Hotel management and profit distribution

The yields of investment in hotels largely depend on the effectiveness of management and agreements with the management company

According to a survey by Tranio.com, the second most popular foreign commercial property type in 2015, after flats, was hotels. However, the hotel business is complex. In addition to finding a suitable property, the most complicated issue an investor usually faces is managing this property. Tranio.com tells how the hotel property management is executed and the profit is divided between the owner and the operator. In short, the owner can either manage the hotel independently or hire a management company.

Independent management

If the investor runs a hotel business independently, it is necessary to calculate beforehand the supposed income and expenses. Being directly involved in management, the investor does not have to share profit, which remains after paying the taxes and maintenance costs.

Independent hotel management revenues and expenses

Revenues Regular expenses
– room revenue (key figures: ADR [average daily rate], RevPAR [revenue per available room])
– café facility rental revenue
– equipment rental revenue (bikes, cabin cruisers, etc.)
– food and beverage sales revenue
– property appreciation: capital gains if selling the property
– mortgage payments (if the hotel was bought with a loan)
– annual property tax
– public utilities
– maintenance costs (utility systems, cleaning, security)
– minor repairs
– insurance
– services of personnel
– accountant's services
– advertising
– groceries and equipment

Such a scenario is not suitable for remote investors and those who do not have enough experience in the hotel business. In fact, only mini-hotels (e.g. bed and breakfasts [B&Bs]) are good for independent management: a large number of rooms makes management more complicated, and a management company is needed in this case. About 90% of mini-hotels are managed by their owners. However, exceptions also exist; for instance, the boutique hotels of about 15 rooms, located in the centres of large cities, are managed by relatively small hotel chains (e.g. Louis Vuitton).

Management company services

As a rule, management companies offer their services only if a hotel has at least 70 rooms, as a smaller room supply will not enable the company to pay salaries to their employees and secure profits for itself.

Management company types

Usually, those acting as management companies are the hotel operators who often hold large international chain franchises. Such companies specialise in management and successfully turn a profit. There are two types of operators:

1) Branded operators are branded companies that take charge of hotel management. They include Hilton, Hyatt, IHG, Marriott and Starwood, to name a few. Branded operators generally manage large hotels. Such operators come with their own strong and weak points.

Advantages:

  • brand name helps the hotel owners to generate a constant flow of loyal customers
  • software, instructions and staff training
  • after signing a contract with such a company, the owner can use not only the famous brand but also the manager's services
  • the hotels under brand management are considered to be low-risk investments, and it is usually easy to get funding for this kind of purchase
  • the owner does not have to pay any franchise fee

Disadvantages:

  • the owner has to pay royalties to the brand, which invariably decrease income
  • branded operators usually are not so eager to compromise when discussing rewards, in comparison with independent operators
  • a famous brand does not manage each and every hotel: many major operators have strict requirements for the location and the characteristics of the property

"Branded management companies are also more rigorous in the terms of the agreement, especially in its cancellation terms. This is exactly what must be taken into account when performing Due Diligence", states Denis Borisenko, Head of Commercial Property at Tranio.com.

All that glitters is not gold: sometimes, hotels are offered for sale under a famous brand, and the potential buyer can think it to be a low-risk investment. Being fully aware of the nature of your relationship with the brand — its role in management and its obligations — is crucial. For example, it is quite probable that the brand is nothing more than a front, while the hotel is really managed by OOO Romashka, which obtained a right to using the famous brand; if something is wrong, the brand will not be responsible for the actions of the OOO. It is a different story when the rental contract is signed directly with the owner of the famous brand holding company, which must fulfil the obligations embodied in the management agreement.

2) Independent operators are management companies which focus on management only, not providing a brand. For instance, the U.S. major independent operators include GF Management, Interstate Hotels & Resorts and White Lodging Services. Usually, the owners of small and medium-sized hotels are those who use the services of independent operators. As a rule, these operators manage hotels under different brands.

Advantages:

  • such operators are usually more flexible in comparison with branded companies when discussing contract terms
  • such companies often bear fewer expenses and generate more profit than branded operators
  • all the cash flows remain completely available to the hotel owner

It is important to pay attention to how responsible the management company is, what the consequences of its failure to fulfil obligations are and whether it has money and motivation to keep up its reputation in order to provide for liabilities.

