A professional hotel management firm can be an excellent strategy for leveraging operational expertise, gaining brand recognition and enhancing market competitiveness. Many owners do not realize the risks that these agreements pose to their long-term asset value. A hotel management contract that is not carefully negotiated can be a boon to the operator at the expense of the owner.
Before signing a management agreement, every hotel owner must be aware of and prepared for ten major risks.
1. You lose control of key decisions
In most hotel management contracts, the operator has a wide range of decisions to make, including those relating to staffing, pricings, vendor contracts and marketing initiatives. Owners may not have much say in the major financial and operational decisions if there are no owner approval rights.
- Consequence: Some decisions may conflict with an owner’s long-term investment strategy or goals, such as hiring too many people, making unnecessary renovations or misaligning marketing campaigns.
- Mitigation: Owners should negotiate clearly defined approval rights for operating budgets, senior personnel, capital plans and marketing expenses. Owners should retain the right to veto key hires, brand standard waivers and veto over capital plans.
2. Misaligned financial incentives
Operators usually earn fees based more on gross revenue than profit. It is important to drive top-line revenues, but this can come at a cost of operational efficiency or prudent expenditure control.
- Consequence: Operators may put occupancy above rate, invest excessively in promotions or ignore cost savings opportunities, leaving owners with little or no profit, despite increasing revenues.
- Mitigation: Incentives management fees can be tied to revenue and profit metrics, such as GOP (Gross Operation Profit), NOI(Net Operating Income), or even GOPPAR (Gross operating profit per available room). Include budget-to actual tests and obtain owner approval for high-cost expenses.
3. Ineffectiveness with no easy exit
Hotel management agreements are usually for 10, 20, 30 or more years. They have limited termination provisions. Owners can find themselves stuck with an unproductive manager if the contract doesn’t include performance clauses.
- Consequence: The effects of operational mediocrity and mismanagement can last for a long time, degrading the value of assets, frustrating investors and lowering returns.
- Mitigation: Include a two-performance test with a limited cure period (e.g. RevPAR Index or Budget-to Actual GOP). Most importantly, include a termination-without-cause option or a defined operator buyout clause that allows the owner to exit the agreement by paying a pre-agreed termination fee.
4. Hidden and uncontrollable costs
Operators will often charge for centralized service, loyalty programs and marketing fund contributions. These fees can be opaque, poorly explained, or non-negotiable.
- Consequence: These costs can be a significant drain on profitability, especially when the market is soft.
- Mitigation: Negotiate transparency, audit rights and all charges for corporate. For loyalty programs or services centralized that do not demonstrate ROI, push for opt-out provisions. Spending caps should be set on consultant and system charges.
5. Asset Reputation Damage and Market Position
Operators could fail to deliver an consistent guest experience, make brand decisions which are in conflict with local markets, or underinvest in maintenance. Misaligned branding can also reduce value and competitiveness.
- Consequence: Reduced revenue and resale values can be directly affected by declining guest satisfaction, low ratings online, poor reputation and reduced market shares.
- Mitigation: Require capital improvement plans on a regular basis and enforce brand compliance. Include contract clauses that allow for replacement of operators in the event of damage to reputation, failure to satisfy guests or misalignment with brand.
6. Conflicts of interest between the operator and owner
Large hotel companies own, operate, or franchise competing properties in the same market. The hotel companies may prefer to manage their own assets or hotels over those managed by others.
- Consequence: You may see your hotel suffer from cannibalization or internal rate competition. It could also receive less attention, and have fewer resources, than properties owned by operators.
- Mitigation: Negotiate a clause of protection that prohibits the operator from managing, branding or marketing directly competing properties on your market. Demand that all properties being considered or developed by the operator to be competitive with yours are disclosed.
7. Brand Standards are the Cause of Excessive Investments
Many operators use property improvements plans (PIPs), mandated by their brands, to enforce costly renovations. They do this sometimes for the sake of brand marketing and not necessarily ROI.
- Consequence: Owners are often required to spend millions of dollars on renovations that have little return, affecting their investment and locking up capital.
- Mitigation: Owner approval is required for all capital projects. A feasibility study or ROI projection should be used to tie capital expenditures. Defer non essential brand upgrades and negotiate an amortization schedule over the remaining terms of the agreement.
8. Transparency is lacking in financial reporting
Some operators restrict access to financial data or use unclear internal systems. Others do not provide detailed departmental breakdowns.
- Consequence: Owners cannot evaluate performance, control costs, or identify inefficiencies without accurate and timely financial reports.
- Mitigation: Include robust reporting requirements with monthly detailed P&L statements, cash flow forecasts, and variance analyses. Include audit rights, and the ability to hire an external asset manager for operations oversight.
9. Legal and Compliance Risks
Operators may expose property to risk due to unsafe work practices, non-compliance with local laws or inefficient labor practices. The operator is the agent of the owner, so liability can be transferred to that entity.
- Consequence: Fines, reputational damages, legal action and, in some cases loss of license or insurance coverage.
- Mitigation: Require an annual audit of compliance and legal issues. Assure that the operator has proper insurance, licensing and training. Include indemnification and legal compliance as material performance obligations.
10. Inflexibility in the Sale or Refinancing
Hotel management agreements can hinder efforts to refinance the hotel or sell it. Lenders and buyers may be reluctant to sign long-term contracts with management that restrict operational flexibility.
- Consequence: Hotel management may be unattractive to buyers, resulting in a loss of potential customers or a discount on the value.
- Mitigation: Include clauses that will allow the termination of a hotel management contract upon sale. This can be done with or without fees. Make sure the agreement can be assigned and is structured to meet financing needs.
