The Hotel Management Agreement: What, Why and How?

Written By Craig Garbe and Shahrose Javed

With the global downturn in certain asset class valuations, hotels are experiencing something of a renaissance and have re-emerged as a preferred asset class. With challenges in all but the best in class and transit-oriented office properties, hotels are benefiting from strong demand and recovery in key segments like leisure and business travel. Canadian Revpar (revenue per available room, a key industry metric) averages have recently rebounded to pre-Covid levels, with 2025 projections looking higher still.

As the industry booms and demand increases, hotel operators are looking to establish new locations, and CRE (commercial real estate) owners are providing (or, frequently, repurposing) land and buildings to serve that need. But for both owners and operators alike, the key to unlocking value in this asset class comes in correctly determining and drafting an efficient and effective operating structure—one that incentivizes performance, rewards success and compensates each party for input. More often than not, that structure takes the form of a hotel management agreement. In this article we take a close look at these agreements—what are they, what are they not and what might they become.

Franchise/Licensing Agreements

But first, a word about franchising and licensing.

For corporate owned and managed hotel operators—whose management teams, intellectual property rights and reservation systems are run in-house—a franchise agreement is unlikely to be part of the structural picture, but for those hotel operators who license the brand, staff or other systems of a third party, a franchising or licensing agreement may exist.

CRE owners will want to ensure that, where their hotel operator is relying on a franchise or licensing agreement for some of its operational assets/rights, they have conducted proper diligence on such arrangements to ensure that their hotel operator will be able to continue operations for the duration of the term of agreement with the CRE owner. The agreement between CRE owner and hotel operator should contain representations and warranties with respect to the sufficiency and status of the franchising/licensing agreement, as well as covenants to maintain it in good standing—potentially even step-in/cure rights in favour of the CRE owner to ensure continuity and compliance. To the extent that any franchise/licensing agreement contains financial or performance metrics, the parties may also wish to consider parallel or equivalent metrics within the agreement between CRE owner and hotel operator to simplify reporting and ensure that the hotel operator has a consistent set of objectives.

These franchise/licensing agreements are not the place where the CRE owner and hotel operator set out the specific terms of their arrangement, but they do form an important part of the contextual background in which that arrangement will be formed. As such, careful consideration of their terms and conditions is critical to the proper creation of that arrangement.

Leases

So, if the franchise agreement is not home to the arrangement between CRE owner and hotel operator, what agreement is? One option is a real property lease.

Leases are the bread and butter of CRE income producing assets—familiar turf for CRE owners and business operators alike. A real property lease is a powerful agreement which, by its nature, creates a legal real-property right in the lands and premises which are subject to the lease, and creates a common and well-established relationship of landlord and tenant between the two parties. On the tenant side, leases generate a registrable interest in land which protects the tenant against third parties, grants the tenant exclusive possession over a physical space, and limits the landlord’s ability to disrupt the tenant’s business. On the landlord side, leases create a clear and knowable rental payment obligation, define liability and end-of-term obligations, and give the landlord certain preferences in the event of a tenant insolvency.

Despite all of this, however, leases are infrequently used as the vehicle to create the owner-operator relationship—and with good reason. For all their benefits, leases tend to create a division of the business relationship between landlord and tenant that is more pronounced than tends to be beneficial in the hotel space. For hotel operators, a lease with fixed rent obligation per square foot creates a disproportionate risk in the event of an industry slowdown, given the large floor space needed for hotel operation; and for CRE owners, per square foot rent doesn’t capture all the income upside (nor compensate adequately for building deterioration) during periods of high demand. Even percentage rent concepts—whereby landlords are entitled to fixed percentages of tenant income—tend to not be sufficiently detailed to capture the ‘gross revenue less expenses/fees’ concepts that have become common in the hotel asset class. Other typical lease concepts such as the division of insurance obligations, additional rent splitting and end of term restoration also do not necessarily reflect the business arrangement that tends to maximize profitability in hotel operations, and so require heavy modification in order to fit in the hotel context.

The supposed benefits of a lease are also, where a hotel is involved, not preferred. Security of tenure vis-à-vis third-party land purchasers is not as great risk for a hotel operator (where the real value of land comes from the operation of the hotel business), so lease registration does not carry the same weight. Likewise on the landlord side, the meager insolvency protections for the landlord are less important where rental income fluctuates seasonally and is derived mainly from the operating business.

