Control of Hotel Real Estate

SHA612: Control of Hotel Real Estate
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SHA612: Control of Hotel Real

Estate
What you'll do
List factors that influence decisions about who controls the daily
operations of hotels and explain why these factors are influential
Examine the key attributes of contemporary hotel leases and their
applicability in different international settings
Evaluate the financial costs and benefits of a proposed franchise
agreement
Evaluate letters of intent for new management agreements
Analyze management agreements from the perspectives of owners
and operators
Course Description
The control and management of hotel real estate has

evolved to become a complex process with a wide variety
of options for both hotel owners and hotel companies.
The primary considerations include who manages the
hotel on a day-to-day basis and whether or not the hotel should affiliate
with a brand. Based on his academic and real-world experience,
Professor Jan deRoos provides you with the tools and knowledge you
need to navigate the options and make sound decisions for your hotel
investment.
In this course, you will examine the most prevalent ownership structures
in the industry and determine how these structures impact costs,
benefits, and risk for both the owner and the hotel company. To evaluate
decisions about affiliating with a brand, you will use an Excel-based tool
to calculate the costs and benefits of converting an independent hotel to
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a franchise. Finally, you will examine the most commonly used control
mechanism in the industry, the hotel management agreement. Professor
deRoos provides best practices for negotiating agreements that achieve
the objectives of both hotel owners and hotel companies.
Jan A. deRoos
Associate Professor and HVS Professor of
Hotel Finance and Real Estate, School of
Hotel Administration, Cornell University
Professor Jan A. deRoos, on the faculty of the

School of Hotel Administration since 1988, has
devoted his career to hospitality real estate, with a
focus on the valuation, financing, development, and
operation of lodging, timeshare, and restaurant
assets. He holds BS, MS, and PhD degrees from Cornell University, all
with majors in the School of Hotel Administration. Areas of teaching
expertise span the entire range of hospitality real estate topics: real
estate finance, real estate principles, hotel asset management, real
estate portfolio management, hotel and restaurant valuation, lodging
market and feasibility analysis, hotel/resort planning and design,
hotel/resort development and construction, and the analysis of
timeshare/vacation ownership projects. He teaches courses in the School
of Hotel Administration's undergraduate and graduate degree programs
and teaches extensively in the School of Hotel Administration's executive
education programs.
Author Welcome
Forty years ago, the hotel business was a much simpler place. Hoteliers
simply owned their hotel, operated it themselves and branded it
appropriately. Today, however, control of hotels is frequently divided
between an owner, a brand, and a manager. In this course, we consider
questions such as: Why has the separation of ownership control
happened? How are the hotel revenues shared between an owner, the
brand, and the manager? And who carries the risk of hotel investment
when ownership and control are separated? To answer these questions,
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we examine the two major control decisions faced by owners.
First, should I brand the hotel or not? What are the benefits and the costs
of franchise affiliation? We will learn how to financially evaluate any
potential franchise. Secondly, we answer the question of who manages a
hotel. Management agreements and leases are both used in the hotel
industry. We explore contemporary management agreements with
respect to both the owner's and the manager's position. In addition, with
leases being common in many parts of the world, we take a look at
contemporary lease practice. Woven into the course is a sophisticated
view of the relationships that matter in these control decisions. I know
that you'll find the course rewarding and stimulating.
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Table of Contents
Module 1: Control of Hospitality Assets

1. Module Introduction: Control of Hospitality Assets
2. Watch: Who Controls the Operation of the Property?
3. Watch: Different Structures of Control
4. Tool: Hotel Control and Brand Options
5. Watch: The Hotel Income Statement
6. Watch: Hotel Company and Brand
7. Read: If the Owner Operates, What are the Options?
8. Read: If the Owner Doesn't Operate, What are the Options
9. Driving the Negotiating Process
10. Watch: Introduction to Leases
11. Watch: Hotel Leases Around the World
12. Ask the Expert: Why (Not) Hotel Leases?
13. Read: Typical Hotel Lease Provisions and Issues
14. Lease Structures and Provisions
15. Module Wrap-up: Control of Hospitality Assets
Module 2: Negotiating Contemporary Hotel Franchise

