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Tue 15 Jul 2008 04:00 AM

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Pendulum still swings in contract battle

TRI Hospitality Consulting director Gavin Samson examines the latest swings in hotel management contract negotiation and discusses the resulting implications for both owners and operators.

TRI Hospitality Consulting director Gavin Samson examines the latest swings in hotel management contract negotiation and discusses the resulting implications for both owners and operators.

Throughout the GCC, as the pace of development has increased exponentially, the continuum of relative bargaining strength is shifting in favour of the operator.

Our current understanding of the market continues in line with the findings of TRI Hospitality's 2006 Hotel Management Contract Survey; as the level of owner sophistication is increasing, so too is the preference of international operators with the top deluxe, five- and four-star brands to forego hotel opportunities rather than accept lower fees and less control in the strongest GCC markets.

With more than 135,000 confirmed new hotel and serviced apartment rooms due to enter the GCC market by the end of 2012 (73% of these being developed in the UAE alone) the competition for internationally branded hotels is intense. Combine this figure with an undetermined amount of unconfirmed supply being generated via many of the new large scale master planned projects and the opportunity pendulum is likely to sway further in favour of the operator.

Put simply, with only a limited number of properties able to be represented by any one brand in any particular market, aspiring owners should perhaps be less worried about the pendulum swinging back their way any time in the immediate future and concentrate on securing the services of those operators who can offer either strong, well established brands or niche products.

Where development opportunity gaps exist within an operator's expansion strategy, the good news for owners is that those with prime sites and strong concept offerings in either business or leisure locations are still able to negotiate favourably across the entire agreement. In addition, the arrival of first-time operators to the region with limited brand-recognition is allowing the negotiating balance to be maintained.

Top line fees

As management companies globally continue to reduce their owner- operator asset position in favour of pure management contracts, the focus on fees and length of tenure as a means to guarantee future income streams is intensifying and, although full consideration should always be given to all terms of a management agreement, fees remain a key battle ground across the region.

Despite the increasing sophistication of owners with access to experienced consultants and lawyers, top line fees are increasing, reflecting the relative strength of the operator's bargaining position. Base fees maintain a range of between 1.5% and 4%, depending on brand positioning, with a 0% fee in existence (albeit in very limited circumstances). We consider that a ‘top line' fee of between 2% and 2.5% of total revenue represents a neutral point averaged across all market sectors. Operators are willing to reduce base fees in the initial years, but insist on stepping them back up to higher levels from years three to five onwards.

Increasingly operators are splitting the ‘top line' fee into a base fee and another fee that is most often referred to as a ‘licence' or ‘royalty fee'. The reasons for doing this are varied but they are often due to tax issues, the need to submit a fee to head office or the holding company and the right to earn it based on the value or power of the brand. Owners will notice that this fee is invariably non-negotiable and the ability to negotiate on the entire base fee is therefore being restricted.

Incentive Fees

We continue to see a wide range of incentive fee structures. A flat fee of around 8% to 10% of gross or adjusted gross operating profit (AGOP being defined as the GOP less base fees) remains the most commonly witnessed. When these fees rise above this level, they are usually linked to sliding scale structures or a lower base fee.

Structures based on a sliding scale dependant on GOP performance are increasingly demanded by owners and are higher for five-star deluxe brands when compared to those lower down the scale. Levels may exceed 12% to 14% at the top end of the structure for the premium brands and reduce to 6% at the lower end for mid-market brands.

In anticipation of declining market performance as the supply demand equation begins to level out and increased competition comes to the market, operators are likely to tighten up sliding scale structures.

Other fee structures used include the linking of the incentive payment to the annual budgeted GOP level where the operator receives a fee based on incremental levels achieved over and above the budgeted GOP amount.

Length of term

Length of term and subsequent renewal remains one of the main negotiating areas. Operators are generally focused on increasing tenure against the desire of owners to drive down the number of years that the initial term is in effect.

