As a hotel consulting professional, I have reviewed hundreds of management contracts for hotels and negotiated them. Each agreement has hundreds of clauses that need to be negotiated. Owners are often at a disadvantage because hotel companies negotiate agreements on a regular basis. This means they may overlook important clauses. This newsletter will highlight three provisions that many owners do not even know they have. In my future newsletters I will cover many other clauses.
Overlooked Provision 1:
Include a limit on the total management fee.
It is probably the most important provision in a management contract. This is often overlooked. All management contracts include a fee structure which compensates the hotel operator for the services rendered. The management fee usually includes both a base and incentive fee. The base fee can be calculated as a percent of total revenue ranging between 3% and 4%. The incentive fee is usually based on a percent of a defined profit. This is often the gross operating profit. However, the structure of the incentive fee can vary. In an upcoming newsletter, I’ll cover incentive management fee. Forecasting the hotel’s incentive fee can be a bit more difficult. The incentive fee will depend on many factors, including the local economic and market conditions, the ability of the operator to maximize revenue and control expenses, and the physical layout and design of the hotel. When you negotiate an incentive fee, it’s impossible to know exactly how much the operator will receive. I’ve seen hotel management firms take a substantial portion of a hotel’s profits in the form of a poorly-structured incentive management fee.
Even though I think a hotel operator should be compensated if they have a good financial record, their compensation can get out of hand. To this end, I recommend all hotel management contracts include a cap for total management fees as a percentage. So, the hotel owner will not be forced to pay more than the operator deserves. I recommend the management fee cap should be between 4% and 6% of total revenue for a first-tier company (one which provides both management AND a brand). If you are a second tier management company, the fee cap ranges from 3% to 5 % of Total Revenue.
A cap is a straightforward and simple way to calculate and implement total management fees. It protects owners and compensates operators fairly. Your management contract has a fee cap.
Overlooked provision #2:
The proceeds of a condemned property should never be shared by operators.
A number of management agreements that I have examined contain clauses that permit hotel operators to receive part of the proceeds of condemnation. Although this provision seems reasonable, it is completely incorrect. I will explain why.
The government can take all or part the hotel’s property through condemnation. The compensation, or condemnation award is meant to compensate the hotel owner for their loss. Real Estate, consisting only of land and improvements. The operator should not be entitled to any condemnation proceeds because, under the terms of a management agreement, the operator does not have an interest in the real estate. The Operator may technically have a business interest in the hotel. This is not compensated by a condemnation.
Management companies can argue that they are entitled to a share in the condemnation proceeds due to the loss of future fees for management or the premature termination of the contract. Courts rarely award these damages unless they are specifically allowed in the management contract.
Negotiating a management contract, you should not let the operator convince you that they can share in the proceeds resulting from a condemned property.
Overlooked Provision 3:
How to structure a buyout clause for an operator
When I negotiate a Management Agreement containing hundreds or provisions, it is important to understand that the agreement will be governed by a number of different laws. Most Important Operator buyout provisions is the clause I would like to negotiate for my client. This clause is important because it achieves multiple key objectives. It can terminate a bad operator quickly. It allows an owner to sell their hotel without having to worry about a management agreement. Owners may take over hotel management and save significant operating costs. Operators perform better when they know that the contract can be terminated quickly at the owner’s discretion.
In order to structure an operator buyout, you must first determine the price of the buyout. Assume that the owner can terminate the contract at any time and for any reason without incurring costs. This will help you to begin negotiations. If the operator doesn’t agree with this approach, you will need to come up with a formula for a buyout. The buyout formula must be simple and objective, and should not rely on future projections and subjective discounts rates. I’ve seen a formula for calculating the buyout value by discounting the future management fees to the current value using the “current discount rate”. The approach could be subject to a massive amount of litigation.
It is better to multiply the management fees over the past year by a factor ranging from 2 to 5. This factor should be included in the agreement, and it can decrease as the contract nears its expiration.
It is worth it to include an operator buyout clause in a contract management. This can be done by trading off other things, such as a higher fee cap or management fee, a longer period, or the elimination of performance tests. The owner gains ultimate control and leverage over the operator with the buyout.
The conclusion of the article is:
You may be sacrificing significant value and control if you don’t include provisions like these into your management agreements. In future newsletters I will discuss additional topics. “Overlooked Provisions.”