Agreements
1. Module Introduction: Negotiating Contemporary Hotel Franchise

Agreements
2. Watch: Franchising Around the World
3. Read: Deciding on a Franchise Affiliation
4. Read: Analyzing the Business Mix
5. Tool: Process for Analyzing a Franchise Affiliation
6. Read: Assessing the Benefits and Costs of Affiliation
7. Ask the Expert: How Brands Can Add Value
8. Tool: Calculating Franchise Fees
9. Watch: Evaluating the Benefits and Costs of Affiliation
10. Watch: Completing the Franchise Affiliation Analysis
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11. Evaluating Franchise Affiliation

12. Read: Addressing Qualitative Matters in Franchise Decisions
13. Watch: Why Be An Independent Hotel?
14. Read: Outlook for the Future
15. Module Wrap-up: Negotiating Contemporary Hotel Franchise
Agreements
Module 3: Negotiating Contemporary Management

Agreements
1. Module Introduction: Negotiating Contemporary Management

Agreements
2. Watch: The Continuum of Power
3. Watch: The Preliminary Negotiating Objectives
4. Tool: Owner and Hotel Company Negotiating Objectives
5. Read: Bargaining Strength
6. Watch: Negotiating the Letter of Intent
7. Read: Negotiating Key Provisions: Contribution, Term, and Fees
8. Read: Negotiating the Final Provisions
9. Tool: Key Provisions of the Letter of Intent
10. Watch: Strategy in Negotiating the HMA
11. Analyzing a Letter of Intent
12. Changing the Letter of Intent Provisions
13. Crafting an Advantageous Agreement
14. Tool: Control of Hotel Real Estate Action Plan
15. Module Wrap-up: Negotiating Contemporary Management
Agreements
16. Read: Thank You and Farewell
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Module 1: Control of Hospitality

Assets
1. Module Introduction: Control of Hospitality Assets
2. Watch: Who Controls the Operation of the Property?
3. Watch: Different Structures of Control
4. Tool: Hotel Control and Brand Options
5. Watch: The Hotel Income Statement
6. Watch: Hotel Company and Brand
7. Read: If the Owner Operates, What are the Options?
8. Read: If the Owner Doesn't Operate, What are the Options
9. Driving the Negotiating Process
10. Watch: Introduction to Leases
11. Watch: Hotel Leases Around the World
12. Ask the Expert: Why (Not) Hotel Leases?
13. Read: Typical Hotel Lease Provisions and Issues
14. Lease Structures and Provisions
15. Module Wrap-up: Control of Hospitality Assets
Back to Table of Contents
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Module Introduction: Control of Hospitality Assets

The question of control—how control is apportioned
between the owner, the brand, and hotel company—has
a powerful influence on the outcome of a hotel
investment. Control influences the hotel's financial
performance and the returns of each partner. Control is
also a key means of shifting risk between partners.
This module introduces key concepts around control decisions and

examines hotel leases in greater detail. You will examine the different
options around who controls the operation of the hotel and examine the
factors that influence this critical decision. By connecting the interests of
owners with the available branding and operating options, you will
explore how owners can shift the risk involved in owning hotels. Finally,
you will define the key attributes of contemporary hotel leases and
examine how leases are used in different international settings.
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Watch: Who Controls the Operation of the Property?

