Bird & Bird

Leases, HMAs and Franchise

Agreements

September 2023

© Bird & Bird LLP September 2023 1

Our speakers

Karen Friebe James Fowler

Head of Hotels, Hospitality Senior Associate
& Leisure james.fowler@twobirds.com

karen.friebe@twobirds.com

© Bird & Bird LLP 2

Model #1: Lease
Landlord
• Owns the freehold or headlease.
• No involvement in or responsibility for the
operation of the hotel.
• Retains approval rights e.g. over
alterations to the hotel property; dealings
with the hotel property; and the entry into
HMAs and Franchise Agreements.
• Receives rent from Tenant.
Tenant
© Bird & Bird LLP
• Has exclusive possession for an agreed
term (usually a minimum of 15 years).
• Pays rent to Landlord; could be a fixed
amount (subject to review); based on
turnover; or a combination.
• Tenant may appoint a manager to
operate the hotel under an HMA or
operate the hotel itself under a Franchise
Agreement.
3
Model #2: HMA
Owner
• Owns the hotel and the hotel business
(including, typically, the staff).
• Funds all on-going capital and operating
expenditure.
• Converts, fits out, and periodically
refurbishes the hotel to meet Manager's
brand standards.
• Pays management fees to Manager
(usually base fee of 2-4% of revenue, and
incentive fee of 8-10% of operating profit).
• Retains all profit after payment of
Manager's fees and operating expenses.
Manager
© Bird & Bird LLP
• Operates the hotel on behalf of and as
agent of Owner.
• Provides the brand.
• Provides technical services to Owner (for
a fee) to ensure the hotel is
designed/fitted out to meet Manager's
brand standards.
• Provides chain-wide services to the hotel
- e.g. reservation system, marketing &
loyalty programmes.
• Receives management fees from Owner.
4
Model #3: Franchise
Franchisor
• Provides the brand.
• Provides initial and on-going training.
• Provides technical services to Franchisee
to ensure the hotel is designed/fitted out
to meet Franchisor's brand standards.
• Provides chain-wide services to the hotel
- e.g. reservation system, marketing &
loyalty programmes.
• Conducts periodic quality assurance
audits.
• Receives franchise fees from Franchisee.
Franchisee
© Bird & Bird LLP
• Owns the hotel and the hotel business.
• Operates the hotel on its own account.
• Funds all on-going capital and operating
expenditure.
• Converts, fits out, and periodically
refurbishes the hotel to meet Franchisor's
brand standards.
• Pays franchise fees to Franchisor
(usually a fixed initial fee per key, and on-
going royalty of 1-7% of revenue).
• Retains all profit after payment of
franchisee fees and operating expenses.
5
Which model should investors choose?
Lease
• Limited hotel expertise needed.
• No responsibility (financial, operational
or legal) for hotel operations.
• Predictable income stream, and an
attractive, saleable capital asset.
• Easier to finance.
• Limited market/operating risk.
• Tenant repairs & reinstates property.
• No control over hotel operations.
• Tenant gets trading upside (after rent).
• Less control over hotel positioning.
© Bird & Bird LLP
HMA
• Limited hotel expertise needed.
• Limited responsibility for hotel
operations.
• Leverage Manager's brand & expertise.
• Owner gets trading upside (after fees).
• Some input / approval over budgeting
(though with exceptions).
• Easier to finance with good Manager.
• Limited control over hotel operations.
• Higher market/operating risk.
• Limited recourse against Manager
(usually only for gross negligence/wilful
default).
• Tied to (potentially costly) brand
standards and chain-wide systems.
• Revenue-based fees payable even if
hotel is loss-making.
Franchise
• Full control over hotel operations (within
brand standards).
• Greater control over operating costs.
• Leverage established brand, systems,
customer base and operational know-
how of Franchisor.
• Franchisee gets trading upside (after
fees).
• Strong hotel expertise needed.
• Full responsibility (financial, operational,
legal) for hotel operations.
• Lack of control over brand reputation.
• Franchise Agreements pro-Franchisor,
harder to negotiate than HMA.
• Tied to (potentially costly) brand
standards and chain-wide systems.
• Revenue-based fees payable even if
6
hotel is loss-making.
 Thank you

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Lease, HMA or Franchise
Which model is best suited to today’s investor?

Presenter Name: Chris Martin

Date: September 20, 2023
Overview

▪ Hybrid Lease Structures

▪ Covid “Lessons”
- Leases
- HMAs
- Franchises

▪ Franchise / Third Party Operator Focus

▪ Some Other Trends

- Flip to Franchise
- Guarantees with Annual Caps
- Franchisors Guaranteeing TPO Leases
Hybrid Lease Structures

▪ Leases have traditionally been very much a “European” thing

- far less common in US and Asia

▪ Fully fixed leases are becoming rarer:

- accounting requirements / balance sheet implications
- stock market / investor pressure for operators to be operators, not owners or tenants
- many traditional lease investors now want some of the upside

▪ Turnover Rent elements:

- provide upside potential for Owner
- reduced balance sheet impact and risk for tenant
- more closely align Owner and tenant interests
- more risk than fully fixed, but often combined with a (lower) minimum fixed rent
Hybrid Lease Structures (cont’d)

• NOI / EBITDA-based leases

- An indexed minimum rent, plus X% (e.g. 90%) of upside

- Capped guarantee to cover the minimum rent (circa 2x)

- Tenant / operator is paid a Base Fee before upside calculated (FF&E Reserve also deducted)

- Top-up mechanism if guarantee is drawn upon

- Basically an HMA with a minimum guarantee

- Still legally a lease, so tenant / operator employs the staff

- Minimum rent should last the entire term (if you want to sell to an institutional investor)
Covid “Lessons” - Leases

▪ For those who didn’t already realise, Covid showed us that, in many cases, a lease
doesn’t really protect an Owner against major economic shocks.

