An Overview of a Hotel Management Agreement
A hotel management contract is a legally binding agreement between an owner of the property and a hotel operator, whereby, generally speaking, the operator agrees to manage, operate, and market the property in exchange for a fee. In performing its obligations, the operator must adhere to agreed performance standards and operational protocols under the contract to ensure consistent guest satisfaction and generate adequate financial returns to the owner. Essentially, a hotel management contract outlines the rights and responsibilities of each party with regard to the development, construction, pre-opening, operation, maintenance , and improvement of the hotel.
The purpose of the hotel management contract is to address the manner in which the operator will develop, market, finance, insure, refurbish, and generally manage the hotel. If drafted appropriately, the terms of a hotel management contract can align the interests of the operator and the owner in the normally conflicting areas of risk and return by allowing the owner to minimize the risks inherent in hotel development, construction, and operation, while still allowing the operator to enjoy substantial financial upside rewards and reasonable latitude to act according to industry business practices.
Fundamental Elements and Terms Found in Hotel Management Contracts
A typical management contract will set forth the roles and responsibilities of both the owner and the operator, and the framework that will govern the relationship between the owner and operator of a particular hotel. The contract will set forth the rights and duties of the operator, the compensation that must be paid to the operator, and the duration of the contract. Many times a management contract will also have an exhibit (or exhibits) that set forth the particular metrics by which the operator’s performance will be measured, be it through a minimum revenue guarantee, a minimum return on investment, or otherwise.
The following are the major components typically found in most hotel management contracts:
- Management agreement parties. The parties to an agreement are normally the hotel owner and the manager. Ownership may sometimes be shared amongst two or more persons or entities. The manager may either be the same entity (or affiliate of the same entity) as the franchisor or may simply be a third party management company.
- The subject property. The agreement will generally contain a description of the subject real estate that will be the site of a hotel, convention center, restaurant, or other venue subject to the contract.
- Owner’s appointment. The owner will appoint, and the manager will accept, the property to be managed by the manager.
- Manager’s authority. The manager will outline the scope and nature of the services to be provided to the owner and how such services will be carried out.
- Owner’s authority. The owner will designate a representative with full authority to bind the owner to all matters under the agreement.
- Term. The term is the period of time that the agreement will remain in effect. The agreement may also contain a renewal provision, that will automatically renew the term, unless the parties agree otherwise. Additionally, the agreement will also contain a provision that will allow the owner to terminate the agreement because of a default by the manager under the agreement.
- Management fee. The agreement will usually set forth the fees to be paid to the manager for its services. The fees are generally broken down into two components: base fees and incentive fees.
- Operating statement. A manager will furnish the owner a statement of all income and expenses related to the operation and management of the subject property. The statement will be prepared on a monthly basis, within a defined number of days after the end of the applicable month.
- Capital expenditures. Some management agreements will require the analysis of proposed capital expenditures for the applicable property, however not all agreements contain such a provision.
Various Kinds of Hotel Management Contracts
When discussing hotel management contracts, the question often arises whether there are any other types of management contracts other than a straight management agreement. There are actually three types of hotel management contracts: lease agreements, franchise agreements and management agreements.
A hotel lease agreement is commonly thought of as being the best possible arrangement whereby one company is leasing real property from another company, and a third company is managing that property and running the hotel under an established brand. That may not be the best arrangement because when one lease ends, the lease ends, so while it is easy for an investor to sell the real estate, the investor is selling a brand new hotel that is not yet operating under an established brand. A tenant is going to try to push the envelope and enter into such a lease, but most of the time the investor has concerns over what happens when the brand is gone. So you probably have a situation where the hotel is not operating well. But the investor does have the opportunity to sell real estate, which can be a good thing.
A franchise arrangement is a long-term relationship between the owner of a trademark, the franchisor, and the franchisee. An example of a franchise is the internationally recognized brands of Marriott and Hilton. In the franchise arrangement, the owners of the hotel are free to use the brand but they must adhere to the control and quality standards outlined by the brand. The hotel owners have a lot of control over their hotels, but a franchise agreement is a little bit like leasing the hotel from the brand. What is good about a franchise agreement, at least when compared to a lease, is that the hotel owner can operate under the brand without fear of having the brand disappear if the lease agreement does not get renewed.
A management agreement is a contract that gives rights to a company to operate a hotel in a defined way. Bad management is the worst thing an owner can suffer, but with a management agreement, the owner still gets the benefit of the brand. If the brand is not pulling up its weight, it is very easy for the owner to go to a new brand. It is easy to get rid of the manager because the brand is gone. The management company and brand do not have long term lives anymore, so the manager does not go away until a new manager is in place.
So, in summary, it is not your basic management agreement that hotel owners are using; it is a mixture of a management agreement and it is very much developed by negotiation.
Advantages and Disadvantages of Hotel Management Contracts
Management contracts: Benefits and challenges for both hotel owners and management companies
The inevitable issues with hotel management agreements begin with the high level of detail within the agreement. For an owner, the many nuts-and-bolts provisions can prove to be very limiting with respect to the flexibility of day-to-day operations and decision-making as to what to do to enhance the hotel. For an operator, the extensive number of provisions designed to protect the owner and its asset and/or limit certain operational discretion can prove to be a burden.
