2014 Hotel Management Contracts Survey
JLL’s Hotels & Hospitality Group, in collaboration with Baker & McKenzie, reviewed 286 hotel management contracts all of which were executed since our last review in late 2008. This compares to 139 contracts in 2008, 80 contracts in 2005 and 107 contracts in 2001.
Reflecting global development trends, the Asia Pacific region dominates our 2014 sample accounting almost half of all contracts surveyed with EMEA and the Americas accounting for a further 34% and 17% respectively.
Our survey spanned 32 countries with a fairly even split between mature (46%) and emerging (54%) markets. Representation among mature markets was greatest for Australia, Japan, Germany, Singapore, Spain, United States and United Kingdom whereas Brazil, China, India, Middle East, Thailand, Turkey, Ukraine and Vietnam dominated the emerging markets sample.Learn more
2014 Hotel Management Contracts Survey
An abrupt end to a decade of evolution
The global recession of 2009 brought new challenges for the hotel investment market. For owners, it became apparent that the funding structures for some new entrants were not supportive during the down cycle, putting additional pressure on an already credit-restricted environment. Construction projects stalled and new developments were wound back. For operators, the growth of operations outside the home base made them more susceptible to the wide and varied economic impacts of the crisis. Non-performing loans put brand reputation at risk, potentially eroding the significant investments in brand equity which had been made over the previous decade.
As markets recovered and liquidity improved, the ownership profile shifted as well-capitalised inter-generational investors came to the fore and competition between operators intensified with the explosion in global branded offerings. The hotel market also mirrored wider commercial property markets in that secure investments were initially chosen over higher yielding opportunities.
Our 2014 hotel management contract analysis provides an assessment of how this backdrop has impacted global hotel management contract trends.
Global trends diverge
Strategies have shifted as growth opportunities have slowed with an increasing number of operating groups putting their balance sheets to work through the adoption of ‘asset right’ strategies. Mature markets have been the focus with operator equity contributions of up to USD5 million evident in 20% of the contracts we analysed. This compares to just 8% of contracts in emerging markets and represents a marked change to 2008 when hotel operators were aggressively expanding their brands across the world but allowing hotel owners to assume all of the development risk.
Increased competition between operators is also resulting in downward pressure on contract terms with an increasing prevalence of contracts with initial terms of less than 10 years in the world’s mature markets. Base fees are also under pressure with more than one third of contracts in mature markets attracting fees of less than 1%. It is in the mature markets where we note that the key terms are weighted in favour of the owner.
On the contrary, high demand for luxury global hotel brands in emerging markets became tainted over the past five years with an increasing prevalence of stalled development projects. As a result operators have become more selective with their choice of owner and more rigid when negotiating terms for their premium brands, hence seeking initial terms of at least 20 years. Unencumbered by pre-existing contracts or trading history, lenders often insist upon sponsorship by an experienced operator for owners to be able to secure development financing and operators are being engaged early on in the development process. It is in these instances that we note the key terms are weighted in favour of the operator.
Restructuring incentive fees to align with hotel asset cycles
Incentive fees are commonplace in hotel management contracts, but are becoming more complex in how they are structured. As owners seek greater reward alignment, the basis of incentive fees has shifted with adjusted gross operating profit (i.e. gross operating profit less base fee) the most commonly used in our 2014 survey.
The inclusion of an incentive fee subordinate further aligns owner and operator interests as it recognises that owners should be paid an initial return as a matter of priority for owning and maintaining the asset. Incentive fees were subordinated in 37% of contracts in mature markets we surveyed in 2014, but only 6% of contracts in emerging markets.
As globalisation trends gain pace but global growth remains slow, we expect owners to continue to focus on greater reward alignment. Incentive fee subordinates are an alternative way in which an owner can ensure that a minimum performance is met, particularly as income guarantees and performance clauses have become less common and more difficult to extract.
Expanded fee base
In general, the hotel industry faces a threat from Third Party Internet (TPI) reservation channels, which represent a growing share of hotel room bookings. These intermediate channels charge higher commissions and demand rate parity from hotels, potentially putting revenues and margins under pressure. Many operating companies have sought to combat this onslaught with the development of their own central reservation systems and guest loyalty programs. Brand service fees commonly totalled around 6% of revenue in our 2014 hotel management contract survey, which is considerably lower than the commissions charged by most TPIs.
