Hotel Management Contracts in India: The Game is Changing
By Manav Thadani, Founder Chairman and Juie Mobar, Director - Special Projects at Hotelivate
Change is inevitable, and more so in an industry as dynamic as hospitality. Market performance, lending environment, number of players, owner and operator objectives, costs and margins, and customer profile are all changing almost constantly, and so are hotel management contracts that have evolved remarkably in India in the past decade. Once an operator stronghold, hotel management agreements had little to no room for negotiations, leaving an inexperienced owner (with no expert advice) with a sub optimal contract. However, the game is now changing! Today's more experienced and perceptive owner is demanding higher returns for lower fees from operators, who are at present in much larger numbers than in the past, increasing the competition and offering the owner more choice. Additionally, owners are showing their might, with many of them developing a portfolio of hotels as against just stand-alone properties. Understandably, operators are more than willing to sweeten the deal in such cases, since it is easier to negotiate with one party for a larger number of hotels than with different parties for each of their properties. Also, the nature of hotel ownership is changing today, with a growing number of institutional investors assuming a more dominant role than HNIs and family holdings - mainly attributable to the industry upcycle, relaxation of FDI norms in the sector and more widespread development of lower-positioned assets that are easier to transact. This new breed of owners has a clear exit strategy in mind, as against retaining legacy assets, and thus, expects management companies to have skin in the game. This may take the form of equity participation, key money, an operator loan or a more robust performance-based compensation structure.
The length of the initial term averages around 20 years in India, while that of the renewal term is around 8 years. Over time, the management contract term has been reducing, although the Figure alongside shows differently; this is due to the newer contracts in the sample set mostly being of higher-positioned hotels that tend to have a longer initial term than their budget-mid market counterparts. Another notable trend is that renewal on mutual consent of both parties is more widespread than before, when it was at the operator's will or automatic. In stray cases, we have come across conditional renewal wherein the operator is required to meet a certain performance threshold prior to the term being extended, such as achieving a pre-defined occupancy, RevPAR or operating profit level in the two or three years preceding the expiration of the initial term. We expect this clause to become more popular in the coming years.
Provision for area of protection (AOP) or restricted area has been common in contracts signed then and now, although a few prominent trends are emerging. First, a greater number of contracts signed before 2010 offered an AOP for the entire length of the initial term and for a larger radius than currently seen; recently, the duration of the AOP is mostly restricted to 8-10 years from signing or 5-7 years from opening, with the radius shrinking (especially for lower-positioned assets). This is largely because of the changing demand dynamics in various hotel markets, including the formation of micro-markets that support the development of more hotels of the same/similar branding in a city. Second, having two areas demarcated for an AOP is more prevalent now than in the past -the first one with a larger radius for a shorter period, followed by another with a shorter radius but for a longer duration. Additionally, AOP burn-off provisions linked to development milestones are becoming increasingly relevant and frequent, with an intent to safeguard the operator's interests when projects get delayed.
The base management fee (aka operating fee) has an inverse relation with market positioning, i.e. higher the market positioning, lower is the base fee. It has generally decreased over the years, with a flat annual rate becoming less common, making way for a ramp-up structure. The Figure shows the first-year base fee to be averaging at around 2.00%; however, we have come across this fee going as low as 1.50%-1.75% for strategic projects. Additionally, operators have occasionally even agreed to a ramp-down, with a higher fee in the initial years, before stabilising at a lower percentage of total revenue. That said, operators tend to try and keep the format of this fee as stable and uncreative as possible, preferring more flexibility with the incentive fee.
Most of the management contracts being signed today have a performance-based incentive fee structure as against a flat annual structure, with or without a ramp-up. Also, the fees are declining for the various GOP/AGOP margin thresholds as shown. In fact, operators at times have even agreed to no incentive fee in the initial few years, or a significantly reduced fee for a GOP/AGOP margin less than 30%. Further interesting to note is that the concept of subordinating the incentive fee to a desired level of owner's return is gaining ground. This may take the form of an owner's priority amount, where the incentive fee is linked to the residual/available cash flow. Moreover, operators today are more willing to commit to a minimum performance guarantee, whereby a certain level of profit is assured, and should that not be achieved, the operator makes up for the shortfall. So, evidently, owners are seeking to safeguard their investments in more ways than seen before.
An operator performance test is more prevalent in management contracts signed in or after 2010, with it commencing typically in Year 4 or 5 for new properties and Year 1 in case of conversion assets. Notorious for not being as effective as it looks, the performance test clause is often drafted in a manner that it is nearly impossible to terminate the operator based on poor performance. Thus, owners and their advisors are finding ways in which the test can be made more robust and fairer to both sides. For instance, while the test period is commonly two consecutive years, we find that a period of two out of every three consecutive years or three out of every five consecutive years is also being agreed upon. Additionally, higher test thresholds are being demanded (greater than 90%), and instances of operators agreeing to GOP "or" RevPAR-based tests, where failure on "either" account could give rise to owner's right to terminate (if left uncured) are increasing. Other customised test formats such as achieving certain EBITDA levels during the test period can also be found.
Contracts that allow the owner to terminate upon hotel sale to a third party are more frequent now than prior to 2010, though it always attracts a severance/termination fee that is payable by the owner. Nonetheless, owners still try and include this provision in the contract as the sale is a lot easier when the asset is unencumbered by a management contract. Moreover, an incompetent operator can be terminated sooner than possible under the typical performance test clause.
Besides the key commercial clauses discussed above, a hotel management contract comprises several other critical aspects that need scrutiny prior to signing. For instance, the technical services fee, which has not undergone a significant change over the years in terms of the absolute monetary amount charged by the operator, is now time-bound. We are seeing more and more contracts stipulating a period ranging from 36-48 months for the technical services to be rendered. Beyond this duration, there is an additional fee payable by the owner to the operator. Moreover, if an operator is making an equity contribution by way of offering key money, the length of the initial term and the management fees charged tend to be toward the higher-end of the spectrum. Not to forget the myriad of fees and charges associated with shared services or chain services - all of which are non-negotiable and can be revised at the operator's discretion. Though most brands now mention the fees for marketing, select reservation services and the loyalty program contribution in the contract, these are just the tip of the iceberg.
Hence, the significance of the owner getting expert advice or guidance before signing a hotel management contract cannot be overemphasised. Over the past two decades, we have seen many owner-operator relationships sour or fail only because not enough care was taken prior to entering the association. As we are asset managing a greater number of properties today, we find that aligning the expectations and financial objectives of both parties is challenging, and an equitable and fair management agreement can go a long way in making the operation of the hotel smoother.
Note: Around 70 hotel management contracts signed between 2003 and 2018 were reviewed by Hotelivate. These contracts represent all market positioning and hotels of different scales - less than 100 rooms to between 300-500 rooms. Also, Hotelivate would like to qualify that all the management contract terms and trends depicted here are broadly indicative in nature, and can vary depending on factors such as location, project profile, operator and investor type.
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