what’s next? - trends in lease, management and franchise contracts

The contractual relationship between owner and operator has always been a key issue in hotel development. In the past, we have seen significant changes in this relationship which resulted from various factors such as the expansion strategies of hotel groups, the types of investors active in the hotel market, and the requirements of lenders with regard to debt funding.

major developments

On a global scale, hotels operated under a management agreement are prevailing and increasingly replacing owner-operated hotels and other contract constellations such as lease agreements. This development can be traced back to  the expansion strategies of the major international hotel operating groups. In order to facilitate faster growth, these groups have been pursuing an asset-light business model. On the one hand, this was implemented by major sale-and-manage-back transactions of existing assets which have set free valuable capital for new developments. On the other hand, the focus was clearly put on an expansion by signing new management agreements. Most hotel groups are focusing on their core competence of managing hotels and — as a consequence — are shifting operational risks to the owner. However, in some regions (e.g. Europe), the lease agreement is still the predominant contract model and its replacement by the management agreement is proceeding at a slow pace. This can partly be ascribed to the background of hotel investors and to the requirements of lenders.

A significant share of hotel investment in Europe is undertaken by institutional investors such as real estate funds, pension funds or insurance companies. These investors often require (either by law or their articles of incorporation) income from rent and lease. Due to this fact, these investors can only enter lease agreements, but not management agreements (which would generate income from trade and business).

Furthermore, lenders in Europe are still rather conservative, which becomes evident in their preference of lease agreements, where the lessee bears the full operational risk and the lessor can provide a steady cash flow to cover the amortisation of debt. However, the assumption that a lease agreement always carries less risk than a management agreement has to be generally questioned.In times of economic prosperity, over-rented agreements were signed by lessees anticipating a continuous economic growth. In the economic downturn, lessees were often not able to (fully) pay the rent. If no guarantees (e.g. bank or corporate guarantee) were provided by the lessee (which would cover such a shortfall), a default of the loan repayment by the lessor was often the consequence. Thus, a lease contract per se is not always a safe bet and therefore should be analysed in conjunction with several factors such as the creditworthiness of the lessee, the provided guarantees and, of course, the cash flow the lessee can generate.

In order to evaluate as to whether a reasonable coverage of the rent is feasible, the rent coverage ratio (= adjusted net operating income before rent divided by rent) is the figure being used most commonly. As a rule of thumb, this ratio should not be below 1.2 in order for the lessor to feel comfortable that the lessee still has a certain buffer in difficult economic times.

tri-party agreements

The above-mentioned development has also set the framework for the so-called tri-party agreement.
In this contract constellation, a franchisor (which is usually an international hotel operating group) provides a brand name, brand standards and selected services (e.g. reservation system) to the franchisee operating the hotel.

Additionally, a so-called owner agreement between the owner and the franchisor is concluded, which records the owner’s right to maintain the brand name in the case of default of the franchisee and often includes the provision that the franchisor steps into an interim management agreement until a new lessee is found. In addition, the franchisor usually commits to identifying potential successor lessors (e.g. amongst their existing network of franchisees).

The Courtyard Vienna Messe (see picture) is one example where such a tri-party agreement has been realised. Overall, this constellation facilitates the risk-averse expansion strategy of hotel groups acting as franchisors. At the same time, it provides a lease contract for the owner which increases the chances of securing debt funding. Thus, the tri-party constellation is an agreement expected to occur increasingly often.

which way out? - dealing with distressed contracts

Since the beginning of the global financial crisis, the hotel industry has been facing an increasing number of distressed hotel operating agreements (such as fixed lease agreements or management agreements with a guaranteed minimum result). In the following, we exemplarily refer to lease agreements, but in principle, the same rules can be applied when it comes to guaranteed results in the case of management agreements.

what has happened?

In prosperous times, many hotel developers, investors and owners had asked for significant lease amounts. The lease often had been structured as a fixed payment without including any variable element. In retrospect, one could blame the lessors for being greedy. On the other hand, it still takes two to tango: in order to secure a deal, many hotel operators had not been reluctant to accept leases which one would have had to turn away in light of a thorough commercial analysis.

With the increasingly severe turmoil on the financial markets, almost all tourism destinations in the world slid into depression. Significantly decreasing  average room rates and shrinking corporate as well as leisure travel budgets led to deteriorating revenue levels. Cost-cutting as a countermeasure to offset lost revenue proved successful to some degree, but ultimately, the profit margins were no longer sufficient to cover the lease obligations.

Lessees/operators were forced to either inject funds from outside of the distressed business, or to reduce the lease payments to the owners. The owners, on the other side, had to cope with ever decreasing cash flows, which in turn hindered them from serving their loan debt annuities.

what’s the solution?

