Common Misconceptions of Hotel Owners About Hotel Management Agreements

By John Opar Partner Real Estate Practice, Shearman & Stirling LLP | December 24, 2017

This is not to demean either position; each party is entitled to act in its own best interests. However, it is important to recognize that, in many instances, the dynamics of the relationship can seem akin to a “zero-sum” game, as where the desire of the operator to enhance the operating level of the hotel and therefore to require additional capital investment necessarily affects the owner’s return on investment.

Hotel management agreements and the attendant fees are the life blood of hotel operators. Thus, it is not surprising that an operator will insist on using its forms of agreement. Nor is it surprising that the operator’s forms will represent the then most evolved thinking of operators on issues presented in the owner/operator relationship. There are, of course, owners who can claim significant experience across a portfolio of hotel investments. More often, however, owners will be negotiating these agreements on a one-off basis without the benefit of the operator’s market experience. Even the most savvy owner should understand that the relationship inherently favors the operator. An owner may receive a rude awakening when it realizes that the playing field may not be level.

My management agreement includes a performance test, so I am protected against poor performance by the operator.

Operators typically demand long-term management contracts, with minimum terms often in the range of 20 years, and unilateral rights to renew. This demand rests on the operator wanting a sufficient opportunity to create a market presence and be protected against whatever loss it might suffer on a premature termination of the management agreement. The owner’s counter will be to seek some rights to terminate the agreement upon the happening of certain events.

A right of the owner to terminate the management contract upon a sale of the hotel will almost invariably be rejected by the operator. Buy-outs of management contracts are possible, but expensive. Owners have, however, made some headway in insisting on termination rights linked to operator-performance tests. But these tests may well be less protective than anticipated.

First, the owner must recall the fundamental financial dichotomy between operator and owner. As the operator’s base management fees are tied to gross revenue, its focus will be on maximizing revenue, not profit to ownership. The owner, on the other hand, can only realize on its investment if bottom-line performance after expenses ( i.e., net operating income ) is strong.

If the operator accedes to a performance test, it will want to be tested only on revenue generation. The operator will resist any income-level test, arguing that too many expenses, such as real estate taxes, insurance and utilities are costs beyond its control. Bridging this gap may be one of the most difficult points in the negotiation.

The operator’s test may be akin to a student designing his or her own test; it will be one that the student -- or operator – believes that it cannot fail. The operator will insist on a ramp-up period during which there will be no test; then a multi-year test will require that revenues fall below the agreed standard for at least two out of three consecutive years, with no year eligible to be counted more than once. Revenue performance will be measured against the hotel’s operating budget, obviously established by the operator, and against a set of comparable hotels. Typically, the operator need only satisfy one of these tests to muster a passing grade. The owner may be losing money, perhaps based on management issues, but the operator will be protected so long as its revenue is within some variance from budget or it is achieving revenue levels equivalent to at least some of its peers – the ultimate in grading on a curve.

Operators will also insist on “belt and suspenders”, providing that the performance test not be applied if there is an owner default or a casualty, condemnation, major refurbishment or force majeure event affecting the hotel. Even though the comparable hotel test would seem to protect against market events depressing performance generally, the operator will not want to take the risk that some occurrence disproportionately affects its hotel.

Lessons for ownership should thus include attention to performance at the income level, not just the revenue level, and some limit on the operator’s right to “buy back in” if it fails the performance test. Both parties will need an ability to adjust the competitive set if, due to market or operational changes ( e.g., a change in chain affiliation of one of the peer hotels ), the continued inclusion of a peer hotel in the competitive set is no longer appropriate.

I have approval rights over budgets, so my financial exposure is limited.

The hotel management agreement will almost certainly recognize some right on the part of the owner to review and approve operating and capital budgets. The owner should recognize, however, that many elements of the budget are effectively beyond its purview. Non-controllable costs, such as insurance, utilities and real estate taxes, will automatically adjust from time to time based on actual invoices. The owner may push back insisting, for instance, on competitive bidding of insurance. But the owner may be disincentivized from pursuing this course because other provisions of the management agreement may afford the owner additional protection only if the hotel is insured under the operator’s blanket policy. Employment costs will be affected by any collective bargaining agreement and by the operator’s personnel policies, from which the operator may be unwilling to deviate across its chain.

On the revenue side, the principal point for discussion will be room rates, but the hotel operator will likely vehemently resist any owner-mandated adjustment in rates. This is a reality of the market, but one where owner and operator are most at odds. In a down market, ownership may believe that a reduction in rates is necessary to improve occupancy and to protect its investment. The operator’s interests may, however, be in maintaining its rates across its portfolio of hotels and it may therefore be unwilling to reset rates on a one-off basis.