Hotel real estate investment projects involve a wide range of participants,
most importantly, the owner, the hotel company, and the lender. Each
participant has a specific role to play and has specific objectives and
interests that they want to achieve. In this video, Professor deRoos
describes the hotel company's role in providing management and brand
services. He also provides an overview of the objectives of each party,
which need to be considered when structuring a successful investment.
Video Transcript
Most hotel projects involve a partnership between the property owner, the
lender or lenders, and the hotel company. The hotel company provides
two sets of services, which may be provided separately or bundled
together. The first is management services and the second is brand
services. When bundled together, the hotel company does business as a
branded operator using a hotel management agreement or lease with the
owner to define the roles and responsibility. When provided separately,
the hotel company provides brand services in the form of a franchise or
license agreement to one of three parties: To the owner, who operates
the hotel themselves in an owner-operator model. To an independent
hotel management company, who has a hotel management agreement
with the owner. Or to a tenant who has leased the building from the
owner. In some instances, the hotel company will take the role of tenant if
it is appropriate.
In this analysis, the lenders play the role of interested observer. They do
no generally have a significant role in the decisions. Once a hotel
company is selected however, the lender generally requires an
agreement with the operator, specifying the lender's obligation to the
brand, or the operator, in the case of an owner default. Otherwise,
lenders have little to do with the controlled list questions. Each of these
partners seeks to structure hotel investment to achieve their goals or
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further their interests. In general, owners seek a sufficient return on their

investment, either in the form of cash flows from hotel operations or in the
form rents, if the building is leased. The hotel company seeks revenues
in the form of fees or in the form of profits, if they lease in hotel from the
owner. Lenders seek a healthy yield on their loan. A successful
investment brings all of these together in an agreement that is mutually
advantageous. In this course, we are concerned with who controls the
real estate and how control is apportioned among the relative parties.
The key questions to be considered are, first, who has control of the hotel
and how is it specified? And second, how does the control relationship
shift risk amongst the parties? Both questions need to be borne in mind
through out this course.
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Watch: Different Structures of Control

One of the key questions we consider in this course is who has control of
the hotel and how is control specified? There are a wide range of options
available to owners and hotel companies when making decisions about
control. In this video, Professor deRoos first outlines the control options
available to hotel owners and also discusses how they can engage with a
brand. Then, he turns his focus to hotel companies and looks at the
control decision from their perspective. For hotel companies, they must
consider who controls the day-to-day management of the hotel and
decide how brand standards are enforced.
Video Transcript
Consider the hotel owner's investment structuring decision. The question

of who controls the management of a hotel is a fundamental decision. At
one end of the continuum is a purely financial owner who leases the hotel
to a tenant. The tenant makes decisions about the management and
branding of the property over the term of the lease. The owner retains
control over the building in the long term. In the middle is the financial
owner who uses a hotel management agreement, or HMA. The owner
cedes a large measure of control over day-to-day operation while
maintaining control over the building in the long term.
At the other end of the continuum is an owner-operator who both owns

and manages the hotel, maintaining control over both day-to-day
operations, and controlling the building over the long term. In addition to
the question of operational control, the owner is faced with the decision
about whether or not to brand the property. If the owner leases the
property, the owner and tenant agree whether the hotel will be branded
or not and the tenant is generally responsible for securing brand services.
If the owner hires a management company under hotel management
agreement, they can hire and independent or non-branded manager, or a
branded manager. The independent management company can operate
the hotel under a franchise. If the owner manages a property, the choice
is simple. They can run the hotel as an independent hotel, or they can
brand the property using a franchise or license agreement. Note that the
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owner can get to the same place, operating the hotel under a brand, in
many ways.
Now let's look at the hotel company's decision. Traditionally, going back,
say, 40 to 50 years, hoteliers lived in a very simple world. They owned
properties, they managed properties, and they developed great brands
associated with their properties. It was all bundled together and no one
thought it could be done any differently. That world has changed
significantly. Hotel companies now have a number of choices.
Let's start at the polar extremes. At one extreme, they can still own,
operate, supply their own brand, as in the traditional model, maintaining
total control. At the other end of the spectrum, they can become branded
franchise companies. By becoming a franchisor, the hotel company
exercises much more limited control by creating a defined set of brand
standards, licensing that brand to others, and then enforcing those brand
standards. This allows a third party hotel owner to manage the hotel day-
to-day while providing the hotel company with a platform for the brand
and its distribution, but with limited control. In between these poles, the
hotel company can act as hotel manager without owning the asset. They
bundle together management and brand, operate the hotel under a hotel
management agreement. By providing management services in addition
to brand services, they obtain day-to-day control, but do not have to own
or invest in hotel assets.
So for hotel companies, the question of control is twofold, who controls

