with Major Development Deals
By William A. Brewer III Managing Partner, Brewer, Attorneys & Counselors | February 27, 2011
As with any business transaction, parties to hotel development projects make their respective decisions to participate based on three fundamental inquiries: (1) What are the expected costs?; (2) What are the likely rewards (i.e., returns or profits)?; and (3) What are the financial and legal risks? We examine each of those inquiries below from the perspective of both owners and operators, in the context of negotiating and structuring management contracts between them.
The first question in any major development deal is: What is the cost? Although the question is simple, the answer is often complex depending upon the location of the property, its brand affiliation (if any), and the cost of any financing. As anyone who has been involved in a high-end development project can attest, the less developed the plans and specifications are at closing, the greater the risk of unanticipated development costs down the road.
Unless it is an equity participant in the development of the hotel, the operator is not typically responsible for any portion of design and construction costs. That is not to say, however, that the operator plays a passive role during the pre-opening period. Brand operators and chain management companies usually insist upon rights of review and approval with respect to exterior and interior design, room mix and layouts, food and beverage concepts, back-of-the-house facilities, FF&E, OS&E, and other aesthetic and operational issues. The primary purpose of operator involvement in such matters is to ensure that the hotel under development meets the operator's physical facility standards, so that the guest experience will meet the expectations of the operator, the owner, and the general public. Of course, there may be cost implications once the operator exercises its review and approval rights – such as when it requires design and construction elements to meet its "brand standards."
Owners and operators can address such development risks and allocate the responsibility for additional costs in their hotel management contract. For example, parties can include approvals and representations concerning specific plans, schedules, and/or budgets in their agreement and set forth explicit procedures for any changes or modifications to those documents. Such procedures help to expedite the approval process and also ensure that both the owner and operator are fully aware of the costs of any changes before those costs are incurred. Parties can also agree to some form of cost sharing, whereby the owner is responsible for certain changes or costs and the operator is responsible for operator-initiated changes or costs. In the alternative, parties can agree that one party will have full responsibility for the costs of specific changes or for all costs incurred on the project, and include specific provisions absolving the other party from liability for any costs or changes. By clearly identifying and allocating the responsibility for development risks in management and other agreements, owners and operators can better estimate their respective project costs and avoid disputes if there are unanticipated project delays or cost overruns.
The next question is: What are the expected profits? Although it is a function of both revenues and expenses, profit is often made or lost for reasons attributable to the management (or mismanagement) of expenses. Unfortunately, after one of the worst economic downturns in recent history, many owners are all too familiar with the need to employ operators who can adroitly manage expense-side risks associated with the operation of high-end projects. Marketing and promoting a luxury hotel, or a high-end mixed-used development with hotel and residential components, carries an implicit promise of extraordinary service. Delivering a high-end experience requires a combination of luxury-level physical facilities and first-class service. Naturally, the provision of a luxury experience is a more expensive undertaking than operating a hotel not meeting that standard. That reality impacts gross operating profits, net operating income, and, indeed, the ability of owners to meet debt service during the "tough times" (which the luxury hotel segment recently experienced in 2008-2010).
As a result, there has been renewed focus on the respective rights of owners and operators relating to the management and control of operating costs and expenses. In general, operators earn management fees based on a percentage of gross operating revenues, while owners are rewarded only if "bottom-line" funds are available after payment of all expenses. Many hotel management agreements provide the operator with broad discretion concerning the management of the hotel's expenses in accordance with the operator's standards. Although that discretion is generally limited by the operator's fiduciary duty to manage the hotel in a manner consistent with the owner's best interests, when occupancy rates and revenues are below average, disagreements often arise over the appropriate levels of variable expenses as well as the minimum capital expenditures necessary to maintain the physical facilities at a standard consistent with the operator's requirements.