Real Estate, Construction and Hotels & Leisure Focus
Ian Arnott Senior Counsel, Real Estate
Hotels may be self-operated by their owners although, more commonly, the owner will engage a hotel operator under an existing brand or hotel chain to operate the hotel. This relationship may be structured as a hotel management agreement, franchise / manchise agreement or lease. The hotel management agreement (“HMA”) is the most commonly used contractual arrangement in the Middle East, whereby the operator is responsible for the day-to-day operation of the hotel in return for management fees (typically, a guaranteed base fee calculated as a percentage of gross revenue and an additional incentive fee if profit from the hotel exceeds agreed thresholds).
The HMA sets out the respective rights and obligations of the owner and the operator. In this first of two articles, we consider some key issues in HMAs which often arise in HMA negotiations between owners and operators:
HMAs are typically long-term agreements; 15-20 years with additional 5 year renewal terms is fairly market standard in the Middle East.
Given the length of such contracts, owners should ensure that there is a mechanism to terminate the HMA should the financial performance of the hotel fall short of expectations. The performance test is a mechanism for the owner to terminate the HMA without compensation to the operator if the operator fails to meet certain tests over a certain period of time (two consecutive fiscal years is usual). A typical test would be two-pronged whereby the performance test is failed by the operator if it fails both tests relating to (i) actual Gross Operating Profit (GOP) as compared to that budgeted and (ii) revenue per available room (RevPAR) as compared to an agreed “competitive set” of hotels that are comparable to the hotel in terms of geography, classification and target market.
The operator will often have the right to make an agreed “cure payment” (usually calculated by reference to the relevant shortfall in GOP) which usually may only be exercised by the operator a limited number of times during the term, and which will prevent the owner from terminating. A failure by the operator may also typically be avoided if the reason for the failure can be attributed to events outside of the operator’s control such as a force majeure event or significant works being carried out at the hotel.
For such reasons, standard form performance tests tend to be difficult for the operator to fail. We are able to advise both owners and operators on the various intricacies of the performance test regime and how best to protect the interests of the parties.
A right for the owner to terminate the HMA at any time and without cause (i.e. for convenience) is commonly sought by owners due to the difficulty in removing an operator via the performance test mechanism or operator breach and to provide flexibility with regard to the asset. Operators are usually reluctant to agree to such a right of the owner as the ability for the owner to exit the long term HMA in such a way has a negative effect on the operator’s valuation – which will assume a guaranteed, projected income for the whole length of the term.
If a right of termination for convenience is agreed, it is likely to be subject to the payment of compensation by the owner to the operator if the right is exercised by the owner. Usually, the compensation is calculated as a multiplier of the average yearly management fees earned by the operator in the years immediately prior to the termination. The parties may consider varying the multiplier depending on when in the term of the HMA the right to terminate is exercised by the owner.
As a right of termination of convenience for the owner is a very fundamental term and affects the overall commercial deal between the parties, we would always recommend an owner raising this issue as early as possible at the MoU / LOI stage if it is to have a reasonable chance of agreeing it with the operator.
The owner may seek to restrict the operator from operating other hotels within a certain area in the vicinity of the hotel for some or all of the contractual term. Such restriction is usually limited to the same brand as the hotel and not any other brands within the operator’s portfolio. With regard to HMAs that are signed whilst the hotel remains to be constructed, an operator will usually want to protect itself by way of a provision that the exclusivity falls away if the owner does not meet certain construction milestones. This will allow the operator to strike deals with other owners in the exclusivity area regarding the relevant hotel brand if construction is not commenced by the owner or is significantly delayed.
The HMA will generally provide that the operator has the obligation and the general authority to manage the hotel and do all things that are customary and usual in the operation of hotels within the same brand. This includes a broad range of duties such as hiring and firing employees on behalf of the owner, entering into leases or licences of spaces within the hotel e.g. retail or F&B, entering into service contracts e.g. maintenance and supply contracts, undertaking repair and maintenance works to maintain the operator’s brand standards and authorising capital improvements to the hotel.
A general theme with HMA negotiations is finding the balance between the operator having enough flexibility to operate the hotel on a day to day basis, without undue interference from the owner, and the owner wishing to retain some oversight and control over expenses and other significant decisions relating to hotel operations. This issue of control is often an area of dispute between owner and operator.
The owner will have certain approval rights over the setting of the annual operating and capital budgets, the specifics of which will need to be negotiated. However, the parties may also consider other controls or limitations over the operator’s authority, such as requiring the owner’s approval regarding payments out of the hotel accounts above a certain monetary threshold and leases or supply contracts that are over a certain value or length. Owners’ risk appetites and their desired level of involvement in the operation of the hotel will vary, which ultimately determines the balance of control between the parties in the HMA regarding hotel operations.
It is the responsibility of the owner to ensure that the hotel furniture, fixtures and fittings (FF&E) complies with the operator’s brand standards and the cost of such FF&E is a direct cost to the owner. A separate FF&E bank account (distinct from the operating account) is usually maintained for this purpose. A typical mechanism is that the operator will deduct from the operating account and pay into the FF&E bank account a certain FF&E contribution (generally, a percentage of gross revenue that, for newly constructed hotels, will increase on an annual basis in the first 4-5 years of the contractual term) on a monthly basis, thereby reducing the return paid to the owner. Sometimes, the HMA will contain a mechanism for the monies in the FF&E bank account be “swept out” to the owner at regular intervals where the funds in the FF&E bank account reach a certain threshold that is above reasonable requirements.
It is also increasingly common for the parties to agree to a “notional” FF&E fund, whereby the FF&E contributions are not actually transferred to the FF&E bank account (therefore increasing the cashflow to the owner on a monthly basis). However, in such circumstances, the owner will be obligated to transfer the required amounts into the FF&E bank account as and when required to fund the FF&E expenditure. Such notional FF&E funds may be whole or partial.
For further information, please contact Ian Arnott.
Published in July 2022