The difficulties associated in terminating the current tranche of new management contracts in the market further reinforces the operators desire for increased tenure and this is reflected in the current market trend of lengthening terms, particularly where deluxe brands are concerned. Where longer terms are being achieved however, owners should be in a better position to insist on performance clauses.

The trend of renewal based on two consecutive periods of between five and ten years continues. ‘Mutual consent' rather than at the ‘operator's sole discretion' is becoming the more favoured way of renegotiating renewal periods, but on the same terms and conditions, thus limiting the owner's ability to renegotiate fees.

Guarantees and clauses

Unlike in Europe and the Far East, where operator guarantees and stand aside provisions are commonplace, in the Middle East they remain a rare commodity. With the increasing insistence by owners on well structured incentive fees to reflect a portion of their risk, operators are unlikely to additionally agree to guarantees. If they do, it usually results in higher management fees. The wording of many guarantees also restricts the owner in enforcing the guarantee in unfavourable market or economic conditions; the very circumstances in which the owner would require it the most.

With contract periods lengthening, owners are trying to include more specific termination provisions based upon objective financial performance criteria, but with so many qualifications and carve-outs put in place by the operator it is difficult in practice to terminate. The performance criteria used continues to rely on the combination of actual GOP to budgeted GOP and RevPAR performance compared to a defined competitive set of hotels.

Operators are reluctant to agree to levels above 85% of budgeted GOP and when this is linked to RevPAR, both criteria must be failed for two to three consecutive years. A cure option almost always follows. In the event that budgetary approval is given to an owner, GOP performance clauses are rarely given.

With rising inflation in the region and increasing rent levels, employee accommodation is now being used as a useful carve-out provision within the GOP performance test. In addition to the usual force majeure and uncontrollable expense provisions, the costs of employee housing are being excluded from the performance criteria.

Termination and transfer on sale

The operators focus on tenure is making it harder for the owner to terminate a contract before its full-term has expired. Termination without cause provisions are rarely witnessed and certainly not voluntarily given in the current market conditions. Where they do exist, significant payment is levied in a variety of forms, such as a termination fee equating to a multiple of preceeding year's earnings or the discounted present value of the management fee income stream for the balance of the term.

The debate on an appropriate discount rate to use and projected earning levels can often lead to further dispute. Even with such exit compensation in place, operators argue that hotels never make money on such termination provisions.

Termination on sale is also becoming more difficult to achieve giving less flexibility to the owner in the sale of a hotel unencumbered by a management agreement. Although many contracts will allow a sale to approved parties, the most watertight of sale on transfer clauses comprise a number of conditions and hurdles which the owner will have to go through.

Typically the operator will first restrict a sale to approved third parties; insist upon a first right of refusal to purchase the hotel; require the owner to finalise the sale to a third party within a restricted period of time; and, if operator consent is subsequently given, insist on a new agreement under the same terms and conditions.

Although not all of these conditions may occur collectively within a contract, when they do, an owner will argue that it interferes in the right to manage his assets.

Budgetary approval

Owners approval of the annual operating plan remains an essential tool for protecting their interests The level of control is however heavily influenced by specific wording in the contract which varies from ‘budgets dependant on owner's approval' to the ‘consideration of owner's comments in good faith'. Further dilution of control comes in the form of cost overrun clauses where in some cases, when percentage limits are not set, the operator is not obliged to keep to the approved budget.

Non-compete clauses

Territorial exclusivity continues to be a deal breaking issue in many management contract negotiations as both cities and operator portfolios in the Gulf expand. Gone are the days when operators would agree to country-wide exclusivity for their brands. Owners may still be able to obtain city wide exclusivity for ‘trophy assets' although this often has more to do with the operators' desire to restrict such brands to single representation in any one market as part of their expansion strategy.

