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A Civil Union Between Hotels and Management Companies

A Civil Union Between Hotels and Management Companies

The lodging industry is attracting a lot of new money. “The amount of interest from private equity groups, REITs, and new developers entering the hospitality space is huge right now,” says Doug Dreher, president and chief executive officer of The Hotel Group, a Washington state-based management company. “A lot of capital groups thought this would be like the last recession with a ton of buying opportunities.” But, he says, this recession has turned out a bit different and, for many outside groups, lodging has proven to be a difficult industry to break into. Many of these groups have turned to third-party hotel management firms to help them get a foot in the door.

Lodging is a specialized industry and hotel guidelines are completely different than anything else that many investors and property developers will have worked on. Considering the size of the investment, it makes sense to put it in the hands of a professional. “In the majority of our third-party contracts, we actually opened the properties for our developer and investor clients,” Dreher says. “In many cases we’re right there at the get-go with the franchise selection since it’s so crucial to have input from a good operator at this time.” Most management firms have programs in place for first-time owners to get their property open and then help run it. They handle all the day-to-day operations, from managing employees to maintaining brand relationships to controlling revenue channels.

While these relationships are on the rise, there have been a few high-profile incidents in the past few years between owners and management companies that have shown their downside. In December, the Santa Barbara Beach and Golf Resort sought to oust Hyatt from its contract and replace it with a third-party management company. With the case now in arbitration the resort joins other high-profile cases like the Fairmont Turnberry Isle—now the Turnberry Isle Miami—and the Modern Honolulu, which initially opened as the Marriott Waikiki Edition hotel. Two years ago, the owners of these hotels staged separate takeovers that replaced Fairmont and Marriott as the management firms. In both cases the owners terminated long-term management contracts.

In compensation for their loss, and after months of litigation, Marriott received an estimated $20 million and Fairmont $19 million. The court opinion in the Fairmont case also established an important precedent. Siding with the owner, the opinion noted: “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.”

All three cases put a spotlight on the extent of owners’ rights to remove management firms that they deem unproductive as well as the need for these firms to have security from premature contract termination. Of course, all three cases fall well out of the norm of what most hotels commonly face when it comes to management agreements. “These long-term contracts are from a previous age, says David Buddemeyer, president of Florida-based Driftwood Hospitality Management. “They aren’t so common anymore.” So the hostile takeovers at the Modern Honolulu and Turnberry Isle Miami can be considered management disputes taken to the extreme. Still, the best way to avoid testing these waters is to make sure the match with your management company is solid from the start.

“Owners should look for a one-on-one connection with their management company in which they share a vision,” says Rick Day, chief operating officer at Real Hospitality, a Maryland-based management company. “It needs to be a relationship that’s transparent.” He says the owner and operator agreements don’t work when they get out of sync, which can happen when the management company fails to understand the needs of the hotel. Luckily there are a lot of choices out there for owners looking to make the switch or just explore options beyond their current franchise situation. “The franchises are very good at franchising their brands but not as competitive when it comes to actually managing the hotels,” says Carlos Rodriguez, Driftwood’s executive vice president. “Their cost structures tend to be a little higher than the ones third-party operators use. So you won’t see as much at the bottom line.”

Driftwood positions itself as a turnaround specialist. “A lot of hotel owners will run their properties into the ground or let them get mismanaged by other operators,” Rodriguez says. “They seek us out because they know that we will take a comprehensive look at the entire picture and find ways to make the hotel successful.” The Hotel Group gets a lot of its business the same way, and often embarks on transformational renovations of managed properties to give them a lift both positionally and operationally. But it all starts with identifying the right management team for a particular market. “At a small Marriott Courtyard we now operate, we replaced a large management team that wasn’t right for the size of the hotel,” Dreher says. “Some management companies have a particular niche, while some are so big that they don’t have the one-on-one focus necessary for some markets.”

And while all owners invest in their property differently, most financial structures encourage having a management company with a standardized set of processes and systems there to operate the property. In the eyes of most lenders, having a third-party management firm in place will help turnaround a property. That’s because they have dedicated HR, revenue management, sales, operations, and legal departments that are used to handling the peculiarities of the lodging industry. They also have programs in place to mentor the general manager and staff of the hotel. “Owners that bring in a professional company are going to set themselves up for success as well as create some stability in the lending environment,” Dreher says. “This is especially true in cases where a property joins a portfolio of hotels that is being operated successfully and consistently.”

So how should an owner go about finding the right management company? Dreher recommends calling references and clients and using industry resources to identify a short list. This could mean engaging an attorney, a brokerage firm, or a consultant to narrow the field. “If I’m an investor looking for a management company,” Rodriguez says, “I’d look at the depth of the team. Ask point blank who will be the general manager, regional director of operations, and revenue manager overseeing your hotel. At the end of the day these are the people you will be working with on a day-to-day basis.” Knowing how many properties this team oversees will provide you with a good idea of how much attention you’ll receive.

“Some companies we’ve replaced had ops guys that oversaw 15 to 20 hotels,” Dreher says. “You can’t be a good resource when you’re stretched that thin. You can’t properly review P&Ls for the team on the property level.” A management company with a healthy ratio of staff to hotels will be much more connected to your property on a day-to-day basis. Managers that oversee fewer properties have more opportunity to understand each hotel’s place in the market and what its needs are.

Once you’ve identified the best management company for you, then you’ll want to be very careful when you negotiate the contract. “All of them vary substantially,” Rodriguez says. “Some companies charge just a monthly fee and an accounting fee while others insert all sorts of back charges. You want as much transparency in the charges as possible.” He says if you see that there are problems from day one as you negotiate your management contract then you better not go into bed with that company.

With management contracts so crucial in laying the foundation of a hotel’s operational sucess, they are finding themselves increasingly under the microscope in this transaction heavy environment. For an owner’s protection, these contracts commonly contain earnings tests and cancellation clauses that allow the owner to assess the value of the agreement based on how the operator is performing. Given the importance of these contracts, the performance metrics need to make sense and not be too onerous.

“The contract is where you will negotiate your out,” Rodriguez says. “It’s where you can make it as painless as possible for all sides. We like to provide our clients with a good exit strategy so our investment horizon usually isn’t longer than five years. We come in, we fix it, we stabilize it, and we sell it for as high a return as possible.”
Dreher says the good and bad news for the industry is that there are so many quality management companies to choose from. “This is good for owners and bad for operators because it’s more competitive out there than it has ever been,” he says. “But having a good functional relationship with our owners will only bring us more business.”

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