the day-to-day management of a hotel, the hotel company themselves via
a hotel management agreement, or, a qualified owner under a franchise
license agreement? And secondly, how are brand standards enforced?
Via the hotel management agreement or via the franchise license?
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Tool: Hotel Control and Brand Options
• Use this summary of control and

brand options when you begin
any hotel real estate project.
As you have seen, there are many ways a hotel owner and a hotel
company can structure the control of the hotel's day-to-day operations.
Each party needs to determine which structure best suits their strengths
and weaknesses so that they can identify projects that will enable them to
achieve their objectives. Another important decision that hotel owners
and hotel companies need to make is if and how they will engage with a
brand. You can use these charts that summarize the options for control
and brand to determine which approach makes the most sense for your
hotel real estate project.
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Watch: The Hotel Income Statement

Fundamentally, the decisions about hotel control and brand focus on how
each party can achieve their desired returns and compensation from the
project. Thus, having a thorough understanding of how each party gets
paid is critical to making good control and brand decisions. In this video,
Professor deRoos reviews the income statement, which is based on the
Uniform System of Accounts for the Lodging Industry (USALI). The
income statement is a useful tool for visualizing the revenues and
expenses of a hotel, which determine the compensation of the owner and
the hotel company. Understanding the income statement can help you
see the incentives that exist within the system and how these incentives
can be used to build effective partnerships between owners, hotel
companies, and brands.
Video Transcript
Now that you understand the various ways that control is apportioned in a
hotel investment, we will examine a hotel income statement so that it is
clear how all participants are compensated. The income statement we
used is based on the Uniform System of Accounts for the Lodging
Industry, known as the USALI. It was developed by the American Hotel
and Lodging Association, working with industry stakeholders. It is a very
useful tool for visualizing how the owner and the hotel company get paid.
We start with the example of the BrookEden Hotel. The income

statement starts with a series of metrics that include the hotel's room
count, the occupancy, the average daily rate and the total number of
rooms expected to be occupied on an annual basis. Below this, there's a
revenue section, which includes revenues for each of the major
departments in a hotel; rooms, food, beverage, rentals and other income,
and then the other operating departments, such as spa operations, and
perhaps resort operations. From these revenues, expenses on a
departmental level are deducted for each of the major departments.
Again expenses from room department, food and beverage expenses
from the food and beverage department. These departmental expenses
allow the hotel company and the owner to see whether the manager of
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each department has exercised proper control. Once these departmental

