Understanding the Importance and Use of The Reserve for Capital Replacement

The concept for the use of the reserve account is important to understand. It is also essential that hotel operators ensure the reserve is properly funded per the terms of the Hotel Management Agreement "HMA." The use of the reserve is an important tool to utilize to protect the operator's rights and long-term viability. Many people mistakenly think the reserve account is the owner's responsibility and therefore it's up to the owner to determine and ultimately control the funding. But not so fast, the manager has a right and a duty to ensure the proper transactions are performed on a timely basis using the clauses that are in the HMA. There are many important aspects to understanding the reserve and how it impacts the ultimate success of the hotel. This includes the hotel's values as well as the value of the management agreement. One could say that there is something for everyone here!

First and foremost, the intended use of the reserve account is to ensure the hotel is kept looking and functioning at a high standard. It's essential that both the owner and the brand ensure this is the objective and the funds are set aside to properly maintain the asset. The reason it is not simply left to the owner to decide the amount to fund and when is because it's often the case that the money is not available. This is due to the hotel's profit performance or the owner's other needs, which can be many and endless. Whether the hotel is making its profit targets by way of the budget is irrelevant to the requirement to fund the capital reserve in most cases. Owners are usually quick to request or even try and demand the reserving be stopped when the hotel faces a bad year or a cash crunch. These circumstances are all too often and challenging for both the owner and the manager. Operators need to be on their toes so to speak and hold the owner's feet to the fire, to do what is necessary. Protecting the operator's rights is what is at stake here. Although it may appear counterintuitive to have the manager insist the owner fund the reserve when facing a cash shortage, it is what is required. It is in the agreement to begin with because it is essential for the ultimate success of the hotel, which is what everyone wants.

The clause or clauses in your HMA will outline the amount to be set aside in the reserve account. In some cases, the cash must also be transferred into a special bank account. By doing so it ensures its availability and separation from the operating funds. Look closely at the exact wording in paragraphs covering the reserve account use. Look for "funding" and "transfers." Normally it is somewhere between three and five percent of total revenue monthly. However, it is common for a new hotel to have a period where less or even no funding is necessary until the end of the capital funding grace period.

From the point of view of understanding the HMA's intent around the requirement to fund the reserve, the manager needs to ensure funds are available for future improvements. This is a must for the ultimate goal of keeping the property competitive. This helps to ensure the hotel's longevity, an important aspect for the operating company as it helps to protect the all-important management fees. If the hotel fails to stay ahead of its competitive set and loses its market share, the hotel management company can also lose the right to manage the hotel. The RevPAR test is sometimes included in HMA's for the purpose of protecting the owner should the management company be unable to perform. It is imperative that the manager ensures the capital is properly funded and ultimately spent to keep the asset fresh, helping to ensure that its performance is adequate.

The other test that is constantly being evaluated is the annual profit target test. Most HMA's will have a clause that defines the profit test. When it comes to the hotel's performance everything is tied together. Customers want fresh hotel products, the hotel needs a constant supply of business, the competition makes improvements, and the hotel's profits go up and down based on the performance of the asset. Availability of capital is essential to maintain the profitability in the long-run. The proper use of the capital reserve is inexplicably linked to the ongoing success of the hotel and that means the funding cannot be played with. If it is, the operator risks shooting him/herself in the foot!

Be vigilant when it comes to protecting the rights of the operator and know that owners will try and distract you from your prize. The enjoyment of managing a well-capitalized hotel asset is that prize.

David Lund
The Hotel Financial Coach
+1 415 696 9593
David Lund