Re-Negotiating Your Management Agreement: The Owner’s Perspective

COVID-19 introduced the hotel industry to a lot of uncertainties for the future. It also revealed several weak spots and high-risk areas within hotel management agreements (HMA’s). As these weaknesses become more evident, it is important to decide which points to focus on, how they can be adapted moving forward, and how each party can make the necessary adjustments to help each other out.

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Of course, there are two sides to every agreement. That said, as Asset Managers, it is our responsibility to protect the Owner’s interests as will be seen in the content below. Yet, it is crucial to recognize the importance of the Operator’s rights. After all, it is all about the hotel, and each party will have to make concessions to aid its successful continuance.

There are many clauses within an HMA that may need to be reworked and reconsidered when amending current contracts or developing new ones. It will be a process of re-negotiating as a long-term agreement is likely in place. Below are some of the key areas to focus on should you be able to re-negotiate your current agreement or to keep in mind for future contracts. Many of the below changes will require lender consent, however this paper will not touch on lender issues.

Management Fees

As we know, management fees in an HMA are usually two-fold. There is a base fee and an incentive fee [1]. As structuring the incentive fee offers more flexibility to minimize risk for the Owner and aligns the Owner and Operator’s interests, this is where the focus should be placed.

  • Ensure that your contract is designed to pay the incentive fees, only after the debt service is covered. Assuming that the Owner’s priority [2] or guarantee [3] is met as the debt is paid, the Operator can then receive their portion of the remainder.
  • Increase your incentive fee in comparison to the base fee. Then pay out a percentage of the monthly fee and true up at the end of the year. This will help reduce the yearly risk the Owner takes and compensates for low profitability periods while giving the operator their earned share.
  • To accommodate for the lost base and incentive fees, a minimum monthly base fee can be implemented should the hotel continue to generate little or no gross revenue. This is currently more common in smaller management agreements such as Spas.
  • In an effort to fully balance the risk and responsibility for both parties, consider amending your incentive fee so that it is a higher percentage fee based on EBITDA instead of GOP. This allows the operator to take joint responsibility for the full operation and be in charge of the entire P&L. This ensures both the Owner and Operator have the same objective in mind and focus on the hotel as opposed to their independent goals.

While some of these clauses are most likely already in your HMA, it is times like these that reveal their importance. Take a second look at them to ensure they are fair, and that the risk-compensation mix is balanced accordingly.

Management Fees: COVID-19 Specific

The management fees will also need to be reviewed as more hotels convert into hospitals or offer their beds up for health care workers. This will be a temporary adjustment put in place for the duration of the pandemic.

  • Management fees should be adjusted to reflect the temporary business model and limited services as well as the actual contribution of the Operator.
  • If there is no revenue coming in due to ceased or alternative operations such as a hospital, there will be no fee.
  • If a hotel is still operating to offer beds to healthcare workers, it is likely that they are operating with limited service and the compensation should reflect this.
  • Regardless of the business model, employees should be fairly paid. Many governments are offering direct support in this area. Payroll and the Labor Union’s involvement should be a key consideration. Owners and Operators should jointly try to ensure employees are reasonably compensated under the circumstances.
  • If the hotel is operating under governmental aid, any management fee may be deemed void as this is not pure revenue.
  • In the case of public aid, the hotel may actually be leased to a governmental agency, and the Operator may require a percentage of the rent.

Consider embedding an exclusionary clause that outlines the above for the future. Be prepared and adjust the fees according to each hotel’s situation.

Deferring and Redirecting Fees

Corporate reimbursables should be reviewed so that they are disclosed properly and proportionate to their current year’s usage instead of the previous one as the 2019, 2020 and 2021 usage will be significantly different from one another. These are the fees paid by the Owner to the Operator for central services such as sales & marketing, HR, IT, reservations, or the loyalty program.

  • One option is to defer these fees until cashflow returns, and many brands have already agreed to defer or pause certain activity. However, it is important to ensure these services actually add value to the hotel and are not merely the sharing of costs as incurred in a brand related office.
  • Consider basing these fees off of the actuals instead of the budgeted values. This will account for the limited service as many of these fees such as sales & marketing, are likely inactive or restricted at the moment.
  • The brand must grant approval and may request a form of compensation (i.e. a percentage of the incoming rent, as mentioned above) as fair compensation.

By minimizing or deferring these fees, the operator can lighten the impact on the current diminished cash flows.

Owners may also request operators to consider waiving, deferring or ‘nominalizing’ the contribution to the FF&E Replacement Reserve.