expenses are deducted from revenue we have departmental income,
known in the industry as a house profit. From these departmental
incomes, one deducts a set of expenses, let me move the screen a bit,
known as the Undistributed Operating Expenses. These include
administrative and general expenses, which include the general manager
or human resources and security, and then the other categories of
overheads, information and telecom system, marketing, franchise fees,
maintenance of the hotel, and then, utilities, or energy costs. The result of
deducting these undistributed operating expenses is the line item called
the gross operating profit.
The gross operating profit line is very important. It exists to establish the
manager or hotel company’s span of control, from revenues down
through gross operating profit. That is, the hotel management agreement
makes the hotel company responsible for generating revenues and then
for managing all of the costs of their operation down through the GOP
line. The hotel company is not responsible for managing items below the
GOP line. From the GOP, one deducts the management fee and then
arrives at a line called the income before a non-operating income and
expenses. A very kludgy definition, but it's what exists in this uniform
system. From this line, we deduct a series of non-operating income and
expenses. The owner is responsible for paying this management fee and
then collecting revenues for, say rental of the roof for a cellphone, rental
of ground floor retail space, and then, must pay any rents, property tax,
property insurance, and the reserve for replacement. Making these
adjustments results in a figure called EBITDA less replacement reserve,
otherwise known as a net operating income or property cash flow. NOI,
or net operating income, has a very, very precise definition. It's the
amount of cash that is left over after deducting all of the operating
expenses from revenues. This is the figure that the owner is most
interested in. It is the business's bottom line.
So why are we looking at this? At this point, we are considering how the
owner and the hotel company get paid. Consider an owner-operator
managing under a franchise. The hotel company gets paid franchise fees
that are a percentage of the hotel's revenues and then receives
marketing and reservation expenses. All of these fees are a function of
gross revenues or room revenues. So the franchisor derives their
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revenue from hotel revenues, not hotel profits. Now consider a hotel
company with a hotel management agreement. That hotel company
receives a management fee which shows up as one of the non-operating
expenses. That fee usually has two big pieces, a base fee and an
incentive fee. Base fees are universally percentages of gross revenues.
The incentive fee is universally some percentage of profits.
As the manager, the hotel company gets paid to generate revenue and
the hotel company gets paid to manage the property efficiently.
Additionally, the hotel company receives a set of payments known as
system reimbursable expenses, which are payments for the use of the
hotel company's systems. Note that the hotel company does not receive
compensation exclusively from either revenues, or from profits. The total
fee is a combination. After all of these expenses, including the franchise
fees, and management fees are paid, the owner obtains whatever's left
over in the form of net operating income. The owner therefore has an
immense incentive to hire a good hotel company and affiliate with a good
brand. At it's root, the decision about whether to hire the hotel company
and whether to employ a brand is a decision about whether these
choices increase cash flows. Good brands generate premium revenues.
Good hotel companies manage efficiently. They generate greater profits.
So there's a lot of stake in choosing a hotel company and a brand.
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Watch: Hotel Company and Brand

The owner and the hotel company can structure an agreement around
control and brand in many different ways to meet their respective
objectives. In this video, Professor deRoos provides three different
examples using three fictional investors that exemplify the critical aspects
of these decisions. In these examples, he demonstrates how different
fees, contract lengths, or brand affiliations are negotiated depending on
the interests of each party.
Video Transcript
What are the range of options for control? Let's consider three different
stories, first from the owner's perspective and then from the hotel
company's perspective. For our first owner, consider Alexandra.
Alexandra works for Tarheel, a respected hotel developer. Her firm is
developing a large, new, full-service hotel in the office park adjacent to
the airport in a growing city. Her firm is very successful. Their expertise
has traditionally been to develop and operate smaller, focused-service
hotels in growing suburban markets under a franchise license. Success
has brought the firm an increasing number of opportunities to develop
their core focused-service properties, which has put intense pressure on
their in-house operating arm to meet the growing needs of the firm.
Alexandra feels that having a branded hotel company manage their

proposed full-service hotel is the right decision. Tarheel's in-house
management team may not have the capacity to adequately manage a
full-service hotel at the present time. Guests coming in to this market
want quality lodging accommodations associated with a brand. They
want comfort, convenience, connections. They want quality drinking and
dining venues, and effortless events. The brand's promise of comfort,
quality, and effortless has customer relevance. The branded hotel
companies are very well known for meeting these needs, and can
provide these services that Alex's firm needs.
Now consider Sophie. Sophie works for AIGH Insurance. The insurance
company likes to own large, high quality assets over a very long time.
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They recently acquired a large convention-oriented hotel that was subject