The owner should also recognize that the budget process remains fluid. The operator will seek the right to depart from the approved budget to the extent of agreed percentage variances ( per item and in the aggregate ), to address emergency situations, to maintain the hotel in accordance with law and the operator’s brand standards, and to modify an approved budget at any time based on a perceived change in the market.

The owner should also pay particular attention to resolution of budget disagreements. The operator may try to pre-ordain the result in its framing of the question -- perhaps by providing that the operator’s budget determination prevails unless it is found to be without any reasonable basis.

Finally, the operator will typically include a broad right to require the owner to contribute additional working capital, on an uncapped basis, in the event of any revenue shortfalls. The operator may also be able to exercise the right to compel the owner to fund upgrades mandated by changes in law or the operator’s brand standards ( which standards may by revised by the operator on a unilateral basis from time to time ). As stated above, the operator may be able to authorize such upgrades notwithstanding that the related costs are not contemplated by the budget and, therefore, not subject to the owner’s approval. In this regard, the owner should attempt to limit its obligation to fund working capital for hotel upgrades in excess of an agreed threshold or to limit the right of the operator to upgrade the hotel beyond the standard of an agreed set of competitor hotels. Otherwise, the owner is effectively giving the operator a blank check.

The operator is my agent, not my partner.

Owners will expect operators to have substantial discretion over the hotel. They may be surprised, however, to learn that operators will routinely want to exercise significant control over the owner’s related affairs. For instance, if the hotel is to be part of a mixed-use condominium, the operator will seek substantial involvement in the structuring of the condominium arrangement and may seek approval rights over project design, allocation of costs among the condominium units, and operating budgets of the condominium.

The operator will reserve broad powers to establish and implement staff compensation levels, room rates and rates for other hotel services, policies on procurement and on complimentary rooms and food and beverage service, billing and debt collection policies, training and other human resource policies. In practical terms, the owner’s most effective tool for exerting any influence over the ongoing operation of the hotel is through the annual business plan and budget approval process. However, as stated above, many elements of the budget are beyond the owner’s purview and this process is therefore not fully protective of the owner. The owner should also try to negotiate the right to approve certain major decisions affecting the hotel, such as the appointment and replacement of senior hotel personnel ( e.g., the general manager, financial controller, head of marketing, chief engineer and head of security ), the commencement or settlement of any material litigation, and the approval of any affiliate transactions that are not expressly contemplated by the hotel agreements. Lastly, the owner may require that all contracts for the provision of goods and services costing in excess of an agreed threshold be competitively bid.

I can terminate the management agreement at will since it’s a contract for personal services.

The 1990’s represented something of a watershed in owner/operator relations, as a number of courts first accepted the contentions of disgruntled owners that, because a hotel management agreement is essentially a personal services contract, it is terminable at will, albeit subject to damage claims against the terminating party if wrongfully terminated. Nervy owners were willing to exercise their termination rights, and address later with the former operator or in court, if necessary, whether the termination was wrongful or warranted.

Operators have responded to this legal development by various means, including introducing actual or claimed “interests” in the hotel to avoid the personal services contract characterization. Some operators will insist that a memorandum of the hotel management agreement be recorded in the local land records. At least one state legislature ( Maryland ) weighed in in favor of operators by enacting legislation requiring strict construction of hotel management agreements and precluding any extrinsic argument that the fundamental agency relationship between owners and operators requires that the agreements be construed as personal services contracts terminable at will. It is by no means clear that required use of operator-favorable state law in a management contract for a hotel in another jurisdiction would be upheld by the state court of the situs, but this represents simply the latest salvo in owner/operator byplay.

The operator and I have agreed on management fees, so I have fixed my operating costs.

While the base management fee ( and any incentive fee ) represents the operator’s principal source of revenue, operators have, over time, as with many businesses, sought to maximize their net return by shifting to ownership the cost of a number of services.

While an owner might initially assume that the percentage of gross revenue paid by the owner to the operator entitles it to the broad array of services typical of a brand operation, in reality, many centralized services, such as reservations, marketing, guest loyalty programs, procurement and even staff training, may be available to the owner only upon payment by the owner of separate charges, which may be fixed, but may also include an allocation of overhead by the operator to the owner. While some of these services may be optional, most, in fact, are required to be accepted by ownership. The issue may be compounded by a lack of transparency and the inability of most owners to assess the reasonableness or competitiveness of these charges. As they represent costs embedded within the hotel operator’s overall enterprise, operators are loath to permit the costs to be audited. Operators may, however, be willing to provide some back-up information to the owner relating to these costs or to otherwise assure the owner that such allocation is not discriminatory or is generally consistent across the brand. The operator may also agree that, in respect of any mandatory centralized services, the charges will not include any profit component.