Ultimately—though leases win for familiarity—the interplay between CRE owners and hotel operators over the years has evolved into a form of agreement that preserves the most useful parts of a lease, discards the irrelevant parts, and adds new and important hotel-specific provisions: the hotel management agreement.

Hotel Management Agreements

Hotel management agreements (also known or referred to as hotel operating agreements, operating services agreements, operation agreements or by other various names, and collectively referred to here as HMAs) are in some ways the evolution of the agreement that began as the hotel lease. At least thirty to forty years in the making, HMAs have by this point spawned their own set of norms, their own rules and customs, and their own body of interpretive caselaw. Major (and increasingly minor) hotel operators are likely to come prepared with their own customized form of HMA, and HMAs frequently borrow from the standards and rules established by the American Hotel & Lodging Association. Importantly, HMAs tend to create and foster a deeper business relationship between CRE owners and hotel operators than leases, giving CRE owners a voice (and/or veto power) in key business decisions relating to the hotel and entitling CRE owners to greater potential income rewards (as well as heightened potential income risk) flowing from the operating business. This relationship surfaces in a few key places.

Revenue, Expenses, and Fees

Of course, the most critical part of the HMA—and another key difference from a lease—is the revenue sharing structure. Unlike fixed rent, or even percentage rent, leases (the most typical HMA structure) see the CRE owner entitled to all the revenue generated by the hotel, less the costs and expenses of its operation and less the fees of the hotel operator. Perhaps it is no wonder that CRE owners are willing to take more risk and responsibility in the hotel sector: imagine being entitled to 100 percent of a tenant's profit, less costs and fees?

As might be expected, with such a structure the negotiating points then quickly turn away from revenue classification into the appropriate deduction of costs, expenses and fees. In some ways this is the inverse of a typical operating cost negotiation in a lease, where the landlord tries to ensure that a broad set of costs can be charged back to the tenant and the tenant tries to limit those costs—here it is the CRE owner wants to ensure those costs and deductions are properly limited, and that the fees are properly set. On the cost side, CRE owners will want to pay close attention to costs and expenses that could permit a benefit outside of the specific hotel in question (i.e. head office staffing, travel benefits and free use privileges for management, etc.), as well as related-party services that could see inflated costs passed on to the CRE owner. On the fee-side, parties can be as creative as they like, but current market practice seems to be to establish both base and incentive fees for the hotel operator, with base fees typically ranging from 2-4 percent of total/gross revenue, and incentive fees from 10-20 percent of net operating income. Parties should also ensure that permitted costs/expenses align with the net operating income calculation, since each party's incentive is reversed in each calculation and, as such, alignment of those concepts serves as an automatic check on their reasonableness.

Different circumstances or particular properties may warrant different structures. Equity participation in a joint venture vehicle, real property rights to purchase, future site participations or even creative future franchise options for owners are all possibilities. Hotel operators may also agree to guaranteed minimum revenue generation targets, with an obligation to fund the difference in case of underperformance—a significant advantage to a CRE Owner. CRE Owners also need to be aware of—and hotel operators need to ensure the inclusion of—proper fees and/or cost structures for the capture of non-site specific or non-local services. Specifically, global sales and marketing programs, reservation systems, and loyalty programs require careful consideration to ensure that each specific property is paying is fair share (but not a disproportionate burden for) these value-added services that a hotel operator may be able to provide. Each hotel operator (or franchisor) will have its own mechanics for the operation of these systems and, if left unchecked or too broadly drafted, these costs can seriously impact net income.

For CRE Owners, a budget approval mechanism (which is common in HMAs) becomes the key concept through which they can exercise control over expenses and revenue. Though a breakdown in agreement over an annual budget may ultimately lead to a termination of the relationship, the mechanism allows for an (at least) annual review of detailed financials and performance and can trigger discussions for HMA amendments as needed. CRE owners and hotel operators should ensure that the budget approval mechanism is clear, provides a path for dispute resolution and contains detailed fallbacks in the absence of agreement.

Management and Employees

One of the more unique features of an HMA is that it may require that all on-site employees providing services to the site/business/hotel be employed by the CRE owner. There is a parallel for this in the world of self-managing CRE owners, who may employ any number of specialized property management staff, but for many CRE owners—who would never consider employing the staff of their tenants—this is a marked departure from the norm. CRE owners who do not typically self-manage or who are subject to special or particular legislative regimes (pension funds, publicly traded entities, etc.) or tax reporting requirements (REITs, etc.) should pay particular attention to the inclusion of such a concept and ensure that employment of a significant number of staff (some, or all, of whom may participate in collective bargaining) is properly reported and permitted. Due consideration should also be given to the effects of any employment provisions within an HMA on collective bargaining agreements (both present and future).