to a long-term hotel management agreement with one of the global hotel
brands. The management agreement is nearing the end of its term and
Sophie wants to renegotiate the hotel management agreement. Her
interests are in securing a quality hotel company via a new long-term
agreement and then incentivizing that company to deliver very high cash
flows over a very long time. Sophie really has no interest in having the
power to unilaterally terminate the hotel company. Her interests lie in
selecting a hotel company capable of managing the company very
profitably over a very long horizon. Given this, the hotel company sees
Sophie as a kind of customer that they really would like to do business
with.
Finally consider John. John works for a real estate fund. John's fund buys
underperforming assets, repositions the assets and then sells them for a
profit. John's firm recently purchased an adaptive reuse project. His
vision is to redevelop the office and retail portions of this project,
reposition the hotel, and then sell of the pieces individually. John needs a
branded hotel company to execute on the vision to reposition the
property. However, it is very important to John that the hotel
management agreement is terminable on sale, perhaps by giving the
hotel company the right to buy the property from him at the end of the
holding period or by paying a termination fee on sale. The reason is that
there may be potential buyers that will avoid the sale if the property is not
available, free and clear of management or brand.
So how does our hotel company view all this? Let's go back to
Alexandra. Alexandra asked the hotel company to consider a contract in
which the management is convertible to a long-term franchise
agreement. The hotel company has the opportunity to manage the
property for the near future, but knows that Alexandra's firm may wish to
take over the operation at some point in the future, while keeping the
hotel company's brand associated with the property. The hotel company's
long-term objective is to be sure that the owner is paying for having the
hotel company's brand associated with the property. This is also in the
owner's best interest.
Sophie, on the other hand, is a hotel company's dream. But the hotel
company knows that Sophie knows she is a dream, and that she wants to
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pay below-market management fees. It is important for the hotel

company to focus on the quality of their management and their ability to
deliver cash flows that are very much in line with Sophie's long-term
interest. The hotel company might consider lowering their fees if they
obtain a very long, no cut contract. It is quite certain that the hotel
company and Sophie can come to terms.
John, on the other hand, is a difficult company, difficult customer for the
hotel company. He is a repeat customer. He comes back over and over
and over again, but the hotel company knows that John is not a long-term
customer in any given asset. The hotel company has to earn the right to
control over and over again. To retain the management contract long
term, the hotel company may even have to buy the property and then
turn around and sell it to a company like Sophie's that will be interested in
a long-term interest in owning the property. On the other hand, John is
absolutely not price sensitive in terms of fees. John wants things done.
Wants them done today and is willing to pay a very fair price. John will
not wish to engage in a protracted price negotiation. He has pressure to
get things done, get them done quickly, because the value creation
dominates any meaningful savings in negotiation of fees. Note how the
approach is different in each of the three cases. It depends on the
respective interests. Both sides need to be flexible and creative in
arriving at a relationship that meets their needs.
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Read: If the Owner Operates, What are the

Options?
• Owners can operate the hotel themselves
• Owners can operate independently, as a referral, or as a franchise
Let’s take a closer look at the different control options. Recall that an
owner faces a decision: do they want to manage the property themselves
or do they want to hire a hotel company to operate on their behalf? Here
we consider the first scenario, in which the owner operates or manages
the property. In this situation, there are essentially three choices.
Independent Hotel
As an independent hotel, the owner manages

without a relationship to another hotel company. The
owner has complete control over how the property is
positioned, operated and marketed. They are not
beholden to a franchisor or a branded manager. They don’t have to
conform to any franchise or brand standards. That is the good news. The
bad news is they must make up for all of the support a brand provides.
The owner must create their own national or international marketing
programs and they must create relationships that allow guests to book
the hotel without the leverage of a brand's reservation system. This
entails a substantial amount of work in creating and maintaining a good
distribution system for the hotel's room inventory. Some owners are able
to make this work for the property, especially for a unique property or a
property with a local, loyal clientele.
Referral
A referral provides a middle ground between independence and a

