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Mon 24 Nov 2008 04:00 AM

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Negotiating loyalty for royalties

TRI Hospitality Consulting associate director John Podaras discusses the contentious issue of negotiating royalties in an environment where developers are aligning with big names.

TRI Hospitality Consulting associate director John Podaras discusses the contentious issue of negotiating royalties in an environment where developers are aligning with big names.

The culmination of the world-wide credit crunch - which was precipitated by the ‘sub-prime' crisis last year in the US - is leading to increasing anxiety over the ability of developers to adequately finance their hospitality projects.

Ironically, the current situation is manifesting itself despite an indicative softening of construction material prices, whose meteoric growth in the past few years had given rise to early difficulties in project financing.

Associating residential real estate with a well known hotel management company will endow that building with actual expectations.

Those hotel projects that form part of a larger, mixed-use development have the advantage of being able to benefit from an injection of cash early on in the project, by developing other asset classes that are amenable to early sales (off-plan) or shorter construction times than the hospitality component.

However, as markets mature and competition becomes progressively more relevant, developers are looking to more creative ways of adding value to each component of their mixed-use development.

Appealing to a potential buyer's lifestyle aspirations through real estate branding is one such way and the region is starting to see buildings bearing the mantle of various sporting personalities or the livery of famous car production companies, for example.

Whilst the cynics among us may mutter about the emperor's new clothes, there is little doubt that these strategies have a strong following in the market and have been successfully attracting a price premium charge.

It is therefore logical that associating residential real estate with a well-known hotel management company will endow that building with actual expectations as to build quality and service levels that supplement the lifestyle aspirations in the mindset of potential buyers and investors.

An inherent assumption of such schemes is that the attraction of the residential component will be enhanced by its association with the hotel management company, which will offer a menu of à la carte services to its residents and ensure that the common areas are maintained and serviced to the brand standard.

The business model falls into two broad categories; schemes where the residential component is intended for long term residents - often the owners themselves - and those which offer the added attraction of income generation in addition to capital appreciation, through usage and ‘rental pool' agreements.

The units may be delivered furnished or unfurnished in the case of the first category, which in itself can be a cause for much acrimony between developer and buyer as many owners wish to stamp their individuality on their property.

Many operators, through long and bitter experience, will now only offer a limited set of FF&E packages, which may not be altered.

This policy makes even more sense if the unit is to go into a leasing pool and uniformity across the inventory is required. The attraction of branding to the developer is obvious; they can leverage a well-known brand to attract a price premium, which can be considerable - as much as 40% in some cases. The attraction to the operator however, may not be as straight forward.

The obvious benefit of a royalty fee of between 3% and 7% of the sales price at a very early stage of the project is clearly advantageous to the operator, albeit the operator will require guarantees that their brand standards will be maintained throughout the life of the agreement.

However many traditional management companies do not really work like this. Their business model depends on maintaining cashflow levels which explains typical management contract terms in excess of 20 years and many of their boards will look at the royalty fees (albeit considerable in monetary terms) as a secondary priority.

Experienced developers such as Kuwait's IFA have well-defined business models and tend to develop fairly tight concepts which lend themselves for relatively painless management contract negotiations, as their association with Kempinski, Mövenpick and Fairmont would appear to indicate.

Other operators however take a more cautious approach and it is therefore imperative that developers prepare the ground thoroughly, to avoid protracted and painful contract negotiations.

For any type of long term relationship to work, it is essential that the negotiation process yields a win-win all round and therefore the developer, who has to secure the add-on services of the operator for the duration of the agreement and not simply his brand, has to work out a remuneration package that will keep him interested.

The snag of course is that it is not the developer who will be contractually obliged to pay for these services; it is the eventual owners, through a resident's association.

The main bugbear is the so-called maintenance charges, i.e. the cost of providing services for maintenance and operation of the common elements of the asset.

Many of these developments are part of a master-planned community which may be owned by a master developer who will then apportion a range of charges for items such as district cooling, garbage disposal, landscape maintenance and others to each component.

It will be the operator's responsibility therefore to apportion these costs to the eventual owners, in addition to the costs it incurs in providing services and managing and administering the property.

The issue is that the developer needs to tie the operator into the agreement at an early stage of the development so that he can go ahead and market the residential units.

At this stage, it is unlikely that even the magnitude of these charges will be known, far less the establishment of the entity (owner's association) that will eventually have to agree to these charges.

Many operators require that the developer gives assurances, or underwrites a minimum level of revenue for these services, something that a prudent developer would be reluctant to provide, unless they know the market very well and there are good benchmarks for this type of charges.

The upshot of all this is that each case has to be treated on its own merits. The reputation and prestige of the developer is extremely important and often an operator will be prepared to exercise greater flexibility for the residential component if the hotel component is particularly strong.

As the region's real estate cycles struggle up the growth curve towards maturity, so will the management contracts for branded residential units become more commonplace - and hopefully easier to negotiate.

TRI has assisted and advised on hotel management company selections for numerous hotels on behalf of independent hotel owners and institutional owners across the MENA region.

TRI Hospitality Consulting is one of the world's leading management consultancies in the fields of hotels, tourism, leisure and real estate. For further information: www.trimideast.com or +971 4 345 4241.

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