In the majority of contracts we continue to see non-compete provisions but with the geographical areas becoming increasingly restricted as operators seek to limit what they see as a damaging factor to brand expansion. With the development of so many strategic clusters within Dubai for example, it is giving operators the opportunity to plant more flags in the ground and limit territorial exclusion.

Restriction periods continue to fall within a number of brackets. Initial periods of between one and five years, five and 15 years or for the term of the initial contract are most common. Radius restrictions reducing over time (burn out clauses) based on the hotel's ability to meet certain volume criteria (hotel or market area occupancy for example) to gauge market growth potential are also considered.

Where restriction clauses are not in place, a great deal of trust is placed on the operator balancing the need for operational efficiency gained through multiple properties in close proximity weighed against the risk of cannibalising demand from competing assets. In a mature market it is possible for the operator to achieve this balance.

Non-disturbance agreements

The complex relationship that is generated through operator insistence on non disturbance agreements is often misunderstood by new owners but we see a growing trend towards their inclusion within management contracts as leveraging in the region, and the involvement of local banks, increases. As the market matures, resistance to NDAs is likely to increase from institutional investors and hotel based private equity funds where exit strategy is all important.

From an operator's perspective such agreements are important because they provide the operator with a direct contractual relationship with the owner's financier, allowing tenure to continue in the event of default, for example. From a financier's perspective, such an agreement can be beneficial as control can be handed over smoothly with minimal operational disruption. Some financiers however take the view that hotels are less valuable as collateral if encumbered with an existing contract, particularly if default has been caused by the operator.

While there are operators for whom NDA clauses are a deal breaker, others do not insist upon them, however they will generally not allow vacant possession upon sale and will require such an understanding with the financier.

In signing up to any NDA in future contracts, the owner's dilemma is ‘do I go to the lender having agreed an NDA with an operator or do I go to the operator having agreed an NDA with the lender?' Views are more often diverging rather than converging and owners are advised to seek clarification from both parties before signing these agreements.

Ownership structure

As property ownership is further liberalised and the laws in the region evolve to allow this, both investor and developer appetites for different types of ownership structure within hotel developments is increasing. One of the main drivers is the ability to fund or part fund the construction phase with residential sales. Management agreements are therefore becoming more complex and sophisticated to reflect these structures.

Whether it is due to the embryonic nature of the market, operators are unsurprisingly lukewarm at present to the concept of ‘sale and leaseback' or the ‘condo hotel' and view this as an operational headache with too much associated risk exposure. The concept often brings with it unrealistic yield levels that are promised to the property owner by the developer, too many layers of representation to deal with and often a large percentage of such owners wanting their room or property within confined periods of the year - often at peak times when the operator is looking to maximise the hotel's room inventory.

Operators who would consider managing a hotel room pool generally do so only if such agreements are heavily weighted in their favour. Total control must be given on service delivery, inventory and room letting. One representative body has to be in place to deal with the operator, recognising their right to manage the room pool for the duration of the contract, which usually results in the signing of both a rental pool and association agreement. The investor's use of their property is subject to availability and the operator will be in no way linked to a developer's guarantee of return or yield.

Developers should not presume therefore that operators in the present climate will automatically jump at the opportunity to manage a letting pool. Conversely, recognising that residential sales are financially lucrative, operators are much happier to take a commission rate on the sale of branded residential, and offer a serviced rather than a managed product.

Key personnel and staff

The owner's right to approve the general manager and the financial controller is finding increased resistance from operators given the current ‘war' on manager talent.

With question marks being raised over the ability of management companies to both source and train new staff for the hundreds of new hotels planned over the next five to seven years, senior staff are no exception and talented GM's are becoming harder to find. We therefore expect to see the tightening up of key personnel clauses in terms of the number of potential candidates an owner can turn down.

Brand confusion

Operators are becoming increasingly stringent on the protection of their brand standards as they roll out more concepts across the region and seek to limit brand confusion. Technical Service Agreements are therefore being tightened to define brand criteria and to prevent owners from over engineering new hotels and challenging these standards.

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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