franchise. The hotel belongs to an association such as Best Western,
Preferred Hotels, Relais Chateaux, Worldhotels, or Leading Hotels of the
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World. The referral organizations provide marketing and a

significant distribution system for the owners. The member
hotels do not pay a royalty, but pay to use the referral
system’s international marketing and distribution systems.
There may be some performance standards, some
minimum signage standards, and use of the loyal preferred
customers program. The cost per reservation through a referral program
is non-trivial. For example, the cost per reservation in the Leading Hotels
system is between $30 and $40 per reservation. While these costs may
seem significant, they are not seen as inappropriate given the benefits.
Franchise
The most extensive branding relationship for owners

is to enter into a franchisor/franchisee relationship.
The franchisor creates brand standards and licenses
these brand standards to the franchisee. This brings
a great deal of standardization to the property, which
is both a good and a bad thing. Franchised hotels
lose the individuality of independent hotels, but many
customers are looking for precisely the
standardization franchises provide.
On the benefit side, the franchise brings the owner a large and efficient
international marketing and sales organization. The owner receives the
infrastructure – a website, a dot com address, a 1-800 number; all
created by the brand. Additionally, in many secondary and tertiary
markets lenders will only lend to branded hotels. If you want to be the Ye
Olde Independent Inne in Concord, New Hampshire, it may be very
difficult to obtain financing. If you want to be the next Hampton Inn in
Concord, financing is much easier with the brand.
With these benefits come significant costs. These include a royalty fee of
between 5% and 7% of total revenues. The royalty is a fee for the ability
to use the brand’s name, trademarks, and standards. Additionally, there
are marketing fees, reservation fees, system charges, cost of compliance
charges, that all get factored into the costs of affiliation. The total costs of
a franchise are between 6% and 14% of total revenues, including the
royalty.
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Read: If the Owner Doesn't Operate, What are the

Options
• Third-party management offers benefits to owners
• The options are a management agreement or a lease
Suppose that the owner does not want the responsibility of operating the
hotel. The owner has two choices; one choice is to hire a hotel company
to manage the hotel and deliver the hotel 's net operating income (NOI)
to the owner in exchange for management fees. Alternatively, the owner
can lease the hotel to a tenant and obtain rent instead of the hotel 's NOI.
Management Agreement
In signing a hotel management agreement
(HMA) with a hotel company, the owner
receives professional management. The owner
gives up a great deal of influence or
involvement with the property on a day-to-day
basis, but knows that control can be exercised
via effective hotel asset management skills.
However, almost all HMAs have a non-
disturbance clause, which limits the ability of
the owner to direct day-to-day operations.
Owners bear the financial risk and rewards

when a property is operated under an HMA. The hotel company runs a
property on the owner's behalf, generally as the owner's agent. The hotel
company is paid a fee for providing those services and the owner obtains
the property 's NOI. The hotel company shares some financial risks
through the incentive fee mechanism, but when bad things happen the
financial losses are borne by the owner.
If you hire a branded hotel company, the hotel company will provide
brand services, marketing, and reservations systems. The hotel company
provides group purchasing benefits by aggregating the value of the
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goods they purchase and having preferred vendor relationships. And

lastly, the hotel company may be willing to co-invest in the property
through the provision of key money, a loan or, in rare instances, some
equity capital.
What are the costs? The costs come in three categories. First there is a
basic fee, usually between 2% and 3% of gross revenues. Second, there
is an incentive management fee, which is some function of the property 's
profits. Third, there are system reimbursable expenses that "make the
hotel company whole " for running their systems. These expenses
include marketing, sales, reservations, purchasing, accounting, training,
and other systems that are provided company-wide for the benefit of the
individually managed properties. We will take a detailed journey into
management agreement terms as the course unfolds.
Lease
A second option for owners not wishing to operate their hotels is to sign a
lease. A hotel lease works like any landlord/tenant relationship. The
property owner is a landlord, and the hotel company is a tenant. What
does the owner get in this relationship? As with a management
agreement, the owner receives professional management of the property.
However, there are important differences. Under a lease, the tenant has
"exclusive possession and control of the property, " meaning very little
owner involvement. In exchange for rent, the owner generally is
prohibited from intervening in the operation of the property other than as
specifically outlined in the lease. In exchange for the lease and no owner
involvement, the hotel company takes all the financial risk. This means
that if bad things happen, if the revenues fall precipitously for example,
the hotel company is still obligated to pay rent to the owner.
Rents come in a variety of forms. Rent can be fixed, meaning that it is a