Aside from the (quasi) self-management parallel, this concept itself appears to be something of a concession by CRE owners to hotel operators. The hotel operator is much more likely to be engaged in the day-to-day direction and management of the employees than the CRE owner, which is inconsistent with the shift of the employer-employee relationship to the CRE owner. Ultimately, however, it may not be that important who the employer is, since any HMA will typically permit the deduction of all staff/employee costs from the revenue that is ultimately shared with the CRE owner. Regardless, CRE owners should ensure that they are capable of employing (and properly accounting for) a significant number of personnel, and that any trailing liabilities associated with those personnel are costs which they are willing to assume themselves or for which the hotel operator is obligated to reimburse them. Particular consideration should be given to severance and end-of-term costs upon termination of the HMA (both if a new operator may be taking over or not).

CRE owners may also—as a quid pro quo for taking on employment duties or just given the nature of their connection to the operating business—take veto or approval rights over key hotel management positions in the HMA. When structuring these rights, hotel operators will need to carefully consider their corporate structure and the functions served by staff on-site as well as off-site, as well as existing employee contracts and security of tenure. CRE owners should also be cognisant of the relative power that such a right may or may not carry, and may wish to push for strong 'key-person' protections at the same time, or in lieu of, such rights.

Renovation and Development

A stand-in for the typical tenant improvement allowance or landlord work concept in a commercial lease, the property improvement plan (PIP) concept is a common HMA concept that ensures an adequate level of capital investment in the property by the CRE owner. A PIP is a structured plan that outlines necessary upgrades and renovations that a CRE owner will make to the hotel to maintain standards and improve overall operations. Unlike commercial leases (which provide for tenant allowances or landlord work at the beginning of a term), PIP obligations tend to continue throughout the term of an HMA, often on a rolling 3-8 year refresh basis. To ensure adequate provision for these obligations is made by CRE owners, HMAs will often require the establishment of a reserve account which must be funded by a fixed percentage of total/gross revenue, often greater than or equal to the hotel operator's base fee percentage. Hotel operators will want to ensure that the PIP schedule and specifics adequately upgrade the facilities to meet their brand standards. CRE owners will want to ensure that the PIP schedule and specifics do not unnecessarily detract from revenue, that the timing of the expenditures takes into consideration other plans for the property (redevelopment, operator transition, etc.) and that they have adequate protection of their ownership interest in the reserved funds. All parties will want to consider how the PIP can be used to implement new prop tech and achieve any applicable carbon neutrality metrics.

Term, Performance Tests and Termination Rights

As one might expect, given that the hotel operator will lose out on fees but is otherwise (absent a minimum revenue generation obligation) no worse off if the hotel ceases to generate income, HMAs tend to have longer fixed terms than typical commercial leases—20-year initial terms are not uncommon. Termination rights in favour of each party in the event of default of the other are common, but, given that a longer term tends to disproportionately benefit the hotel operators, it is also typical for the CRE owner to secure additional termination rights. Specifically, CRE owners typically obtain a right to terminate if the hotel's Revpar falls below a fixed percentage (perhaps 85-95 percent) of the average Revpar of an established comparative set of hotels, where that comparative set is carefully considered and established, taking into account existing competitors and potential future ones. This is another unique feature of the hotel industry, where a data set of the data required to make such calculations exists and can form the basis for a contractual termination right (typical practice is to tie the Revpar calculation to the reports published by STR Inc. (also known as Smith Travel Research)).

CRE owners may also negotiate to obtain termination rights: (i) upon sale of the property; (ii) without cause after fixed periods of time (to permit property redevelopment or otherwise); or (iii) if anticipated revenue targets are not hit on a consistent (multi-year annual, for example) basis. The latter right can take the place of (or operate in tandem with) a minimum revenue generation target to ensure that hotel operators are not over-promising total revenue.

Final Thoughts

As the travel and hotel industries continue to expand HMAs will continue to evolve along with them, becoming more tailored to specific industry needs and practices. Already they have outpaced commercial leases and become uniquely suited to hotel operations, creating their own set of norms and clauses along the way. The Bennett Jones Gaming & Hospitality team has decades of experience crafting and creating these agreements—please contact the authors of this post for more information on how our team can assist you in creating a solution for your business or project.

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