The amenities of a hotel have consistently played a key role in supporting hotel guest services, but as an ever-increasing number of travelers today seek more from a hotel than just a place to sleep, the industry has recognized the growing importance of thoughtfully curating a mix of bars, restaurants, spas, retail space, and other leisure amenities to meet this guest demand. It comes as little surprise, then, that the lifestyle hotel, a category of lodging that has existed for decades, has experienced significant growth in the last five years, developing amenities to become a place for out-of-towners and locals alike to gather for unique experiences.
Hotel owners and operators see the value in this trend and are seizing opportunities to maximize amenities in hotels that reflect local flavor and lifestyle, not only enhancing the hotel guest experience but also drawing more local patrons to these hotel amenities. As a result, revenues generated by restaurants, bars, and other hotel amenities have increasingly represented a meaningful portion — ranging anywhere from 10% to as high as 40% — of the hotel’s total revenues.
Hotel owners and operators may have different views on how (and by whom) such hotel amenities should be managed — particularly in light of the potential increases in revenue generated by these spaces. This article explores the different factors hotel owners need to consider when determining whether hotel amenities should be managed separately by a party other than the hotel operator and the ways in which hotel owners and operators may consider protecting their respective interests in a hotel management agreement (HMA) to address this growing opportunity.
Should Owners Outsource the Management of Hotel Amenities?
There are many variables for a hotel owner to consider when determining whether its hotel would be best served by outsourcing the management of a hotel amenity to a third party.
Separate management of hotel amenities may increase a hotel owner’s flexibility to change concepts and result in reduced fees compared to terms in an HMA. While an HMA may have a term of anywhere from five to 40 years, a hotel owner may be able to negotiate a shorter-term arrangement, including more beneficial owner control rights and exit rights, with a third-party operator, providing it the flexibility to exert influence during the agreement’s term and change management if current amenity operations aren’t delivering desired results. Additionally, a hotel owner may be able to negotiate lower management fees with a third-party amenity operator. If a hotel owner structured the outsourced management as a lease, whereby the third-party operator paid fixed monthly rent, it would also benefit from a stable, consistent cash flow compared to the sharing of the remainder of the hotel’s profits and losses (but, correspondingly, it would lose the benefit of the potential upside of a profitable operation).
Beyond potential financial advantages, engaging a third-party operator to manage a restaurant or bar may draw more patrons seeking a unique and authentic vibe to the hotel. Alternatively, engaging a third-party operator — particularly with a local connection to the community — with a strong brand reputation in the larger restaurant or spa industry may also potentially draw more business and complement the hotel’s branding.
Further, depending on the nature of the hotel amenity, the hotel owner may need to engage a third party with necessary expertise — particularly if its hotel operator doesn’t have the same level of knowledge in-house compared to such third-party managers. While there may be some similarities that exist in running a hotel and running a restaurant or spa, managing a restaurant or spa with a unique concept or target audience can be nuanced and necessitate skills and connections that a hotel operator may not possess.
On the other hand, engaging third-party operators to manage hotel amenities introduces complexities to hotel operations. While retaining a single manager for all areas of the hotel will promote a seamless guest experience at a consistent standard, engaging separate managers for spaces within the hotel raises operational and liability concerns that would need to be addressed. Appropriate access to (and sharing of) back-of-house facilities between multiple managers and their employees would need to be agreed upon and documented, along with an appropriate allocation of liabilities and insurance obligations between multiple managers. Further, a hotel owner should consider how room service will be provided (and by whom) and paid for if, ultimately, the hotel operator doesn’t manage the food and beverage facilities. These factors and others can complicate the operating structure, but they are workable with thoughtful planning, guidance from counsel, and clear documentation to govern the arrangement.
Finally, before a hotel owner engages a third-party operator to manage a hotel amenity, if a real estate investment trust (REIT) is a part of its ownership structure, it should seek tax counsel advice regarding the structuring of such an arrangement to ensure that it will not create unintended consequences for its REIT under the Internal Revenue Code and related Internal Revenue Service rules.