An indispensable tool
Owners and operators alike view the hotel as an investment and, because an owner is typically investing in a property for the long term, the careful balancing of the interests of the parties and the details of the agreement can be a significant deterrent to the real estate deal and market success for the operator. A management agreement provides the framework that will govern all operations of the hotel, as well as the relationship between the parties and, as with any carefully crafted document, the mere fact that a management agreement exists will not protect the owner and operator from the inevitable disputes and controversies that arise during the normal course of business.
For owners, a management contract is indispensable to any hotel investment and development play. In addition to enumerating the standard rights and obligations of the parties, a well-drafted management contract will also establish the key terms of the owner/operator relationship, including:
For operators, the ability to obtain on-site control and the support of a brand (the brand recognition, benefits and marketing support that may be provided by the franchisor) undoubtedly makes such opportunities more attractive. However, it is critical for an operator to consider: The operator who is paying a large upfront signing bonus to the owner with a guarantee of performance may be locked into that relationship for the long haul with significant potential liability.
The Process of Negotiating a Hotel Management Contract
When negotiating a hotel management contract, the parties are usually focusing on the economic terms because that’s what puts money in their pockets or takes money away. The parties often pay less attention to other critical terms, often resulting in unintended consequences for both owners and managers.
Some of the more critical terms that are often minimally negotiated, include:
Confidentiality: Parties to a management agreement should always insist upon mutual confidentiality obligations with respect to their respective proprietary information. But, many times, more is required. For instance, does your designed collaborative marketing idea have value? Can the manager approach the brand with your idea, even if that concept is not being implemented? Be careful. If you haven’t protected your ideas, the operator may be free to pursue them and use them with the brand going forward.
Limitation of Liability: In many hotel management contracts, some provisions in the agreement (like the liability cap) may not survive termination of the agreement. So, in addition to negotiating the liability cap , it is advisable to negotiate survival language. It’s also important to make sure the carve out for indemnity obligations survived termination of the management agreement. Otherwise, there could be a significant costs for the owner.
The Tolling of the Cure Period: Most management agreements have a large cure period (like a year) for the other party to cure any default. When does that cure period expire?
Covenants Running with Land: Are there certain provisions that you want to run with the land (assignable to a new owner), and if so, how do you make those rights assignable? Make sure that you’ve taken the time to craft these rights perfectly if you intend to have them run with the land.
Renewal Terms: Is the renewal term automatic? What if you and the brand or operator can’t agree on the terms of a renewal, but there has been an automatic right to renew?
Costs for Inventory Prepared by the Manager: Make sure you’ve addressed this beforehand. It is easy for the Operator to pass along all costs for an inventory when it is just a line item, but, better would be to pass along only costs above a certain agreed amount (a de minimis threshold). Better yet would be to cost share with the brand (50/50) for the inventory.
Legal Aspects of Hotel Management Contracts
There are several key legal considerations that must be addressed in the hotel’s management contract. First and foremost, a hotel management contract should always include clear and unequivocal dispute resolution procedures. The inability to have satisfactory dispute resolution procedures in place prior to the business relationship ending will almost always result in half-truths and misrepresentation on both sides and make amicably resolving the disputes almost impossible.
Furthermore, a hotel management contract should almost always provide the owner with the right to terminate the contract in the event of a dispute over management issues. There is nothing worse than having a highly expensive and burdensome court proceeding where you may have a right in theory but do not have the practical ability to exercise that right.
Another critical component that must be addressed in a hotel management contract is what specific sort of cause must be shown in order to terminate the contract. One of the most common and contentious scenario is when the owner takes the position that the hotel is losing money and that a proper showing was not made regarding the need to take such action. An experienced attorney can create language for the owner to protect against this scenario.
Another point of contention is what happens in the event the branding chain goes bankrupt. Should the contract be terminated in this event or should the party first make reasonable steps to re-brand the hotel? Attorneys often consider the pros and cons of each side and attempt to set forth language in the contract that will protect the owner.
Oftentimes, an issue regarding the legal aspects of a hotel management contract are potential problem areas that may arise down the road. While many owners would prefer to not consider future audit rights or potential liability over brand control, they would be wise to consider these issues when determining what rights to include in the contract.
Hotel Management Contract Trends
Historically, the most common hotel management contract form is one that enables the owner and manager to manage a single hotel or resort as well as manage multiple hotels or resorts at the same time. However, there has been a shift, in the last five years, toward more flexible contract forms and new methods for incentivizing a manager to perform. Owners are favoring flexibility in their management contracts to accommodate new technology and different ownership formats. Specifically, we are seeing:
Changing definitions of stabilized net income. The cost to develop and manage a hotel has and is only expected to continue to increase. More and more management contracts now define "contribution" or "contribution to cash flow" based upon stabilized net income calculated by excluding capital expenditures and other costs that do not reasonably reflect the costs and expenses of operating the property. This allows the owner to better assess the manager’s contribution to the property, while avoiding "nonrecurring" costs to bring the property to a marketable standard. This change in definition is consistent with current valuation estimates that welcome the recent trend of "All-In" full-service or "all-in" lifestyle type hotels (with no branded suites, or categories that have traditionally been the higher-end product).
