HOUSTON — Hotel owners and operators have changed some of their approaches to management agreements because of lessons learned in the pandemic as well as in preparation for a potential recession.
In a presentation on the state of hotel management agreements at the Hospitality Law Conference, Cliff Risman, partner and co-chairman of the hospitality and leisure practice at Foley & Lardner, said the competition is high to strike management deals.
In a crowded field, hotel operators are distinguishing themselves via their balance sheets, he said. Some make an equity investment into ownership through preferred equity or subordinated equity. They might do it through subordinated debt that’s junior to the owner’s mortgage financing. They might also guarantee a certain return.
“The most prevalent way that the managers use their balance sheet is providing key money, which in the simplest terms is writing a check to buy a contract,” he said.
If the manager remains the operator of the property for the full term of the contract, the owner doesn’t pay back the key money, Risman said. Key money amortizes typically on a straight-line basis over the guaranteed term, so if the term ends prematurely, the manager is due the unamortized portion of the key money.
There will be a lot of conversations and negotiations between owners and managers about exceptions to paying back key money, he said. If there are issues with managers defaulting, failing performance tests or other factors, depending on their leverage, owners might make some headway.
“But generally speaking, the key money is repayable come hell or high water if the term ends prematurely,” he said.
Fee Structures
Most management agreements have a base fee — a percentage of gross revenue that comes off the top regardless of whether the asset is operated for a profit, Risman said. Many management agreements have an incentive fee component layered on top of the base fee that could be structured as a percentage of gross operating profits, usually calculated as some return on the owner’s cost.
Lately, many base fees have been lowered while the potential to earn incentive fees has increased, he said.
Another change stems from the fact that when hotels were closed or just not generating any revenue during the pandemic, that meant managers weren’t getting any money because base fees are a function of gross revenue, he said. Now, many managers, particularly non-branded managers, are wanting a minimum guaranteed base fee. For example, that could be the greater of 3% of gross revenue or a specific dollar amount per month or year.
That means they know they’re going to be paid something, because they say when an asset is closed and not generating revenue, they work as hard if not harder than when the hotel is open and operating at a profit, Risman said.
Terminating a Contract
The ability to terminate contracts is always hotly contested, Risman said. A more recent development has been hotel owners, particularly with non-branded managers, seeking the right to terminate a contract without cause. That usually involves paying a negotiated fee.
One reason an owner could terminate a management agreement is if the manager fails a performance test, he said.
“These tests can be designed in many, many different ways, but generally speaking, most of them are designed such that it’s nearly impossible to fail the tests,” he said.
More often than not, these tests don’t even start until three to four years into a contract, Risman said. That’s because judging the performance of an operating hotel while it’s still ramping up, before stabilization, is seen as inappropriate. The tests usually take a two-pronged approach over two years: a cash-generation goal and the hotel’s revenue per available room measured against the competitive set.
The operator would have to fail both prongs to fail the performance test, he said. It might miss its revenue generation goal, but that could be because the entire market is performing poorly, as made evident by the RevPAR comparison.
Even if the operator fails the performance test, there are possible exceptions, Risman said. There could be a force majeure event, a default, the failure of the owner to fund, a significant renovation or several other reasons.
The courts have routinely held that hotel management agreements fall under the law of principals and agency, Risman said. Operators may write their contracts to call themselves independent contractors or call the contract a provision of personal services, but the courts have held hotel owners and third-party managers have a principal-agency relationship.
“The reason that that's important is that under the law of principals and agency, the principal always has the power to terminate an agent, no matter what the contract says,” he said.
The operator can’t go to court and have a judge order the owner to allow them to continue operating a hotel, he said. The caveat is if that termination is wrongful, under the terms of the contract, the manager is entitled to damages.