Types of Hotel Lease Contracts, Operating Contracts
„Lease agreements – management contracts – hybrid contacts – operator contracts
– definitions- explanations – tips and advice from ASP Global Hotel Brokers
The hotel operator contract: main criterion for investments in hotel or gastronomy properties
Hotels, holiday resorts and hotel properties are characterised by their heterogeneous nature; a diversity which is due not only to differences in category, numbers of rooms, location or facilities, but also due to a multitude of different ways in which the hotel owner and hotel operator can regulate their working relationship. The hotel operator contract is of particular importance when investing in hotel properties as it determines the distribution of risks between property owner and hotel operator.
The operator contract used for a hotel determines the form the investment in that property takes. There are currently still two main types of operator contract in use in the national and international hotel landscape: lease contracts and management contracts.
1. Hotel lease contracts: passive hotel investment
Hotel lease contracts represent a passive investment in a hotel property. The lessee of the hotel property generates profits from running the hotel, in particular as subletter of the hotel rooms and other facilities and through providing other hotel services. The property investor can only expect a lasting return on investment if the lease rates are market-based and remain so. This means that is particularly important to analyse current lease rates and review contracts where properties are potentially leased for too much or too little.
Hotel lease contract:
The hotel / gastronomy property lessee bears any risks
Hotel lease contracts continue to be the most common form of hotel operator contracts throughout Europe. In these contracts the hotel owner, the hotel lessor places the usufruct of the hotel property and all elements of the subject of lease at the lessee’s disposal. In the case of hotels the lease usually also includes features, furniture, fixtures and equipment and all facilities required to run the hotel. Usufruct means that the hotel lessee runs the hotel under their own name, at their own account and at their own risk.
The hotel owner receives fix or variable lease payments or a combination of both. Hotel lease contracts provide hotel property investors with a certain amount of security, which does however depend largely on the hotel operator’s solvency and commercial development. Essentially, it is the long-term profitability of the hotel operation itself which is of the most importance and should be analysed in detail before investing in any hotel property. As a general rule it is possible to work out realistic and operationally sustainable lease rates using the following steps:
A. Derivation of the operating result after all operator deductions: As well as meeting normal operator costs, hotel lessees are expected to bear the cost of reserves for future renewals or replacements of furniture, fixtures and equipment even if these are owned by the hotel owner/lessor.
B. Hotel operator premium for the lessee:
The hotel operator remuneration is equivalent to a risk premium for running the hotel and often equates to six to twelve percent of the hotel’s total turnover. The remaining amount remains at the lessee’s disposal to pay lease rates to the hotel investor / hotel lessor.
To work out the hotel owner’s EBITDA the agreed hotel lease rate needs to be adjusted for yearly reserves for organisational costs and other costs which need to be met by the hotel investor /property owner (tax, insurance, etc).
Based on reports of the most important hotel organisations in Europe (Germany, Austria, Switzerland, Italy, GB, Spain and France) the EBITDA for hotel owners and investors averages at between 14.5% and 21.5% of the hotel’s total turnover. Hotels belonging to international chains can diverge considerably from these values.
2. Management contract: run a hotel property actively
By way of contrast, hotel management contracts represent an active investment: not only the hotel property needs to be actively managed; this type of investment is all about the operational side of the hotel together with all its opportunities and risks. The managing company serves merely as an operator for the property owner. The manager will normally receive a turnover or profit-based commission and does not bear the economic risks, as the hotel owner is normally responsible for employing most of the hotel staff, apart from a few members of senior management.
Hotel management contract: opportunities and risks
In legal terms hotel management contracts are the complete opposite to hotel lease contracts. The hotel manager or operator is obliged to operate the hotel professionally on the property owner’s / hotel investor’s behalf and for the owner’s account.
Hotel management contracts are often accompanied by licensing contracts enabling the use of brand names (Hilton, Mercure, Pullmann, Novotel, Ibis, Sheraton, Ramada, etc.). The hotel owner’s profits normally consist of the hotel’s operational results (property owner’s EBITDA) minus an operator remuneration reserved for the management provider. This contract form means that the hotel owner bears both the opportunities and risks of their investment and the hotel’s operation.