Most often, the responsibilities of management companies are:

  • managing all the aspects of hotel performance (maintenance, room service, administration, food supply, etc.)
  • staff recruitment, training and control
  • setting prices and tariffs
  • advertising, marketing and PR
  • cost planning and control
  • preparing financial reports for the owner
  • purchasing equipment and contracting service providers

Contract terms and types

The hotels in good locations without management companies are usually more expensive than the hotels with them, as the buyer is considered to have more opportunities for action and earn a higher profit on the asset being purchased. The price difference is about 20%.

The contract with the operator is signed for 10−30 years, and in the case of upmarket and luxury hotels, the contract terms are longer (20−30 years on average) compared to midscale hotels, for which the contract terms last 10−15 years at most. The contract duration also depends on the hotel company management type: for instance, branded operators require longer contracts than the lesser-known companies do. There are also indefinite duration contracts. The owner can sign either a rental and management contract or just a management contract with the management company.

1) Rental and management contract

The owner rents the hotel out to the management company and signs a management contract with it. In this case, the investor has two ways to turn a profit:

  • getting a fixed rent from the management company (e.g. of €700,000 p.a.) with an opportunity of adjusting it once every few years (e.g. by 2% every five years). The fixed rent usually makes up 20–30% of the revenue in the management company's expense structure. If a management company proposes paying the owner more, such a situation should be analysed separately. You need to find out why the management company is ready to pay more and whether there is a risk of its future bankruptcy. If you sign a fixed rental contract, it is important to do so with a large and well-known management company
  • getting a fixed rent plus a percentage of turnover (e.g. 2−7% p.a.); the rate depends on the hotel location, brand, management company and type (e.g. business, resort, etc.)

Advantages:

  • transparency and predictability of cash flows: the owner can estimate the expected profit for several years to come
  • the rate does not depend on the hotel occupancy (if receiving rental income only)

If the owner believes that the operator will be able to carry out its responsibilities successfully and market conditions will be positive, such a contract with the management company is more advantageous. Notwithstanding, it must be understood that this scenario will require more time and control over the management company regarding compliance with its obligations.

Disadvantages:

  • the yields are lower than under a rental contract
  • the rental contract does not allow the owner to affect the hotel's performance

Upon signing the rental contract, the company becomes the deputy owner of the hotel, and does all the management by itself. If the management company decides to terminate the rental contract, it will forsake the property, leaving the owner with a non-earning hotel for the time being. The risk of losing income in this case is compensated by the heavy penalties for the early cancellation of contract. If withdrawing from the contract prematurely, the owner will also be liable for a penalty, the amount of which depends on the transaction terms. This fact should be taken into account when performing Due Diligence.

2) Management contract

The owner does not rent the hotel out to the management company, but only signs a management contract and pays the following two fees to the management company:

  • Base fee, which is 1−5% of the total revenue obtained from renting out rooms, catering and spas, as well as conference hall rentals, hiring bikes and much more. It can be either a fixed amount or depend on the hotel revenue
  • Incentive fee, which is 6−8% of the hotel gross operating income and motivates the operator to increase property management efficiency and reduce costs. The lower the expenses get, the more beneficial the incentive fee paid by the owner gets. In addition, the higher the hotel revenue (as well as the owner's income) becomes, the more the management company earns

At the same time, some rooms can belong to the management company while the others belong to the owner. In this case, each of the two benefits from their own rooms. The owner pays for management only. The advantage of management contracts is that, in this case, the yields are higher than when renting your hotel to the management company. However, this approach has a disadvantage as well: the risks are higher and it is difficult to predict profit, as it completely depends on management efficiency, the hotel occupancy rate and characteristics, room prices and other factors.

What investors should pay attention to when performing Due Diligence (if using a management company) and drawing up a contract consist of the following:

  • management company scale
  • the role and responsibilities of the management company in the interaction with the owner
  • the consequences of the management company's failure to provide for liabilities
  • management company fee and brand usage costs
  • rental term
  • the types of rental contracts and profit distribution.
George Kachmazov George Kachmazov,
managing partner at Tranio
We recommend that those foreign investors who wish to have a passive income and save as much time as possible on property management sign simple rental contracts, as in this case the risks are minimal, or specify a certain revenue percentage to be added to the rental income. This is an optimal risk-yield balance thanks to the revenue growth potential.
Yulia Kozhevnikova, Tranio.com
Originally published on themoneycloud.com
 
 
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