  • It may make sense to either defer this contribution in order to conserve cash and reimplement it in better financial times.
  • Funds may be used for more urgent costs such as payroll or the additional costs needed to clean and re-open the hotel. This would ensure the necessary is covered while lessening the owner’s financial pressure.
  • Instead of having a restricted access bank account, both parties may agree to treat these fees as a nominal account, paid out upon request by having a liability on the balance sheet. This way, the Owner retains access to the cash available instead of letting it sit in a low interest accruing bank account. The Owner can then be expected to provide the funds upon the Operator’s request.

If a deferral is put in place or being considered, it is important for each party to remember that it is only a deferral, and eventually, in better financial times, the fees will need to be paid. Act now as these changes will require both brand and lender approval which can be difficult to obtain and could take a significant amount of time.

Force Majeure

Force Majeure has been a popular topic and heavy issue for most hoteliers. It differs from country to country, state to state, and contract to contract. While several months ago, COVID-19 could have potentially been claimed as unforeseeable, it has now been seen. Moving forward, what will qualify as “unforeseeable” is questionable. Will it be unexpected if a new COVID strand strikes six months from now? If a completely unrelated pandemic hits in a year, can it be claimed as unpredictable? Pay close attention to your Force Majeure clause and consider how to amend it for the future.

  • Explicitness will be key as items such as “pandemic” will need to be listed on their own.
  • It’s expected that the management companies will lead the redraft of this clause.
  • Owners will require more specific clauses including the right to determine if and when to close the hotel, and how and when to reopen it.
  • If it is simply impossible to operate the hotel for an extended period of time, the impossibility clause can be used as a right to terminate the agreement.

Another reason to re-evaluate the force majeure clause is to determine how it can be used in regard to the future of a property. If after the leniency period certain terms and obligations have still not been delivered, the Owner or Operator are free to enact force majeure in order to end the agreement. For example, if the Owner decides the hotel business model is too risky and wants to repurpose the hotel, they can use force majeure as reason to terminate the contract. This should be enacted cautiously. If the termination is perceived to be for a reason other than COVID-19’s impact, it could lead to a lawsuit and an on-going legal battle.

Exclusivity Period

Many development projects will face severe delays as a result of COVID-19.

  • In order to ensure operations and protect their business, Operators will want to enact a contingency clause within the exclusivity period. This clause will likely require the hotel to open by a certain date in order to honor the contract’s exclusivity period.
  • While this is understandable and acceptable in a normal market, the Owner can make the case that it is not currently necessary. As no hotels are operating and the entire supply chain is backed up by months (at the time of writing), there is no need for the Operator to break the exclusivity period.

The Operator should be understanding towards the Owner and vice-versa. Both parties should acknowledge that all projects are experiencing the same distress and consider adding an extension to the exclusivity period beyond the length offered by Force Majeure.

Performance Tests

The performance test may also be a point of contention and Operators will deem this year an unfair period to be evaluated. Review your contract’s force majeure adjustment provision. In case your contract does not include one for performance tests, consider adding one upon re-negotiation.

  • If a performance test was failed in the previous year and 2020 is counted, it could be detrimental for the brand and an unfair representation of performance.
  • Deem the performance test null and void for 2020 and reinstate it once the budget for 2021 is approved or once normal operations have returned. If a test was failed in 2019 and it is a two-year test, failing again in 2021 will count as a failure in two successive years.
  • If a RevPAR test is used, there should be no contention as the comp set’s performance will have also been affected.
  • When good benchmarking is available, GOP or EBIDTA Flex/Flow Through could also be implemented as part of the performance test.

Conclusion

Once again, the management agreements should reflect the interests of both parties and while the above caters to the owner’s perspective, the brands’ and operators’ terms should be respected. At the end of the day, both parties should work together to preserve the hotel.

The above clauses have either been affected by COVID-19 or the pandemic revealed their weaknesses, and each should be adjusted and renegotiated according to each hotel and contract. Please contact us at [email protected], we would be delighted to offer you our services, evaluate you management agreement, and tailor make an action plan for you to move forward.

[1] Incentive Fee: Management fees that are contingent upon achieving certain predefined levels of performance typically based on GOP or AGOP. It minimizes the risk for the owner in comparison to base fees as it encourages the operator to take responsibility for all operational expenses, and not only the top line. [2] Owner’s Priority: Amount or percentage to be paid to the Owner before the Operator receives their incentive fee [3] Owner’s Guarantee: Fixed amount the operator must pay to the owner in case of GOP short fall

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