Management contract

The management contract is a business format which separates ownership from operation. In the hotel industry it has provided the opportunity for much-needed capital to fund the demand for new construction in world markets, while creating the vehicle for such tourism management companies to expand their networks and market shares with reduced exposure to investment and political risks. The growth in contracts has also been driven by hotel owners' need for experienced and established operators for their own peace of mind and to satisfy investor's demands.

There is no standard definition of a hotel management contract, but it is usually defined as a formal arrangement under which the owner of a hotel or another tourism business employs the services of an operator to act as his/her agent to provide professional management, in return for a fee. The operator assumes full responsibility for the management of the business, while the ultimate legal and financial responsibilities and rights of ownership of the property, its furniture and equipment, its working capital and the benefits of its profits (or burden of its losses) remain those of the owner. The owner may be a private individual, a financial institution, a real estate company or a government. The operator is most likely to be an established hotel chain offering marketing strength, brand names, bargaining power, systems and procedures, project design and management, technical services, training and management development. However, the rate of growth in the number of independent hotel management companies is increasing; these include groups that do not have their own international brand and reservations systems and who operate hotels for a variety of owners.

The owner usually seeks an effective return, the contractor an effective earnings stream. Typically, the fee structure is in two parts: a base fee of around 3 per cent of hotel turnover and an achievement fee of around 10 per cent of gross operating profit or earnings before debt, interest and tax. Economic changes impacting upon the hotel industry, accelerated competition amongst operators worldwide and greater performance demands by owners and lenders are leading to adjustments in contract provisions and increased owner bargaining strength.

A hotel management contract stipulates that the operator of a hotel is acting fully and completely as an agent of the owner and for the owner, and assumes fully responsibility for operating and managing the hotel. Such operators can be individuals or a third party management company. Employees of such hotels are employees of the owner. Generally any losses resulting from lawsuits or judgments against a hotel operating with management contract must be absorbed by the owner. Similarly, the final financial result of the operation, be it a profit or a loss, is recorded on the owner’s account, not the operator’s account. For fulfilling the role of manager of the hotel on behalf of the owner, the operator receives certain fees. American hotel companies have been aggressively expanding internationally, using management contracts, because the owner or country is assuming all of the financial risk in order to develop tourism. The management company provides the management talent, standardized training programs, and name recognition.

For a hotel company the management contract is a way for a hotel chain to grow with a low level of investment. Third party management companies even have assisted the owner in some cases by providing funds such as loans to the owner to finalize the deal. Also, for the hotel company a management contract rarely requires that the operator participate in operating deficits because the owner is assuming the financial risk. On the other hand, a hotel company operating under a management contract has little control over the transfer of ownership. An under capitalized owner can restrict the cash needed to cover the expenses that are essential to the maintenance of quality, adversely affecting operations. While in the long term this will decrease the value of the hotel and adversely affect the owner, in the short term, the task of operating the hotel becomes difficult for the management company.

A typical management contract may contain a cancellation provision through which either party may withdraw from the contract, with penalties imposed on the party that initiates the cancellation, unless it can show that the other party has defaulted on terms that were included in the agreement. The cancellation, while requiring a fee that must be paid to the management company, although it does avoid other problems, can result in a surplus of key management personnel and a public relations problem. Traditionally, management contract fees have been specified rates that are set each year. More recently, this arrangement has changed to a graduated fee structure tied to the financial success of a hotel. In some cases, a maximum cap on the total management fee is negotiated by the owners. The management fee can be calculated in different ways. If it is based solely on total revenue, the operator can spend money freely, particularly on advertising. In this case, because the revenues of the property are high, a high fee is achieved, even if the hotel might not show a profit. On the other hand, calculation of the fee on the basis of the gross operating profit places pressure on the operator to manage the hotel profitably. When results are poor, the management company may find that it is not recovering its costs. A combination fee based on a combination of total revenue and gross operating profit is typically the most equitable arrangement for both the operator and the owner.

In addition to stating the fee calculation method and clarifying the responsibilities of the operator to the owner, management contracts usually contain certain other clauses including the technical services to be provided by the management company, pre-opening services, and the operational duties of the management company. During the contract negotiations stage, there are a number of issues that are usually debated. Three key issues are contract duration, financial reporting, and contract termination. The owner usually wants a contract duration as short as possible with renewals at the owner’s option, which permits the owner to change operators with minimal costs and the management company wants a long-term contract with renewals at the operator’s option which gives the management company an opportunity to recover costs association with start-up such as marketing, employee training and management payroll. The owner typically wants to maximize the number of financial reports, budget data, and financial meetings in order to better control how his/her money is being spent, while the operator may seek to minimize such information and meetings. A typical owner wants the power to approve or reject all transactions, while increased autonomy is the goal of the operator.

The owner wants the freedom to terminate a contract upon immediate written notice, while the management company under no circumstances wants the owner to be able to terminate before the expiration date. Generally, the keys factors in the selection of a management company include cost, market strengths, lender reputation, efficiency of operations, and flexibility in contract terms and negotiation. The management company profile describes its present status and its future plans. The number of properties and the number of years it has under contract, the locations of the properties, chain affiliations, facilities, amenities, ages, market orientation, and of the owners of managed properties all are typically considered carefully by an owner.

The management company that can demonstrate greater market strength, which is a successful track record in capturing and servicing the market segments that are critical to the success of the hotel, has a distinct advantage. Because financial lenders are often critical to an owner the reputation of the management company with financial lenders is also critical in the selection process. Lenders often are more comfortable funding projects that are operated by companies that are recognized both for their operational success in the market and for the product concepts that the hotel reflects.

Other factors that an owner may consider when selecting a management company include: efficiency and profitability of the management company and the methods for charging central services to the contract, such as accounting, reservations, engineering, architectural design, and labor relations, insurance and purchasing.

Reference
Stutts, Alan T. (2001) Hotel and Lodging Management – An Introduction. New York: John Wiley & Sons.

Further reading
Sangree, DJ. and Hathaway, P.P. (1996) 'Trends in hotel management contracts', The Cornell Hotel and Restaurant Administration Quarterly, October: 26-37. (Discusses how a 1996 survey finds a vastly different landscape for hotel management contracts compared to the 1980s.)