Most hotel management agreements also recognize the opportunity for the operator to earn incentive fees. Certainly, owner and operator are more aligned here, in that these fees, which can actually approximate the operator’s base fees in amount, tend to more closely reflect the hotel’s bottom-line performance. However, there can still be tension in trying to design an equitable incentive formula. The owner will, in these arrangements, which tend to be somewhat less uniform across the industry than other terms, seek to realize a net return on its investment before paying out an incentive fee. However, the issue will be how capital is measured. Is it initial investment only or does it recognize ongoing capital investments? From the operator’s standpoint, it will attempt to adopt an “adjusted” measure, which recognizes hotel performance, but excludes from the calculation of the incentive fee uncontrollable costs such as real estate taxes, which can depress a hotel’s bottom line with no real opportunity on the part of operator or owner to ameliorate their impact.

It’s my hotel and I can finance or sell it if I choose.

Perhaps most surprising to an owner will be the fact that hotel operators often seek to limit the owner’s right to finance or sell its hotel. To assure that the hotel will not be over-leveraged, operators will often require limits, by debt service coverage, debt yield or loan-to-value tests, on the debt which an owner may incur. If an owner is amenable to any such limitations it still must remain attentive to the potential consequences. For instance, if the owner seeks to finance the hotel as part of a portfolio, a LTV test might be especially difficult to satisfy.

While this approach may itself seem paternalistic, the issue is perhaps compounded by the operator’s insistence that it be “non-disturbed” and that its management contract remain in place after foreclosure and be enforceable against a foreclosing lender or any purchaser of the hotel out of foreclosure, thereby, in the view of many, capping the value of the foreclosed asset against that of a hotel free of a “flag”. Lenders have, however, generally reconciled themselves to this additional operator protection where the operator is an established brand. The dialogue here will focus primarily on the operator’s need to be assured that its base management fees cannot be interrupted by a transfer of hotel ownership to a lender or a foreclosure purchaser, while the lender will seek assurance that it cannot be held responsible for any amounts otherwise owing by the defaulted hotel owner to the operator.

The operator may also seek approval over sales of the hotel, though input into the sale process would seem appropriate only in the case of sales to direct competitors of the operator or to those appearing on a specific list of prohibited persons ( but note that, in the case of operators with a casino business, this may be an unexpectedly broader universe ). The operator may attempt to mandate net worth and/or liquidity requirements for any purchaser. A loose “qualified transferee” standard may be acceptable to the owner so long as any financial test may be measured at the level of the acquirer’s parent.

Worst case, I’ll have my day in court.

Owners and operators likely share some desire to maintain the confidentiality of any issues between them, but, even if an owner were prepared to make public a dispute by commencing legal action, operators will usually reserve the right to require that any disputes be resolved through a non-public arbitration proceeding, thereby limiting the risk that an issue on one hotel is publicly disclosed to other owners.

At a minimum, both parties will want to carve-out from mandatory arbitration the pursuit of interim relief through judicial processes. It may also be helpful to identify the appropriate arbitrator with some specificity -- that is, an accountant or consultant with hospitality experience to address operational matters and a JAMS ( formerly known as Judicial Arbitration and Mediation Services, Inc. ) forum to address legal issues. Where a speedy resolution is critical to hotel operations ( such as budget-related disputes ), owner and operator should consider agreeing to a more expedited proceeding.

The dynamics of the owner/operator relationship will, of course, continue to evolve, but attention to the consequences noted above may enable the parties to reach a more mutually satisfactory arrangement for operation and disposition of the hotel.

Mr. OparJohn Opar is a partner in the Real Estate practice of Shearman & Stirling LLP. He has extensive experience in all areas of commercial real estate law, including foreign investment in U.S. real estate. He has worked frequently on Shari’ah compliant investments and has been involved in development projects in the U.S., the Middle East, China, England, Germany and the Philippines. Some of his most recent representation includes advising the Qatar Investment Authority, advising Wafra Investment Advisory Group, Inc’s acquisition of numerous properties and advising Social Security of Kuwait on an investment in a joint venture to acquire a US$1 billion+ portfolio of regional shopping centers. Mr. Opar can be contacted at 212-848-7697 or jopar@shearman.com Please visit http://www.shearman.com for more information. Extended Bio...

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