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Changing hospitality agreements for sector’s good health

Simon Allison

Published: Updated:

Most people outside the hotel industry do not realize that the brands you see on nearly every hotel around the world, such as Hilton, Marriott and Holiday Inn, do not own the hotels on which they sit.

Instead, the underlying properties are owned by a wide array of real estate investors – developers, specialist funds, listed companies, pension and insurance companies, family offices and sovereign funds. This structure came about as hotel companies came to realize, starting in the 1980s that the stock markets were unable to value their real estate holdings and that specialist property investors would pay far more for them – leading to a massive sell-off.

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Since then, the brands on hotels have generally used one of three structures: leases; management contracts, or franchises under which to operate. The COVID crisis has shown that two of these three no longer work and that owners need to create new and innovative ways of ensuring that their operators share risk but do so in a viable way.

Leases are widely deployed in continental Europe - and in Germany, especially these are traditional fixed leases. When COVID hit, these immediately became impossible to service for smaller operators who did not have the cash-backing to pay rent when they had no revenue.

Fair enough.

However, most of the big brands, and even those with billions of dollars in the bank, also went to their landlords and demanded rent holidays or even long-term reductions. The theory was that landlords would be hard-pressed to find a new tenant on the same terms if they took back the keys, so they would buckle. Some did; others, in markets where the rent is a legal obligation, held firm, but it left a pretty bad taste in the mouth.

The situation in management contracts is more complicated. These arrangements usually give full control over all staff and all decisions to the operator with the owner’s only real control being to approve the annual budget (and even that right is now being limited by carve-outs when the big brands negotiate with new and naive owners).

The brands in theory get rewarded with a base fee (a percentage of revenue) and an incentive fee (a percentage of operating profit). Most owners have become pretty savvy about those fees and the long-term structure of 3 percent base and 10 percent operating fees has now gone out of the window – with a 1-2 percent base and a ratcheted 8 percent incentive fee becoming the norm.

Unfortunately, the brands have found multiple other ways of charging and recharging costs to owners, costs over which the owners nearly always have zero say. Some are fair and transparent, with for example, the inclusion of a sales and marketing fee. Others are hidden in the fine print of a lengthy contract or, more often, simply enabled under the discretionary terms of the contract wording.

One brand reputedly has up to 600 different charges and recharges for owners, including a charge for every IT-related email sent to the hotel and another charge for resetting a hotel employee’s password. These are, of course, on top of the management fees, which make owners increasingly question what those fees cover.

To make matters worse, in the interests of simplicity some brands have replaced individual and auditable line-item recharges with blanket “system fees” which cannot be challenged. This certainly saves a lot of hassle for both owners and operators and avoids brands dealing with often fatuous objections from aggressive owner reps, but it also moves another block of costs away from any oversight.

In 2020, owners did not worry about this too much - nobody in the hotel sector was making any money and zero revenue means zero fees. In 2021, however, the mood is changing. Owners with hotels running at occupancy from 25 percent to 50 percent may well be losing money – but still paying a significant amount to their operator and they increasingly feel dissatisfied. In the long-term, it is simply not viable to have an industry structure where one side is locked into a deal where it can lose money year after year, while its partner continues to prosper.

What can be done?

Owners have several alternatives. One is to use the third model, franchising, whereby they pay a fee for the brand and its distribution and brand standards, but run the hotel themselves or through a third-party operator. This is now the normal structure in the US and gaining increasing traction in the Middle East and Europe.

Another way would be to look at hybrid structures under which the owner and operator share risk. This can involve:

Hybrid leases, where the owner pays relatively low base rent at perhaps 4-5 percent of revenue and then a profit-share element which ensures they do well if the hotel makes money – but so does the owner – this is common in Spain and Scandinavia.

Risk-sharing management contracts, where the remuneration is mostly in the incentive fee and where the brand can be terminated if it is not hitting profit targets which represent a reasonable return on equity for the owner (today’s so-called performance tests under which an operator can, in theory, be terminated are in practice almost impossible to fail).

A new form of management contract in which the brand has to live on a pre-agreed set of fees and recharges, which can be fully audited and which it cannot change during the life of the contract without owner approval.

If any of the big brands were to offer the last two of these, they would have a massive advantage with owners; and if they do not, owners should band together to press for these changes, which they need and deserve to achieve.

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Disclaimer: Views expressed by writers in this section are their own and do not reflect Al Arabiya English's point-of-view.