Hotel Management Agreement Negotiations Regarding Third-Party Management of Hotel Amenities
In addition to myriad variables, including those previously noted, a hotel owner’s ability to elect whether to engage a third-party manager to operate any hotel amenity also depends on whether it has the express right in the hotel management agreement to outsource these operations. As a general principle, an HMA grants the hotel operator the exclusive right to manage the “hotel,” which is typically defined as not only the lobby, guest rooms, and corridors but also the banquet halls, bars, restaurants, fitness centers, spas, and other amenities. Therefore, a hotel owner desiring to retain flexibility to engage third-party operators to manage certain hotel amenities should proactively negotiate for that right to be expressly included in the HMA. Revenues (and expenses) from the operation of third-party managed amenities are typically excluded from the calculations of gross revenues, operating expenses, and profits, which the hotel manager’s fees are based on under the HMA. Depending on the potential profitability of a hotel amenity, hotel operators seeking to maintain exclusive management of the hotel and earn fees on profits generated by such areas, may be inclined to resist providing hotel owners this flexibility.
The ability of any hotel owner to negotiate for this discretion will depend on several factors, including the size of the hotel, the number and type of amenities available, the leverage of the respective parties, and the classification of the hotel (e.g., luxury, upscale, midscale).
For example, in the luxury brand hospitality market, with limited exceptions, a hotel operator retains approval rights (often at its sole discretion) over the third-party management of any portion of the hotel. Luxury hotel operators point to their long-term commitments under their HMAs and the need to ensure consistent high-quality guest experiences reflective of the luxury brands’ reputations. This type of approval right doesn’t necessarily mean that a hotel operator will always prohibit third-party management of an amenity space within the hotel if a hotel owner were to propose that approach, but this hotel operator approval right is rooted in the understanding that, in the context of luxury hotels, all of the variables and factors previously described, and many more, will need to be considered on a case-by-case basis by the parties to ensure such usage aligns with the luxury brand’s standards.
As an alternative approach to engaging a third party to manage a hotel amenity, if, ultimately, parties agree that a spa or restaurant within the luxury hotel could benefit from a strong brand name in that specific industry, parties may consider adopting a consultancy arrangement with a third-party consultant (i.e., a so-called “celebrity chef” arrangement). Under this arrangement, the hotel operator would continue to operate the amenity, but it would engage a third party to provide high-level strategic advice (e.g., establishing menus, providing recipes) and grant a license to the hotel to utilize its brand name in connection with such amenity in exchange for fees. Because the hotel operator would continue to operate the amenity, the revenues and expenses of operating such amenity under this arrangement would continue to be considered revenues and expenses of the hotel.
Outside of the luxury brand space, depending on the size and number of amenities available at the hotel (and the leverage of the respective parties), hotel operators may be willing to agree to provide hotel owners the discretion in the HMAs to elect if and when a hotel amenity may be managed separately by a third party, provided certain conditions are satisfied. Such conditions are considerably negotiated and, therefore, vary among HMAs, but they often include requirements that such third-party arrangements be with qualified, reputable, and first-class operators and that such agreements governing the arrangements be approved by the hotel operator. HMAs allowing for the third-party operation of hotel amenities may limit their applications to specific spaces within the hotel as well and often require that such arrangements (i) allow the hotel operator to operate (uninterrupted) the remainder of the hotel in accordance with the standard and (ii) require the amenity space to be operated in a manner consistent with the hotel standard. A hotel operator will also seek to clarify in the HMA that it is not responsible for the acts of any third-party operator. Finally, hotel operators should consider negotiating for either an oversight fee, an equitable amount of revenues from the third-party operated area to be included in the hotel’s gross revenues, or the ability to require equitable adjustments to be made to its fees and performance tests if, and to the extent, the revenues and profits calculated under the HMA will be significantly impacted as a result of a third-party arrangement.
Conclusion
Given the potential complexities of third-party operated arrangements within a hotel, hotel owners and operators alike should seek legal counsel to explore the benefits and challenges these arrangements may raise — whether agreeing to a specific third-party management arrangement or allowing such flexibility at a later date in the HMA. Stakeholders should consider the various available structures when engaging a third-party operator. For further discussion regarding the various operating models a hotel owner can consider when engaging a third party to manage a hotel amenity, please read “Structuring Hybrid Hospitality Projects for Success” by Matt Pohlman from Goodwin’s London office.
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