Funding Hotels and what to look out for in Hotel Management Agreements
The choice of operator and strength of its brand is often integral to a hotel's success in today's highly competitive leisure market. However, the appointment of a third party operator in relation to a hotel also brings with it an extra layer of complexity for any financing arrangement.
A funder should make sure that it carefully reviews the operator's hotel management agreement (HMA) before agreeing to finance the hotel in question as the agreement may restrict the funder from doing what it wants in relation to the property, particularly in the context of an owner default and an enforcement of its security. In addition, the funder will want to enter into direct contractual relations with the hotel operator, typically by way of a non-disturbance agreement.
Reviewing the HMA – things to look out for
Operator "services standard": The operator will wish to operate the hotel in accordance with the services standard for their brand so that it can maintain the brand's value and reputation. A funder should check what rights an operator has to vary the services standard or the brand of the hotel itself. Some owner controls should be in place to limit the operator's discretion to make changes that could, for example, adversely reduce the hotel's target customer market or increase operating costs, thereby reducing revenues available for the owner to pay its funders.
Revenue distribution: A funder should make sure that the agreement clearly sets out how the hotel cash flows operate and how revenue can be used. The operator will usually have primary control over the main operating account so that it can, among other things, release funds to pay hotel operating costs incurred as and when they fall due. The agreement should include some form of priority of payments waterfall so it is possible to determine when funds will be distributed to the owner (and which can be used to repay funders). Some agreements include an owner priority return or operator revenue guarantee which helps create some assurance for funders that an owner will be guaranteed to receive some revenue from the hotel.
Budget controls: Whilst an operator should be allowed to get on with the business of running the hotel, the scope of the operator's discretions should be limited by certain budgetary constraints and owner approvals. Cost controls on hotel expenditure should be in place to make sure that some revenue is left for the owner to pay its funders.
Each year, an annual budget should be agreed between the owner and operator which sets out the proposed operating budget and capital budget. The annual budget should also include details of the hotel's anticipated revenue and expenses, occupancy, charging structure, salary costs and marketing plan. It will be important to make sure that there are no hidden charges or unexpected costs which could adversely affect revenue available to the owner. The agreement is likely to contemplate the establishment of a fund for the replacement of furniture, fittings and equipment, but the size of the fund should be capped at a specified percentage of annual revenue, typically 2-4 per cent. The agreement should also give the owner the right to have regular meetings with management so that the owner can check that the hotel is being run in accordance with expectations. The funder will, at the very least want to be given a copy of the annual budget and may also wish for such budget to be subject to their approval.
Management fees: The operator should be remunerated by way of a basic fee and an incentive fee. The basic fee should be an amount equal to a percentage of adjusted gross revenue and the incentive management fee should be a percentage of gross operating profit. The funder should make sure that the percentages are set at the right level for the hotel so that they appropriately incentivise the operator to maximise profit and keep the hotel running to the best of its abilities.
Termination rights: The agreement should include provisions enabling the owner to terminate the agreement in certain circumstances. Such circumstances may include where the operator has become insolvent, is guilty of fraud and/or wilful misconduct in connection with its obligations under the HMA or if they have persistently breached material provisions of the agreement which give rise to material loss or damage to the owner. Some agreements also include gross operating profit performance targets for an operator which, if not met, enables the owner to terminate the agreement.
Whilst the targets are usually set so that they are hard for an operator not to meet, such provisions can be effective in making sure that operators maintain a hotel's performance.
Purchasing contracts: During the term of the agreement, the operator will be responsible for the purchase of all goods and services. Funders should check to make sure that the operator is only able to enter into supply contracts or leases that are competitively priced and which are appropriate for the hotel in question. The operator should also be required to account the owner for any discounts or benefits it receives so that they can be priced into budgets or passed onto the owner. The provisions should help avoid the owner being overcharged for services that could ultimately reduce funds available to the owner for funders.
Selection of key personnel: A funder should check to make sure that the agreement gives the owner the right to be consulted on the operator's selection of manager for the hotel. The selection of a suitable manager will be important for the successful running of the hotel and the owner may have helpful insight into who the manager should be. Some agreements allow the owner to propose the removal of the manager where he reasonably considers that the manager is underperforming. Such a right may be a useful tool in making sure that the operator always has appointed the best manager possible. Where a manager is appointed to manage more than one hotel, the liability for the manager's remuneration should be shared appropriately between the hotels.
Protection of IP brand: An operator will wish to protect its IP rights and brand reputation at all costs. There may be instances where the operator will wish to take action in the name of the owner to protect its rights. Funders should check to make sure that an operator is not able to take action which could adversely affect the owner and in turn potentially impact upon the value of the owner or the hotel.
Ownership of guest details: When reviewing the agreement, a funder should check to see who owns what customer data. The personal contact details of hotel guests will be valuable information for the owner to have possession of following the expiry or termination of the agreement. Operators sometimes agree to provide owners with copies of guests' contact details but usually consider that frequent or executive customer data collected by the operator belongs exclusively to them.
Assignment and transfer restrictions: It is important to note that most agreements do not enable the owner to freely assign or transfer the ownership of the hotel. The agreement usually prohibits the owner from selling, sub-leasing, exchanging or otherwise disposing of the hotel to a party which could reasonably be considered unable to fulfil the financial or other obligations of the owner, be linked to organised crime or be a competitor of the operator. The term competitor is usually broadly defined to cover any potential competitor of any brand belonging to the operator. The provision is designed to protect the operator from having to operate a hotel for an entity that it would not otherwise wish to be in business with. However, the restriction may be problematic where the owner has defaulted on its financial obligations, the funder has enforced its security and it is looking for a potential buyer to sell the property to. The restriction is likely to reduce the number of potential buyers eligible to purchase the hotel.
Dispute resolution: During the term of an HMA, there may be disputes between the parties that will need to be resolved. Types of dispute could include disagreements over proposed costs to be included in the annual budget or over the occurrence of events leading to a potential termination event. Funders should make sure that the agreement contains clear dispute resolution provisions which facilitate the speedy resolution of disagreements in a cost effective manner. Prolonged disputes could impact of the revenues generated by the hotel and owner funds available to pay funders. Appropriate provisions might include arbitration arrangements or references to a recognised independent specialist in the area which is the subject of the dispute.
HMAs usually have a long tenure, such as 30 years or longer, with an option to purchase the hotel at the end of term. This is to allow operators time to build up the reputation of the hotel in question and maximise the incentive fees that they are likely to receive. Agreements usually contain a non-disturbance provision such that the agreement cannot be terminated when a hotel changes hands, even in the circumstances where a funder enforces its security and takes control of the property.
In addition to this, funders typically seek to enter into a non-disturbance agreement directly with the hotel operator and the borrower. A non-disturbance agreement can be helpful for funders as they usually contain provisions that enable a funder to cure owner defaults or step into the obligations of the owner under the agreement so that operating arrangements can be maintained in owner default situations. These rights may be helpful during the period immediately after an owner default where the funder may wish for the operator status quo to be continue before it decides what enforcement actions to take. In addition, to the extent that any provisions in the HMA are not satisfactory to a funder, this can be dealt with in the non-disturbance agreement.
Please contact the author if you require further detailed advice on HMAs or non-disturbance agreements.