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Explainer

What Are The Hotel Operating Arrangements?

Explainer by Gregory Autin

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Last updated on 8 December 2020Comments

Hotel Leasing
Under a hotel lease agreement, the owner of a hotel property leases it to the tenant, who uses it to run its hotel business. The owner (landlord) has no control over the property's operation and bears no risk and liability for the hotel business.

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The landlord leases the property to the tenant under a commercial real estate lease commonly for 20 years and longer for a fixed rent. The landlord is typically responsible for property maintenance while the tenant is responsible for managing the hotel business and staffing and bears all the operational risk.

Common issues for negotiation of property leases are build-out/construction issues, where the premises are either turn-key or built out by the tenant, capital expenditures, and repairs. Either the landlord or the tenant owns the furniture and equipment and bears the insurance for business interruption coverage and indemnity for personal injury or negligence claims.

A subordination, non-disturbance and attornment agreement (SNDA) is commonly also negotiated. This is required for the protection of the tenant toward creditors of the property owner.

The landlord typically receives a fixed rent, usually subject to periodic review and some agreed rate index. Banks and institutional investors favor lease arrangements over other hotel operating models as they provide stable cash-flows and a secure return on their investment.

Leased properties may be managed by the tenant or an operator on the tenant's behalf. Hotel brands tend to avoid leasing property directly, for various reasons, and instead enter into a franchise agreement with the tenants.

Sale-and-leaseback transactions (SLBT) have led to the "sandwich model", in which an operator is contracted to run the property for the tenant, the tenant receives the operational profit/loss, and the landlord receives the lease payment under a lease guarantee. The sale and manage-back is used in realizing the asset-light strategies of developers and chains for the disposal of assets.

Hotel Franchising
Hotel franchising is an arrangement between a business owner in which hotel property is operated under a hotel chain franchise agreement. The franchisor's brand, distribution channels and intellectual property are used by the business owner - property owner or tenant - to operate the property while retaining the risks, liabilities and control of the property.

The hotel business owner (franchisees) sign a franchise agreement with a hotel brand (franchisor) to operate the property under a franchise agreement in exchange for a franchise fee. Hotel owners or tenants set up their own team or engage an independent operator to run their hotel business, with whom they enter into an operator agreement.

Although an operating company may offer the business owner both a hotel management agreement (HMA) and a franchise, they are separate agreements. They provide two different services, although the legal paperwork may be combined.

The terms and provisions most tightly controlled by the franchisor in the franchise agreement are brand standards and guidelines, term, assignability, and franchise fees. Operators are commonly concerned about compliance of the business owner with the franchise agreements because of their different - often conflicting - aims and objectives.

A manchise agreement is an operating agreement with a hotel brand operating company that contains an option to convert into a franchise agreement once the hotel business owner has developed sufficient skill and knowledge to take over the hotel's operations. After the initial period of providing traditional hotel management, the contract reverts to the brand's franchise agreement, which reduces the fees payable to the operator at the later stage of the operating term.

The asset-light strategy of hotel brands to hold a reduced portfolio of properties in favor of lighter portfolios is commonly achieved through franchising. It allows hotel companies to grow business with limited requirements for capital and to focus on fee revenues and fee margins.

Hotel Management Agreements
Under a hotel management agreement (HMA), a hotel chain or independent management company operates a hotel business on behalf of the business owner for a fee. It is typically heavily negotiated, to establish the respective rights and responsibilities of the client and operator.

The property owner is generally responsible for the hotel's assets, including maintaining the property, furnishings, fittings and equipment (FF&E), and inventory as well as funding the hotel's bank accounts. The hotel business owner is usually also the employer of the hotel's staff and, therefore, liable for all employee claims.

Operator fees are paid by the business owner to the operating company for managing the hotel, typically consisting of the base management fee, the incentive fee, and other fees and/or reimbursements. The hotel owner generally requires the agreement to contain a performance test, where failure to meet GOP and/or RevPAR metrics gives the owner the right to terminate.

An operator may accept a lower base management fee in return for a higher incentive fee, to reward the operator for outperforming agreed targets. As an alternative to a set profit-related incentive fee, scaled incentive fees reward effective operators while increasing the free cash flow to equity in the event of poor operator performance.

Control over operations refers to the right of the business owner to approve budgets, key personnel, contracts, etc. The operators' ability to manage hotels must be balanced with the owner's ability to approve significant or material matters.

An assignment right in an HMA is the operator's right to assign the operating agreement to a third-party successor operator. The open-ended right to assign the HMA to a successor that has not been vetted and approved is rare.

Termination rights are contract provisions that allow the contractual parties to terminate the agreement. They include termination for breach, without cause, and on sale of the property.

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