Management contracts put under the microscope

(Editor in Chief)

In 1949, Hilton Hotels opened its first hotel outside the continental United States, the Caribe Hilton Hotel, in San Juan, Puerto Rico. Expanding the Hilton brand outside the U.S. was not the only significance of the deal: the Caribe Hilton marked a new operating method for hotels, the operating lease. 

Conrad Hilton, the founder of the Hilton Hotel chain, proposed to the Puerto Rican government that he would design and operate the hotel that the government would finance through bonds. The deal’s cornerstone was that the government would lease the property to Hilton, which would pay rent based off of operating profits. All Hilton put up was $300,000. 

In “Lessons of a lifetime: the development of Hilton International,” which appeared in the June 1996 issue of Cornell Hotel & Restaurant Administration Quarterly, Curt Strand, the former CEO of Hilton International, wrote, “Hilton had to come up with a plan that did not put Hilton’s equity at risk.” This was the precursor to the management agreement as it is known by and widely used today by hotel operators.

High start-up costs were the drawback of operating leases; hence, the management agreement. Strand continued, “With our competitive advantage, we fought hard to gain the best terms possible in our management agreements. Terms extended up to 50 years; management fees were 3 to 5 percent of revenue plus 10 percent of gross operating profit. Contracts did not allow for earnings tests or cancellation clauses, let alone forecast guarantees. The idea of sharing management with owners we felt to be analogous to driving a car with two steering wheels. If a prospective owner felt that we should give him our name and he would exercise his managerial judgment on budgets and key staff, we felt we would be better off to pass on that opportunity.”

Today’s management agreements look similar to the ones Hilton was negotiating more than 40 years ago—save for the earnings tests and cancellation clauses, features that hotel owners are now apt to seek in a contract. Management agreements govern the business of hotels and they are finding themselves increasingly under the microscope as hotel transactions activity picks up. Real estate investment trusts are now firmly back in the buying game, putting out vast sums to acquire properties—DiamondRock Hospitality’s recent acquisition of a $495-million Blackstone portfolio testament to this. 

“It is our belief that with continued improvement in equity valuations and limited supply growth, hotel REITs, which were responsible for a large portion of 2010/2011 transaction activity, may be back at the negotiating table soon,” said Will Marks of JMP Securities, in a recent hotel sector report.

Post sale
Hotel operators make money off fees they generate from operating hotels. This is the crux of the management agreement. When they aren’t operating a hotel, they cannot make money off of it. That is why attaining and holding onto management contracts is vital for the ongoing success of a branded hotel operator. After a hotel is sold and acquired by a new party is where things can get dicey. “The legal rights of the parties will depend upon the specific hotel management agreement provisions, and applicable state contract law,” said Jim Butler, a partner at Jeffer Mangels Butler & Mitchell. 

Based in Los Angeles, Butler chairs the law firm’s global hospitality group and is a foremost expert in hotel management agreements. “In most cases, without contractual provision, a management contract for a hotel or other piece of real property is a personal services contract, and is only binding on the parties to the contract. Without more, it does not bind the property or someone who buys the property,” he added.

With that in mind, it’s still not a slam dunk that a new owner can change the hotel’s flag. “Virtually all of the hotel management agreements used by traditional hotel brands—Marriott, Hilton, Starwood, Hyatt, etc.—do contain special contract provisions to change this result,” Butler said. “These branded management agreements typically prohibit an owner from transferring the property unless the operator has approved the transferee, and the transferee has agreed to be bound by the management contract and stand in the shoes of the prior owner.” 

Butler also said that the brands often use a Subordination, Non-Disturbance and Attornment agreement, which obligates lenders to honor the hotel management agreement if they should foreclose upon the property.

The short of it: hotel operators aim to craft management contracts in their favor. It is why some hotel operators have successfully negotiated management contracts under Maryland Law, which more or less upends the so-called agency relationship between an owner and operator, wherein an operator is seen as a fiduciary unto the owner. Under Maryland law, when courts interpret contracts, they follow common law of contracts rather than common law of principal and agency, which protects owners by making the agent, or management company, obligated to put the interests of the owner ahead of its own.

“[Management agreements] are designed to ensure that anyone taking the hotel from the original owner will be bound by the original hotel management agreement,” Butler said. 

Money matters
A new owner, more often than not, will retain the hotel’s brand because it makes fiscal sense. “Typically, if there is a franchise agreement in place, it will have some number of years remaining on it and if you make the decision to not want that franchise, someone has to pay that franchisor liquidated damages,” said Michael Medzigian, CEO of Carey Watermark Investors, a publicly registered non-traded real estate investment trust. “There needs to be an analysis: is the brand you are going to be sufficiently more valuable to you from a business perspective that you are willing to incur those costs associated with terminating the old brand? 

Generally speaking, it does not behoove an owner to rebrand a hotel, unless they are looking to take the hotel up the chain scale after a renovation. It can happen, but it is rare, said Bill Fortier, SVP, development, Americas, Hilton Worldwide. “In a case like [that], we look to understand the reason for the change,” he said. “Our contracts are generally very strong so getting out without a right to terminate can be very expensive or we can just refuse. It takes a lot of hard work to operate a hotel successfully and if a brand loses its flag it can take a long time to replace. If we are not performing per the contract, the owner can terminate most management agreements. If we are doing what we promised, then we will fight to keep our position.”   

Hotel owners always keep an eye on their bottom line. “We aren’t doing this for fun; we are doing it to make money,” Medzigian said. “How do you maximize the value of the asset? Who can bring you the most revenue and what happens on the cost side? It’s [about] maximizing revenues and minimizing costs; it’s an unemotional analysis.”

It’s also an analysis that has played out in public. While not involved in a transaction, two high-profile properties have had recent sensational owner/operator disputes, which resulted in the owner, literally, kicking out the operator. The hotels in question, Edition Waikiki—now the Modern Honolulu—and the Fairmont Turnberry Isle—now the Turnberry Isle Miami and part of Marriott International’s Autograph Collection—went through similar owner takeovers. In both cases the owners terminated long-term, “no-cut” hotel management agreements. 

Neither Marriott nor Fairmont ultimately regained control of the properties, but both were rewarded handsomely for their dismissals: Fairmont was awarded $19 million as a breakup fee; Marriott had reportedly sought $72 million, but the final number they received was more than likely closer to $20 million.

The Fairmont court opinion (FHR TB, LLC, et. al. v. TB ISLE RESORT, LP), however, may have far-reaching implications. In it, the court sided with the owner, not the operator, unlike in the Marriott case, where the owner’s takeover was not validated. A portion of it read: “The notion of requiring a property owner to be forcibly partnered with an operator it does not want to manage its property is inherently problematic and provides support for the general rule that a principal usually has the unrestricted power to revoke an agency.”

For owners, Butler said they need to fully understand the management agreement and their rights and obligations under it before making any decision as to whether to change the brand. “Owners need to avoid the mistake of ‘fire, ready, aim,’” Butler said.