Based on reports of the most important hotel organisations in Europe (Germany, Austria, Switzerland, Italy, GB, Spain and France) hotel owners using management contracts can normally enjoy an average EBITDA of between 19% and 21% of the hotel’s total turnover. Hotels belonging to international chains can diverge considerably from these values. When compared to lease contracts the risk premium can amount to 5 percent or more of the hotel’s operational turnover.
Hotel management contracts with a guaranteed minimum result:
In this type of contract, a contract form dependent on success, the manager or operator commits themselves to obtaining a certain operational result. If they do not meet this target, then they will forfeit their commission either partially or in whole. In the case of consistent underperformance the property owner may have special rights to cancel the contract prematurely.
Management contract with a cap:
A cap is a kind of advance account for accumulated losses in which payments to make up the difference between the result guaranteed by the management provider (hotel investor, hotel owner) and that actually obtained are accumulated. Once a specified maximum deficit has been reached the guarantee provided by the manager or hotel operator ends. Normally the hotel owner and operator will also agree on a balancing payment in the eventuality of any future profits
Management contract with stand aside arrangement:
The management provider (hotel investor, hotel owner) will only receive the agreed operator premium if the hotel achieves a certain operating result. In temporary periods of economic difficulty this premium can be postponed to a more successful period. If profits do not start to look up within a defined time frame then the management provider (hotel investor, hotel owner) reserves the right to end the contract prematurely.
3. Hybrid contracts combining lease and management contracts are on the increase
Between hotel lease contracts with a fixed lease rate on the one hand and hotel management contracts directly dependent on success levels on the other hand, there is scope for a wide range of different contract set-ups. Hybrid contracts which combine elements of both forms are on the increase. Stage models, in which property owners and operating companies sign a lease agreement, whereas the operating company signs a management contract with a leading brand name, are also widespread.
Using hybrid contracts for hotel properties allows risks to be shared fairly:
Experience shows that strict hotel lease contracts and strict hotel management contracts seldom share the financial risks and gains between the two contractual parties (hotel owner and hotel operator) in a fair manner. When things are going well neither party would share their success unless contractually bound to do so and in unfavourable market developments losses as a result of declining revenues and/or increasing expenses must be borne by one partner. Hence the importance of counteracting arrangements, so-called hybrid components; in which elements of hotel lease contracts and hotel management contracts are combined. They are signed with the aim of distributing risk more evenly between the property owner and hotel operator. It is widely acknowledged that hotel developments can normally only be achieved when the hotel operator has certain collaterals and guarantees to cover any risks.
The need for regulation is undoubtedly considerably higher in the case of hybrid contracts in comparison to traditional hotel operator contracts. It is imperative that hybrid contracts are drawn up using a carefully considered detailed legal and economic analysis of all aspects and we highly recommend you engage an experienced tourism consultant to do so.
Prognosis and scenario analysis by ASP Global Brokers
When considering investing in a hotel or gastronomy property, it is imperative to analyse substantiated and detailed prognosis of the company’s future cash flows projections. The international market leading tourism consultancy ASPI AG - Auer, Springer & Partner International (www.aspi.ag) recommends analysing different scenario for the hotel in question based on development forecasts for the respective hotel market. Projections of a realistically obtainable future lease rate are crucial in determining the hotel’s property value at the end of the term of the operator’s contract contractual period. It is also necessary to assess cash flows in the light of possible risks involved in the operator contract, so as to ensure that the investment more than adequately satisfies hotel investment criteria such as the internal rate of return (IRR) or return on investment (ROI) even in the worst case scenario.
Please contact the international market leading tourism consultants Auer, Springer & Partner (www.aspi.ag) or your hotel broker at ASP Hotel Brokers (www.aspimmo.com) for professional, neutral, expert advice in choosing and drawing up a lease, management, or hybrid contract for your hotel or gastronomy property.