Key issues in Hotel Management Agreements (Part 2)
Real Estate & Construction and Hotels & Leisure
Clauses in hotel management agreements (“HMAs”) which often arise in negotiations between hotel Owners and Operators.
Law Update: Issue 359 - Real Estate & Construction and Hotels & Leisure
Ian ArnottSenior Counsel,Real Estate
Serena StangroomAssociate,Real Estate
This is the second of two articles in which we highlight some further key issues and clauses in hotel management agreements (“HMAs”) which often arise in negotiations between hotel Owners and Operators. To view Part One of the article, please click here.
An Owner will typically be obligated under the HMA to fund (i) the pre-opening costs and expenses of the hotel; (ii) the initial and ongoing working capital requirements (to the extent hotel revenues are not sufficient); (iii) major capital expenditure relating to the hotel; and (iv) expenditure relating to FF&E.
In addition, an Owner will be directly responsible for certain costs relating to the hotel as property related insurance premiums and taxes, master community fees and debt servicing and financing costs (rather than such costs being treated as operating expenses of the hotel).
An Operator will usually want as much flexibility as possible built into the terms of the HMA to call on the Owner for funding, such as if capital expenditure is required in order the keep the hotel aligned with the Operator’s brand standards or if there is a deficiency in the hotel accounts to meet upcoming operating expenses.
Given the importance to the Operator of the value of its brand and reputation, it is usual that the Owner is unable to object to capital expenditure, proposed by the Operator during the annual budget approval process, that is required in order to maintain the hotel in accordance with the Operator’s brand standards. However, there are ways that this position can be mitigated to be more favourable to the Owner.
With regard to working capital, an Owner may seek to put a maximum cap on the amount that it is required to fund should there be a revenue shortfall (for example, 1-3 months of working capital required as forecasted by the Hotel’s general manager would be typical). Such cap can also serve as a fixed benchmark as to how much working capital should be retained in the operating account in order to provide the Owner with more certainty as to the amount it will receive back as its return from the hotel for the relevant accounting period (after the operator has paid its own management fees, operating expenses and other contractual payments or contributions have been paid).
As mentioned above, an Owner will usually have strict obligations to ensure that the hotel is maintained in accordance with the Operator’s brand standards (which are subject to change during the course of the operating term). However, where a hotel is being newly constructed, an Owner may be concerned about being faced with additional costs, following soon after its initial capital outlay on the hotel, due to a sudden change in the Operator’s brand standards.
For this reason, the terms of the HMA may include a moratorium that takes effect at the beginning of the operating term for a certain period whereby the Owner is not obliged to implement any changes to brand standards during such period. There are usually caveats to such moratorium, such as if such changes relate to fire, life and safety matters or any changes in the law.
An Owner should also seek to ensure that any changes to brand standards that need to be implemented are not hotel specific and apply on a more general basis to other hotels with the same brand.
The payment of “key money” by an Operator to an Owner involves the payment by the Operator of a pre-agreed amount to the Owner to contribute to either (i) in the case of a newly constructed hotel, the initial fitting out; or (ii) in the case of an existing, operational hotel that is being taken over by a new Operator, the costs involved in bring the hotel in line with the Operator’s brand standards pursuant to an agreed property improvement plan. The payment of key money is not a standard HMA term but is often seen with those hotels where there is strong competition between different Operators and is offered by the Operator as an inducement to the Owner to enhance its chances of success in being appointed. The amount of key money paid by the Operator can be structured in various ways including by way of (i) cash, (ii) a loan or (iii) deferred management fees. If the HMA is terminated early, the key money contributed by the Operator usually needs be repaid on a pro-rata basis back to the Operator (which is calculated depending upon how much of the agreed “burn off” period remains unexpired as at the date of such termination).
In addition to a base fee payable to the Operator, calculated as a fixed percentage of gross revenues, HMAs will also usually provide for the Owner to pay an additional incentive fee, which is linked to the profitability of the Hotel. The Operator may sometimes agree to forego its incentive fee for an agreed period at the beginning of the term if the Owner’s return is below a certain threshold. This arrangement aims to help with the Owner’s debt servicing in the early years of a hotel’s operation whilst hotel operations are getting up and running.
Expert determination is the process whereby the parties will try to resolve a dispute by involving an independent expert with industry expertise in the matter in dispute. The expert will make a binding decision based upon their area of expertise rather than looking into the legal issues. This is an alternative method of dispute resolution rather than the relevant dispute being resolved by way of the courts or arbitration – which can be time consuming and costly.
Resolution by way of expert determination will usually only apply to disputes under the HMA relating to certain matters such as the approval of the annual budget, the operation of the performance test and the calculation of management fees.
For further information,please contact Ian Arnott or Serena Stangroom.
Published in June 2023