As current and emerging intermediaries take advantage of an increasingly active digital travel market, they will wield substantial influence, imposing fees and charges for directing the consumer traffic to the hotel and expanding the transparency of hotel pricing structures. The combination of the higher booking volumes passing through intermediaries, the costs imposed for intermediation and the pressure on rates will challenge owners and operators to maintain current profit levels.
My brand, my way
Brand standards affect not only the guest experience, but also the value placed on the hotel by investors and lenders. This creates a complicated juxtaposition between the desire of the brand to upgrade its brand standards and the desire of the hotel owner to control operating and capital costs. Our 2014 survey found that 90% of global hotel management contracts stipulated that the hotel be maintained in accordance with evolving brand standards. In general terms this means that the operating budget or annual plan must include such items as the manager deems appropriate to maintain the Brand Standard.
In any new-build hotel or change of brand, the hotel brand agrees to provide certain planning, equipping, design and opening services to the project owner or developer for a technical services fee. The most important goal is to ensure that when completed, the hotel or resort will comply with the brand standards and be operationally efficient. New build hotels and brand conversions commonly attracted a technical services fee in the order of USD200K to USD300K in our 2014 survey.
As hotel brands seek to differentiate themselves against an increasingly crowded backdrop, it is likely that the scope and scale of brand elements will increase (at the owner’s cost) and this has the potential to cloud future changes of management or sales.
Spinning the restrictions web
Driven by the requirement for growth, operators have sought to circumvent non-compete clauses with the launch of new brands and sub-brands over recent years. Non-compete clauses specify varying degrees of restriction across operators, brands, geographies and duration, reflecting the fact that operators and brands vary in their appeal and ability to attract different consumer market segments. This becomes more of a concern in markets where the rate differential between segments is less pronounced as the two brands will likely compete to attract the same customer base. Similarly in a market where the existing room product is aging, a sub-brand could command a rate premium compared to the existing higher rated product, due to newness.
Understandably hotel management companies desire smaller and shorter exclusion zones. Our 2014 survey found that non-compete clauses were more common in emerging markets (79% of contracts). This compares to their inclusion in only 56% of mature market contracts, reflecting both the lack of growth opportunities (for operators) but also the greater depth and scale of these markets. As markets mature and opportunities for organic growth slows, operators are likely to pay greater attention to non-compete clauses.
Flight to flexibility
Clauses in a management contract which restrict an owners’ exit, either the range of prospective purchasers or timing of sale, are those which can most significantly increase or decrease total returns for an owner. Termination fees have become more complex as operators seek greater compensation for a reduction in tenure, reflecting the importance of non-terminable contracts or alternatively a contract that locks in compensation upon termination. Whilst overall the proportion of hotel management contracts which allow the owner to terminate at any time without cause or upon sale has reduced over the past decade, our 2014 survey highlights divergent trends between mature and emerging markets. Termination upon sale was permitted in almost half of the contracts we analysed in mature markets but only 15% of contracts in emerging markets. This highlights the value that is being attached to liquidity and market transparency in today’s financial markets.
Growth in third party operating companies in mature markets is adding to the competitive pressures for hotel operators. These companies can often offer more commercially attractive agreements with shorter and more flexible terms (thereby enabling ease of exit), as well as incentivised fees which are profit-linked or subordinated to an owner’s priority return. Third party operators will affiliate with a variety of hotel brands for marketing and distribution which is spurring more operators to adopt franchise models as they look to aggressively grow brands over the coming years.
As liquidity improves and the global economy returns to growth, our next survey may highlight that the good times for operators have now passed. Already we are seeing the scales tip back in favour of owners in the world’s mature hotel markets as global growth opportunities have slowed.
Hotel rooms are sold in a dynamic and volatile distribution landscape which is launching market savvy and financially well-endowed “gatekeepers” in an increasingly active digital travel market. At the same time, competition amongst hotel management companies has intensified with exponential growth in hotel branded offerings and the emergence of third party operators which can often offer more commercially attractive agreements with shorter and more flexible terms.
As investors refocus their attentions on non-core locations or once again ‘travel up the risk curve’, this may see risk management take on new forms as investors continue to focus on liquidity and transparency. In this environment we expect that operators will have to become more flexible in contract negotiations, if they are to achieve aggressive growth targets. The alternative is growth through acquisition. Any corporate merger and acquisitions which do take place over the coming years are likely to include a greater focus on operating synergies, technology platforms and building global brand equity. The importance of emerging source markets, e.g. BRICs, is also expected to become a key focus as these travellers provide the primary source of incremental global demand over the coming years.