5 Owner Errors In Negotiating Hotel Management Agreements
- November 19, 2019
- / Ormend Yeilding
- / Articles,Hotels & Resorts
By: Ormend Yeilding
Published in Law 360
Industry projections have provided some sobering news for hotel investors: After years of steady increases, top line revenues of hotels have remained relatively flat over the past year and further increases over the next few years are expected to remain slow to nonexistent. Many hotel owners have shifted their focus to driving profitability over revenue growth.
But there is a problem: Many hotel owners have the wrong management incentive fee structure in place to do so.
Most hotel owners and developers do not directly manage the day-to-day operations of their own properties. They instead turn to third-party management companies that specialize in managing hotels to do so. A typical hotel owner will therefore enter into a management agreement, or HMA, with either the management arm of one of the large hotel brands, or an independent hotel management company to operate its hotel.
But while the owner gets the benefit of the management company’s expertise, there is a potential for conflict between the owner and the management company in that while the latter has possession and operational control of the owner’s asset, the management company is not responsible for operating losses. Almost all liabilities are borne by the owner.
Hotel owners try to mitigate this conflict by negotiating the HMA in such a way as to align, as much as possible, the interests of the owner and the management company in the operation of the hotel. One way to do so is by structuring the management fee to incentivize the management company to operate the hotel profitably.
Most HMAs provide a base fee to the management company of 2% to 5% of total gross revenues of the hotel, which the management company earns whether the hotel earns profits or suffers losses. While this structure may incentivize the management company to increase revenues, it does not provide an incentive to mind the bottom line, which is more important to the owner. That is the intent behind the incentive fee, which is an additional fee paid to the management company and based on a portion of any profits earned by the hotel.
But what is the best way to structure the incentive fee to properly align the interests of the owner and the management company?
There are as many ways to structure an incentive fee as there are hotel brands. The problem is only a few of them achieve the desired alignment of interests. The following is a list of common mistakes hotel owners make when negotiating an incentive fee.
1. Basing the Incentive Free on Owner’s Internal Rate of Return
When evaluating whether to commence a proposed hotel development project, developers often rely on the project’s internal rate of return, or IRR, to the developer. Given that IRR is such a critical tool in evaluating and green-lighting a project, and that a major factor in determining IRR is a project’s cash flows (which will be driven by the performance of the management company more than the owner/developer), wouldn’t it make sense to base the management company’s incentive fee on the IRR the management company achieved for the project?
While this might seem to align the interests of the owner and the management company, the problem is that the IRR is also affected by the owner’s capital structure. For instance, a project funded with a combination of equity and debt may have a higher IRR (and higher risk) than a project funded by equity alone. Therefore tying the incentive fee to owner’s IRR puts the management company in the position of being affected by the owner’s capital structure, and thus puts the management company in the position of wanting to approve owner’s capital structure.
In the real world, owners and management companies usually agree that the owner’s capital structure really isn’t any of the management company’s business (except in evaluating the risk of termination in a foreclosure), so owners and management companies usually agree to base the incentive fee on something other than IRR.
2. Basing the Incentive Fee on Budgeted Operating Profit
Many first draft management agreement term sheets propose the management company earn a portion of the increase in profit earned by the hotel over the amount originally budgeted for such year. This seems to make sense, after all, because the owner approves the proposed budget in advance of each operating year, and any increase in profit over budget just means that the management company’s performance exceeded expectations. But the problem here, from the owner’s perspective, is that the management company prepares the budget, and is much closer to the actual operations of the hotel and hotel expenses than owner.
A management company has many more ways to sandbag the budget (that is, deliberately underestimating performance in the budget in order to easily exceed an artificially low threshold and therefore earn a higher fee), than an owner has to detect such sandbagging. Though I do not suggest that management companies are in the habit of manipulating operating budgets for their own advantage, I do suggest that it is well within their capabilities to do so, and so owners should not structure a management fee that incentivizes them to do so.
3. Basing the Incentive Fee on Gross Operating Profit, Instead of Net
Many HMA’s use different terms for what this article will refer to as gross operating profit, or GOP, and net operating profit, or NOP. Generally speaking, NOP is best understood as analogous to the earnings before interest, tax, depreciation and amortization, or EBITDA, earned by the hotel during an operating year, while GOP is EBITDA without deducting certain fixed expenses, such as property taxes and insurance (so NOP is always less than GOP).