Separate management contract negotiation. A few brands have started offering Franchise NICs. Franchise NICs are similar to franchise agreements and are conditioned upon a hotel opening under a management agreement wherein the manager is not the franchisee. This is meant to allow an owner to negotiate a franchise agreement without manager involvement. These Franchise NICs, however, may become problematic due to the fact that they are generally executed after a management and development agreement is already in place and cannot be exited without a cost to the developer.
Longer terms, limited exits. Management contracts commonly range from 20 to 30 years and typically provide for termination upon a change of control, default, casualty and condemnation. It is not unusual for managers to be granted a short management term to replenish working capital at the end of the term and determine the feasibility of continuing the relationship before the owner decouples their relationship with the manager. Given the strong performance of hotels during the last ten years, managers are increasingly requesting contract terms of 30 to 40 years and eliminating shorter terms to replenish working capital. While this is often the effect of a manager’s unwillingness to enter into a long-term agreement, it is also the case that many debt instruments require a longer management contract to maximize debt repayment. We have noticed that some managers are more eager to negotiate the exit for a property that presents a strategically impaired interest and/or weak financial performance. In these cases, the manager may be prepared to undertake the cost of negotiating the exit in exchange for no operational control during the contract term.
Union-free/no unionized property provisions. The legacy cost of unionized properties obligates the manager to staff the property with union labor, and offers less operational flexibility. We have seen a shift away from the requirement of a union-free property, particularly in situations where an owner has acquired a unionized property. Associations such as the International Union of Operating Engineers have become more flexible and are willing to negotiate the application of a collective bargaining agreement and the method for operating a hotel on a non-union basis. We expect this trend to continue as labor costs continue to rise and more owners acquire hotel portfolios that include unionized properties.
Social Issues. Many owners today view their operating company as an extension of their values and the brand’s core competencies. As such, many owners want to partner with managers who share their values, including practices related to the environment, local community issues, fair labor practices, sustainability and wellness. Some owners even go so far as to negotiate provisions that require Managers to adopt the owner’s charitable program, mindful of the brand’s reputation and standing in the local community.
These trends are meant to encourage discussion so that owners negotiate a contract that fits within their budget, fulfills the project requirements and provides the best overall return to the owner throughout the life of the project.
Various Case Studies Relating to Successful Hotel Management Contracts
Although "success" in the hotel industry is a function of a number of variables, it often can be tied to performance under a hotel management contract. To illustrate this point, we have highlighted below some real world examples of hotel management contracts that worked as a result of effective strategies implemented by the hotel owner.
Example #1: Working with a brand and its owners association. A large owner of Hilton branded hotels, using the capabilities of an affiliate, acquired a newly constructed Doubletree hotel located in an important business corridor. The acquisition was purchased at a good price because it was being offered for sale by the seller in a distressed situation. Notably, the management contract required agreement with the "brand" (i.e., Hilton) at time of acquisition. The owner skillfully identified the best management company, which was Hilton, negotiated with Hilton, obtained favorable terms including a per-diem rate for the management company’s onsite general manager, maintained oversight of the management company to ensure compliance with the management contract and worked with fellow owners to take control of the owners’ association. This combination of efforts has enabled the single asset to achieve above market performance and an unmatched net operating income.
Example #2: Ensuring effective representation on the lenders’ behalf. In the midst of executing a typical hotel management contract‐negotiated by the prior owner‐a current owner experienced once in a decade water intrusion in the interior of a full service hotel . The owner identified and hired experts in the field to assist with removal of the water‐damaged material, reconstruction and environmental cleanup. The team then obtained building permits and completed reconstruction and repairs. The owner deftly completed this process over several months while operating the hotel and without affecting guests. During that period, the property became highly sought after by prospective buyers, enabling the owner to sell it at a significant profit, and thereafter to use the proceeds to buy out its lender. The property was subsequently sold, at a significant gain, to a third party.
Example #3: Obtaining maximum value. An owner purchased a full service restaurant and bar located directly across the street from a major beach plaza. Although the location was excellent, the prior owner did not have a hotel management contract in place. The owner approached our firm, installed a qualified operator to run the restaurant and bar, and then negotiated a license between the restaurant and the adjacent hotel. Thereafter, the owner assisted the restaurant operator in creating attractive seating in the patio facing the beach plaza, negotiated an exclusive agreement with the nearby hotel for hotel guests in need of a place for dining and an evening cocktail and, finally, negotiated with the owners of the shopping plaza adjacent to the restaurant for additional visibility and signage. This combination of efforts enhanced the restaurant significantly. The ultimate result: a purchase offer at a multiple too high to ignore, followed by a subsequent sale to a third party that would not have otherwise occurred.