▪ You can’t replace a tenant under similar lease terms – who would step in?

▪ Increased security can help Owners, but that is very much against the trend of capped
guarantees.

▪ This therefore negates one of the major attractions of leases, being the acceptance of a
lower return for lower risk.
(but some investors still need leases / can’t employ operational staff / can’t have fully variable
investments)
Covid “Lessons” - HMAs

▪ On top of massive lost revenue, many Owners faced fixed fees to operators even when a
hotel was closed.

▪ Some major operators responded better than others, but we saw some:

- changes to central services fees - less fixed / more variable

- agreeing to “stop the clock” on development deadlines / tech services fee increases

- allowing owners to borrow from FF&E Reserve funds

- short-term loans from operators to complete some new projects

- conversion of agreement type e.g. HMA to franchise

Covid “Lessons” - Franchises

▪ Again, revenue-based fees are much better protection for Owners compared to fixed
fees.

▪ Franchisee’s control over their hotel’s costs made them able to react quicker than under
an HMA with a big global operator.

▪ A franchise often also means a TPO (and thus a more flexible HMA).

▪ Some brands agreed short-term reductions and even standasides on franchise fees,
particularly for franchisees that needed to reduce their rental obligations to Owner.
Franchise / Third Party Operator Focus
2008
▪ Franchise is the fastest growing form of operating structure

▪ In 2008, around 40% of internationally branded hotels* in Europe were franchised

40%
▪ In 2022, this had increased to an average of 60% franchised in Europe 60%

100%
9%
90%
33% 30%
80% 40% 40%
70%

60% 2022
50%
91%
40%
67% 70%
30% 60% 60%
20% 40%
10% 60%
0%
Accor Hilton Hyatt IHG Marriott
Franchised Managed, Owned & Leased

*Data is for Accor, Hilton, Hyatt, IHG and Marriott, by hotels (not rooms)
Franchise / Third Party Operator Focus (cont’d)
US Comparison
▪ Franchise agreements massively dominate the US market
▪ Compared to 60% today in Europe, 91% of the big five global brand co.’s hotels are franchised*
▪ Aimbridge operate more than 1,200 hotels in the US (which is almost double any brand owner)

Franchised - Europe Franchised - US

96%

96%
91%

91%
89%
70%

68%
67%

60%

60%

60%
42%

ACCOR HILTON HYATT IHG MARRIOTT COMBINED

*Data is for Accor, Hilton, Hyatt, IHG and Marriott, by hotels (not rooms), as at end 2022
Franchise / Third Party Operator Focus (cont’d)

▪ As the major global hotel companies have grown larger and larger, most
consider their main strengths to be in the power of their brands and systems

▪ Traditionally, most franchises were for limited service and extended stay
(small to medium sized)

▪ Now, franchises for full service and much larger hotels are also common

▪ Not luxury, and little lifestyle, where the brand owners want more control
Franchise / Third Party Operator Focus (cont’d)

▪ The growth in franchising coincides with the rapid growth of TPOs

▪ Key advantages of management agreements with TPOs:

- shorter terms
- termination flexibility on sale
- lower fees
- much more incentivised fees
- strong focus on cost control

▪ However, Owner has franchise fees and TPO fees

– the EBITDA (and certainly value) upside needs to outweigh these (and often does)
Some Other Trends

▪ Flip to Franchise
- flexibility for Owner (themselves, or TPO)
- some brand owners are more open than others
- need to negotiate key franchise terms when entering HMA
Some Other Trends

▪ Flip to Franchise
- flexibility for Owner (themselves, or TPO)
- some brand owners are more open than others
- need to negotiate key franchise terms when entering HMA

▪ Guarantees with Annual Caps

- usually only cover projected management fees (often just incentive fees)
- if so, its effectively just an OPR with a subordinated incentive fee
- much better to have a strong OPR with incentive and base fees subordinated (if you can)
- but you then also need termination protection against a “zombie” operator earning no fees
Some Other Trends

▪ Flip to Franchise
- flexibility for Owner (themselves, or TPO)
- some brand owners are more open than others
- need to negotiate key franchise terms when entering HMA

▪ Guarantees with Annual Caps

- usually only cover projected management fees (often just incentive fees)
- if so, its effectively just an OPR with a subordinated incentive fee
- much better to have a strong OPR with incentive and base fees subordinated (if you can)
- but you then also need termination protection against a “zombie” operator earning no fees

▪ Franchisors Guaranteeing TPO Leases

- Brand Co. provides a capped guarantee that stands behind TPO’s capped guarantee
- Escrow account (with X% of excess operating cash) to replace Franchisor guarantee over time
- Need agreement up front to cover situation if Lessee fails – will Franchisor step in as operator?
- Make sure Franchisor is fully on board up front, particularly with pro-forma / trading risk