The rationale behind basing an incentive fee on GOP instead of NOP is that the management company has no control over fixed expenses such as taxes and insurance; the management company should be rewarded for what is within its power to control. But this rationale does not address the first purpose of the incentive fee, which is to align the interests of the owner and the management company. Even though the management company has no control over fixed expenses, the owner still has to pay fixed expenses. The owner wants the management company to at least think like an owner in response to increasing taxes and insurance premiums.
To give a concrete example, suppose a brand management company requires the owner to pay for certain improvements, repairs or upgrades to the hotel over the course of a year to keep the hotel in line with brand standards, and, in that same year, the owner is hit with increases in property taxes and insurance premiums. The owner may want to lobby the management company to permit such investments in hotel improvements to be made over the course of two years instead of one to offset the increased expenses. When the incentive fee is based on NOP rather than GOP, the management company has a financial incentive to cooperate with the owner.
4. Not Incorporating a Profit Hurdle
Any incentive management fee should have a built-in concept that the owner should receive 100% of the first cut of profit generated by the hotel, in part to compensate the owner for being the party that has placed its capital at risk in the hotel. This concept goes by different terms, such as “incentive threshold,” “owner’s priority” or “hurdle amount,” but they all describe basically the same idea that the owner and management company should not start to split hotel profits until after the owner receives a certain minimum return.
This profit hurdle is usually set as a fixed amount between 8% to 12% of the cost to build or acquire the hotel, and some longer-term management agreements will also incorporate the idea that the hurdle should increase over time by the same percentage of additional capital improvements invested by the owner in the hotel. Once net operating income exceeds the hurdle in a fiscal year, all net operating income earned over threshold will be split between the owner and the management company, with the management company earning anywhere from 10% to 50% of such income in excess of the threshold as the incentive fee (the range usually depends on the amount of the hurdle).
An added benefit of this structure is that, so long as the hurdle exceeds the owner’s debt service, then the incentive fee is automatically subordinate to the mortgage loan, making the negotiation of the subordination, nondisturbance and attornment agreement much easier.
5. Capping the Incentive Fee
Let me begin by admitting that not everyone who negotiates HMAs for a living will agree that this is a mistake. After all, capping the incentive fee just means that beyond a certain point, all additional hotel profit belongs 100% to the owner. How can this be a mistake? I still believe it is, even from the owner’s perspective, with one caveat: Assuming you have taken the advice of this article and avoided mistakes 1 through 4 above, and you have an incentive fee that is based on actual (not budgeted) net operating profit (not internal rate of return or gross operating profit) that incorporates an owner’s priority hurdle, then yes, capping an incentive fee structured this way is a mistake.
To understand why, consider the constituencies of the owner versus the management company. For the most part, the owner has one constituency: its investors. But the management company has several, such as (1) the owner, (2) its employees (remember, though employee salaries and wages are paid by owner, it’s the management company that signs their checks and wins their loyalty and affection), (3) its relationships with suppliers and service providers and (4) if applicable, its brand.
Consider the following: If the management company’s incentive fee is capped and the hotel is performing at such a level that no further incentive fee can be earned by the management company regardless of how much it increases NOP, why would the management company negotiate aggressively with its suppliers to get the best deal for your hotel (versus another hotel across town the management company also manages and where the management company would share in the benefit from those savings)? Why would a management company transfer one of their star sales directors to your hotel, rather than the one across town where her performance would allow the management company to share in the upside?
Under these circumstances, the owner would limit the size of the profit pie allocated to the management company, but at the cost of limiting the growth of the pie!
As noted several times above, the hotel owner and management company do not always share the same interests. Though owners and management companies are in the same industry, they aren’t really in the same business. A management company is in the business of earning fees, while the owner is in the business of earning a return. But by carefully structuring the fee provision of the HMA, owners can gain the confidence that the management company is aligned with the owner’s interests, and can be assured that every incentive fee dollar earned by the management company means even more profit generated for the owner.