Hotel management agreement and the way forward

Future hotel management agreements may warrant major change to incentive fee structures.

August 22, 2022

Hotel management agreements (HMA) have evolved dramatically over the past four decades.

In the 1980s when many destinations in Asia Pacific were opening up to tourism and seeking the endorsement of a recognized global brand, hotel management companies were often able to dictate terms.

As competition grew between the global chains, owners were able to effectively auction off management agreements with provisos such as guaranteed income, irrespective of market conditions, which saw many hotel management groups crash and burn after the economic downturn in the early 1990s.

This led to a range of hybrid models being unveiled over the following decade, as owners and management companies tried to settle on a workable and sustainable model.

As economic cycles have continued to fluctuate, hotel management agreements have become even more diversified in the past 15 years. This is clearly evidenced by the changes in incentive fee structures, with operators becoming increasingly flexible and creative to better align their interests with owners. 

As professional asset managers, with an enviable track record, we invariably leverage our knowledge and experience to support owners during the negotiation of HMAs with international operators. In the end, it is important to find solutions that can work for both parties and align with their long-term interests.

Are current incentive fee structures relevant to current and future market conditions?

While the base fee provides a guaranteed income for the operator regardless of profit levels, the incentive fee fundamentally serves as an incentive for the operator to boost the hotel’s bottom line by encouraging the operator to maximize revenue and be meticulous with expenses. However, if a hotel is running with a Gross Operating Profit margin of 20% or less, it would rarely be profitable once fixed charges are taken into account. As such, we do not believe that an operator should receive anything more than the base fee for what is effectively managing a non-profitable hotel.

We would suggest that incentive fees need to be re-structured. In the table below, the Type A column represents typical incentive fee arrangements today in a country such as China. However, we believe that this should be revised to the figures represented in the Type B column to reflect a more appropriate outcome.

Incentive fee rate% Type A Type B
0% GOP < 20%
4% GOP ≤ 20% 20% ≤ GOP < 30%
5% 20% ≤ GOP < 30% 30% ≤ GOP < 40%
6% 30% ≤ GOP < 40% 40% ≤ GOP < 50%
7% 40% ≤ GOP < 50% 50% ≤ GOP < 55%
8% GOP ≥ 50% GOP ≥ 55%

Another perspective owners often highlight is why an incentive fee should be paid to an operator before the owner starts recording some level of profit? In a revised scenario, the incentive fee may not kick in for the first year or even the second year. A sliding-scale structure might be more relevant, with a different starting year. For example, 5% for Year X, 6% for Year X + 1; 7% for Year X + 2 and onwards. This would make it easier for owners to withstand losses in the early years, while operators would make up for the delayed incentive fees when the hotel finds its place in the market and starts to maximise returns, most likely after the second and third years.

Then, some owners may think of a further change, with the incentive fee not necessarily based on GOP or IBFC (Income Before Fixed Charges). In some destinations – and taking into account the owner’s position and obligation – it may be more appropriate to base incentive fees either on CFADS (Cash Flow After Debt Service) or CFAOP (Cash Flow After Owner’s Priority). This type of fee structure is not yet commonly seen in the Asia Pacific markets, but there are at least a couple of reasons for owners to insist on a) ensuring necessary FFE is spent before the incentive fee kicks in; and b) a requirement by the lender to ensure debt serve payment. Of course, as the base gets smaller, the percentage may get bigger. Owners and asset managers will need to be fully aware of the structure.

The evolution of the hotel management agreement will continue. Some experienced owners are arguing that a maximum or a cap on the incentive fee should be stipulated in certain HMAs. Owners have already been able to negotiate in some brand and independent operator agreements a maximum or cap on the total management fee paid (base and incentive fees combined). The maximum amount paid under these agreements ranges from as little as 4.5% to as much as 7.5% percent of gross revenues.

By thinking out of the box, owners may also seek to put a cap on the total amount of fees paid to the brand. In addition to base and incentive fees, the cap could cover revenue/channel management fees, national sales office fees, frequent traveller promotion fees, and external industry fees for Global Distribution System, travel agency commissions, technical support, employee satisfaction surveys and all other operator system-reimbursable expenses.

An agreement could be made on the ‘real cap’ to stipulate that all the combined fees to brand should be no greater than, for example, 9% or 10% of Gross Revenue. On the other side, the operator could impose a minimum on the incentive fee in the hotel management agreement.

In the end, it is important for the health of the industry for owners, professional asset managers and operators to work together through a variety of expected outcomes and to negotiate a fee structure based upon transparency and fairness to create and build a long-term win-win relationship.

As owners resort to professional consultants and asset managers and the market matures, it is expected that the negotiation of HMAs will become increasingly sophisticated and operators will need to show even more flexibility to better align their interests with owners.