Owning a lodging property differs from owning any other type of commercial real estate. Hotels are operating businesses housed in the bricks and mortar of real estate. Hotel owners in the U.S. not only own the real estate, but typically own and oversee the hospitality business housed inside as well. Owners also ultimately control all improvements on the site, such as the building itself.
This means that hotel owners fund — out of their own pockets — the property’s staff salaries, repairs and any other liabilities. If the hotel fails to take in enough revenue to make payroll one month, the owner covers the shortfall.
Contrast that with a typical commercial building lease. In those arrangements, a building owner rents to a retailer or business. The building owner collects the rent, but the tenant foots the bill for all business-related expenses. The building owner isn’t worried about whether the tenant can pay wages because the tenant handles that budget line item. A building lease arrangement is not common for hotels in the United States. A hotel owner in the United States shoulders all the operational risks that come with owning a hotel, from building maintenance to guest services.
Hiring The Manager
Owners don’t have to go it alone, however. Often they hire a management company to supervise the daily operations of the property. Recruiting and training staff, ordering supplies and, above all else, providing a satisfying guest experience falls to the management entity. The owner provides the budget, but the manager is responsible for putting those dollars to good use.
That manager is either a major hospitality brand or a third-party management company. A third-party manager can be engaged to operate branded hotels, too. In that instance, the owner would enter into a franchise agreement with a well-known flag. In that type of arrangement, the franchiser only licenses its name and related programs, like its reservation network, to the hotel and has no role in daily operations. With a brand manager, all franchise-related systems are folded into the management agreement.
Choosing a management company is probably one of the most important decisions an owner makes. Owners tie their profits and investment returns to a manager for decades since management contracts typically remain in force for 15 to 25 years for brand-managed, and usually no less than five years for third-party managers. Yet, what happens if the manager fails to operate the hotel to high level and the property loses money year after year? Does the owner have recourse to replace a bad-performing manager? Fortunately, most management contracts include a termination provision for performance. If properly negotiated, this clause will protect the owner’s financial interests and give the owner the right to boot a manager for not doing a good job.
Negotiated in a brand management contract are two tests for the manager. The first hurdle can be written two ways: how a manager performs in relation to the hotel’s budgeted gross operating profit (GOP) or the owner’s preferred return
For example, the threshold may be set at 95% of budgeted GOP, so anything above that percentage is good. Failing below it could be grounds for dismissal. The second option calculates the percentage based on the owners’ expected return on investment. If the owner spends $10 million to construct the hotel, a reasonable return on investment (ROI) would be 8%, or $800,000 a year. A preferred return benchmark, in our view, is the better choice: It protects the owner from the budgeted profit goal being less than the desired ROI because it sets the minimum performance threshold to the preferred return.
The second test involves the industry’s operating standard of RevPAR, or revenue per available room. When they create their pro forma for a property, managers will compare the hotel’s anticipated RevPAR against its competitive set in the marketplace to determine a RevPAR index for the property. The RevPAR index estimates a RevPAR percentage above what the market is getting. For instance, after reviewing the market dynamics, a manager might calculate the property will achieve a RevPAR index of 102%, meaning, if the market’s average RevPAR is $100, the hotel it manages will hit $102.
Base Vs. Incentive Fees
Managers adhering to those thresholds safeguards the owner’s interests, but there’s another powerful lever an owner can wield: an incentive fee. While hotel management contracts include two fees paid to the manager — a base fee and incentive fee — by far the most effective in aligning the manager with the owner’s goals is the incentive fee.
For a base fee, a manager receives 2% to 4% of the hotel’s total revenue. To earn an incentive fee, though, a manager needs to meet a specified profit goal. Now, an incentive fee could be based on a percentage of budgeted GOP, but the recommended alternative is the preferred return, because if there is a downturn in the marketplace, the hotel may not reach its budgeted profit target. Therefore, profits could be less than the owner’s preferred ROI, and owners would be paying an incentive fee on dollars when they are missing their return goal. Using the preferred return threshold guarantees the owner gets his ROI prior to paying out an incentive fee.
In sum and substance, hotel ownership differs greatly from other real estate investments. Understanding the variables associated with operating the business housed in the physical real estate can make or break the return on investment. Not consulting with a hospitality specific advisor is penny wise and pound foolish.