Three Critical Clauses Hotel Owners Overlook in Their Management Agreements

Overlooked Provision #1:
Include a Cap on Total Management Fees.

This is one of the most overlooked, yet probably one of the most important, provisions in a hotel management agreement. All management contracts contain some type of fee structure that compensates the operator for managing the hotel. Generally, the management fee includes a base fee and an incentive fee. The base fee is usually calculated as a percentage of total revenue, ranging from 3% to 4%. The incentive fee is typically based on a percentage of a defined profit, usually the gross operating profit; however, there are numerous permutations of how the incentive fee can be structured. (I will cover incentive management fees in an upcoming newsletter). While it is fairly easy to project the hotel’s base fee, forecasting the incentive fee is another matter. It will vary depending on local market and economic conditions, the operator’s ability to maximize revenues and control expenses, the hotel’s physical layout and design, as well as many other factors. The bottom line is that when you negotiate the incentive fee, you simply don’t know how much it will translate into dollars for the operator. I have seen hotel management companies take a significant portion of the hotel’s profit in a poorly structured incentive management fee.

While I agree that a hotel operator deserves to be compensated for a strong financial performance, there is a point at which their total compensation can be egregious. As a result, I recommend that all hotel management contracts contain a cap on total management fees expressed as a percentage of Total Revenue. This way, the owner is protected from paying the operator more money than they deserve. I recommend that the management fee cap for a first-tier management company (one that provides a brand and management) should range from 4% to 6% of Total Revenue. For a second-tier management company (management but no brand) the fee cap should range from 3% to 5% of Total Revenue.

A cap on total management fees is a simple and straightforward calculation and implementation that protects the owner and fairly compensates the operator. Does your management contract have a fee cap?

Overlooked Provision #2:
Operators Should Never Participate in the Proceeds from a Condemnation.

Many of the management agreements I have reviewed have clauses that allow hotel operators to receive a portion of the proceeds from a condemnation. While this seems like a reasonable provision, it is totally wrong. Let me explain why.

Condemnation (or eminent domain) involves the government taking all or part of the hotel property. Compensation, also known as a condemnation award, is intended to reimburse the owner for the loss of their real property, which comprises only the land and improvements. Since, under a management contract, the operator has no interest in the real property, it should have no claim to the condemnation proceeds. Technically, the Operator might have a “business interest” in the hotel, which is not compensatory from a condemnation.

Some management companies may argue for a share of condemnation proceeds based on the loss of future management fees or the value of the management contract being terminated prematurely. However, unless specifically permitted in the management agreement, courts rarely award such damages.

Therefore, when negotiating a management agreement, don’t let the operator persuade you to allow them to participate in the proceeds from a condemnation.

Overlooked Provision #3:
How to Structure an Operator Buyout Provision.

When I negotiate a management agreement containing hundreds of provisions, the MOST IMPORTANT clause I want to get for my client is an operator buyout provision. This clause is crucial because it accomplishes several key objectives. It can quickly terminate an incompetent operator. It allows the owner to easily sell the hotel unencumbered by a management contract. Owners can take over the hotel’s management, resulting in significant savings on operating costs. Operators will perform better knowing that their contract can be quickly terminated at the owner’s discretion.

The key to structuring an operator buyout is determining the buyout price. You should begin your negotiations by assuming the owner has the right to terminate the agreement at any time, for any reason, without incurring any costs. If the operator won’t go along with that approach, then you need to agree on a buyout formula. The buyout formula should be simple and based on objective facts, rather than future projections and subjective discount rates. I have seen a buyout formula that requires projecting future management fees throughout the remainder of the contract, discounted to the present value at the then “current discount rate.” That approach is likely to be the subject of massive litigation.

A better formula is to simply calculate the buyout price by multiplying the management fees for the past 12 months by a factor that should range from 2 to 5 times. This factor must be stated in the agreement and can also decrease over time as the contract approaches expiration.

Incorporating an operator buyout provision in a management contract is worth trading off things like a higher management fee or fee cap, a longer term, or even the elimination of a performance test. The buyout gives the owner ultimate leverage and control over the operator.

Conclusion
If you are a hotel owner, advisor, attorney, or investor and you’re not including provisions like these in your management agreements, you may be leaving significant value and control on the table. In future newsletters, I will cover additional “Overlooked Provisions.”