A sensitivity remaining from the recent “Great Recession” is that hotel owners are making a concerted effort to ensure that their hotel and all components of it are profitable. This is something that is aspired to but not assured in a hotel management agreement. To this end, many owners seek assistance in negotiating third party management agreements for their lodging and food and beverage services. Typically, the compensation to the manager is split into two components: base fee and incentive fee. The base fee compensates management for their ability to generate gross revenue. It is the fee to keeping the doors open and the lights on and is generally calculated by taking a percentage of hotel gross revenues. Most published sources benchmark the base fee percentage for hotel management typically from 2.5 percent of gross revenues to 4 percent of gross revenues. Since the base fee is calculated on gross revenues, it is not an indication of profitability or how efficiently management runs the hotel. The ability for management to contain expenses and generate an operating profit is not addressed in the base fee.
The incentive fee has been characterized as the place to align the goals of hotel owners and managers. While the structures of incentive fees vary widely, the idea behind them is to incentivize managers to conduct business efficiently and generate a profit for the owner. Negotiations for incentive fees are often contentious, as there are a number of factors that can go into their calculation. The basic structure of incentive fees is a percentage of gross operating profits (gross revenues minus certain operating expenses). Average or “market” incentive fees are challenging to benchmark because they can vary in different segments of the business, such as luxury hotels as compared to full service upscale hotels, but it is often a percentage of gross operating profits, and often after the owner is paid an owner’s preferred return. The goal of the owner is to use incentive fees to compel managers to manage operating expenses and have cash drop to owner’s bottom line.
Similar structures exist in the negotiation of third party food and beverage management agreements. Hotel owners who wish to maintain control over the financial upside of having a restaurant, but want a third party with expertise in restaurant and/or lounge operations to handle those tasks will opt for a third-party operating agreement. Although it is common for the hotel operator to be the food and beverage operator, that is no longer assumed and Hotel manager run food and beverage services can coexist with third-party operated restaurants, lounges and roof top entertainment venues. Under food and beverage management agreements, the owner pays the manager a base fee calculated on gross food and beverage revenues. In most cases, the parties also negotiate incentive fees based on management achieving certain financial targets. Contrary to the straight-lease scenario, these third-party management agreements offer hotel owners more control and earning potential (owners can receive all profits minus management fees), but they also force owners to assume additional responsibility and financial risk associated with the food and beverage operation.
Food and beverage management agreements are now as long and complex as the hotel management agreement, so the same degree of caution and care must be exercised in their structure and negotiation.