Once a hotel lease agreement needs to be labelled as distressed, the first step is for both parties involved to simply acknowledge the fact, to liaise in a timely fashion, and to find a way out which gives both the lessor and the lessee a fair chance to survive. As a technical pre-requisite, it is recommended to commission an operational review of the suffering business in order to find out as to whether the lessee is in default due to mismanagement, or on account of the general market environment. For instance, the owner and developer of the Chopin AirportHotel Bratislava, had anticipated a distressed contract prior to the opening and switched to the now current operator.

The outcome of such an operational audit may be that the property is over-rented, i.e. that the lease payable to the owner is in excess of the cash flow to the lessee generated by the hotel business. This situation is usually of temporary nature, i.e. circumstances which are beyond the control of the parties have caused the turbulence. In some instances, however, the analysis might unveil that the lease amount is too large to be recoverable from the hotel’s potential income under all circumstances.

a possible way out

When the parties re-negotiate a lease agreement, it is paramount for the owner to establish the overriding principle of such an endeavour: to provide relief to the lessee (and thus to the lessor!), but not to effect an irretrievable loss of the lessor’s upside potential, which would result in an enduring depreciation of the asset. In other words: Whatever solution is worked out by the parties, it must not be a one-way road. Once the economy recovers, the lease to the owner should recuperate in an appropriate manner, too.

As an example, fixed leases are usually transformed into variable leases, often being a revenue-based lease with a (relatively low) guaranteed minimum floor rent. The beauty of the revenue-based lease with a fixed portion is: the larger the revenue, the larger the lease (hence, this is basically a reasonable model to reflect eventual recovery). But besides the shared upside potential, there is still some sort of downside protection from an owner’s perspective. The weakness of this model lies in the negotiated longterm fixed lease percentage, and in the rather low minimum rent the operator would commit themselves to when they are still in dire straits. A possible solution which has been elaborated on over the last two years is the introduction of so-called sliding lease percentages and minimum lease amounts.  The larger the total revenue, the higher the lease percentage. And the higher, for example, the GOP (gross operating profit)margin, the larger the minimum lease amount. The rationale behind this: in times of an economic downturn, average room rate and occupancy are usually down, too. The fact that expenses cannot be cut to an extent commensurate with the decline on the revenue side results in a decline in overall profit margin.  The profit margin (or GOP) is a sensible indicator for the potential lease percentage. However, it is not in the owner’s interest having to monitor the lessee’s cost management capabilities. This is why a sliding lease should not only be tied to the GOP, but to the total revenue. The revenue of the rooms department usually makes up for the lion’s share of total revenue, and rooms revenue is basically an equation of ADR and occupancy. An increase in ADR should almost fully fall through to the bottom line (= GOP). And an increase in occupancy should also contribute to the margin besides covering fixed cost.

However, they also bear the full economic risk. Nevertheless, the highly specialised nature of the product barely allows for any standardised operating agreement, which is why the typical lease or management agreement can seldom be used or only in smaller facilities.

As theme parks are heavily dependant on current trends, a continuous extension/adaptation of the offered attractions and thus constant investment into innovations and new visitor attractions are of paramount importance.

The investment in owner-operated models is usually undertaken by the holding company. However, as large theme parks are also part of an overall municipal infrastructure, the local government often partakes in renewing the according infrastructure in and around theme parks in order to ensure a consistent visitor flow. These subsidies are often regarded as incentives for owner-operated facilities to perform well.

The management agreement model is primarily used in small amusement or theme parks, in which the continuous operation would not be possible without governmental subsidies and in which the investment costs are not being refinanced. In this case, local communities or subsidiary companies of these local communities take over the role of the owner.

Benefits for the local communities are mostly realised through secondary effects, such as increased awareness, improved image, additional employment, growing overnights and even successive settlements. In this model, the operator is representing the property with their own name, however, running the overall operation on account of the owner.

challenges and peculiarities

A major challenge in this context is the limited number of professional operators with an internationally recognised brand name (e.g. Disney), as well as the constant necessity of changing and adapting the agreement according to new attractions and new sponsors. In the following chart, some selected challenges and peculiarities of theme parks are summarised.

• limited number of professional operators disposing of brand names with international recognition
• highly specialised product requiring tailor-made operating concept and vice versa
• usually, continuous extensions of theme parks require adequate reflection in the particular operating agreement
• constant investment into innovations and new visitor attractions
• co-branding through sponsors often required in order to secure funding for extension and innovation
• seasonality of operations
• maintenance and development of innovations requires highly specialised expert knowledge and significantly advanced technical/engineering skills
  tailor-made concepts and vast investment require long-term commitment from operator (duration of contract)
• operating company needs to dispose of expertise in various fields, e.g. marketing, gastronomy, hotel, technical operation and maintenance 
  often large catchment area with multinational target groups
• large staff count required
• large insurance premiums on account of severe liability risks applicable

The displayed challenges and peculiarities highlighted in the above chart also indicate the major differences between the operation of theme parks and hotels and the individuality of such specialised leisure facilities.
In conclusion, it can be noted that the rather complex product with all its operational particularities and the tailor-made approach generally requires an owner-operator structure, which is reflected to a significant extent in the top ten of international theme parks.