base rent indexed to inflation. Rent can be variable, meaning that rent is
some negotiated function of property revenues. Rent can also be a hybrid
of the two, in which the tenant pays a base rent or a percentage rent,
whichever is higher. We will take a more in-depth look at lease terms
later in the course.
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Driving the Negotiating Process

Instructions:
You are required to participate meaningfully in all discussions in this

course.
Discussion topic:
Create a post in which you consider the range of control options that
owners can choose from. Whenever possible, include examples from
your real-world experience. Be sure that you comment on the following:
1. What factors do you think drive the owner's decision? For example,
what circumstances would influence an owner to choose to manage
the hotel under a franchise?
2. What circumstances do you think would drive the operator's
negotiating position?
3. What factors would influence a hotel company to manage under a
brand?
To participate in this discussion:
Click Reply to post a comment or reply to another comment. Please

consider that this is a professional forum; courtesy and professional
language and tone are expected. Before posting, please review
eCornell's policy regarding plagiarism (the presentation of someone
else's work as your own without source credit).
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Watch: Introduction to Leases

One approach to answering the question of control between owners and
hotel companies is a lease. In the U.S., leases are not as prevalent as
franchise agreements or management agreements but they are widely
used in other parts of the world. In this video, Professor deRoos
describes why owners and hotel companies may see benefits in a lease.
He describes different lease structures and rents, including fixed and
variable rents, and shows how these different structures shift risk
between the owner and hotel company.
Transcipt
Leases are one means by which owners and hotel companies work out
the question of control. The other being hotel management agreements.
While leases are not as prevalent as franchise agreements or
management agreements in the US, they are an important form of control
in other parts of the world. The owner as landlord, enters a contract with
the hotel company as tenant, who pays rent under a long-term lease.
So why lease a hotel? Well let's consider this from two different
perspectives. We will consider the question first from the perspective of
the owner and then from the perspective of the management company.
From the financial owner's standpoint the choice is between a hotel
management agreement or a lease. They see the lease as a risk
management or financial engineering device. Either term would be
synonymous here. What a lease does is turn risky hotel net operating
incomes into much less risky rents. Shifting risk from the owner to the
tenant. The bottom line is that lease revenues, or rents, are designed to
be much less volatile than hotel NOIs over the business cycle.
Let's contrast this with the hotel company's perspective. If owners use
leases to lower their risk, hotel companies often use leases to embrace
risk in return for a larger potential income from a given hotel. Hotel
companies have the option of whether they wish to operate under a
management agreement or a lease. Often, hotel companies begin by
purchasing a company, then they sell the property to a new owner,
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conditional on the right to continue to operate the property. If they choose

to operate under a management agreement, this is called a sale-
manageback. If they operate under a lease, it's called a sale-leaseback.
The sale-leaseback is seen as an attractive alternative to a sale-

manageback in some situations as a way to earn a higher fee for
operating the property, using a lease to take on greater financial risk. The
hotel company agrees to pay contract rents to the owner in exchange for
the right to control the property and to collect all of the operating
revenues. If operating profits under a sale-leaseback are significantly
greater than the contract rents, the hotel company has the opportunity to
earn more than if the property were operated under a management
agreement. The lease structure requires the hotel company to take on
the risk of operating those hotels very efficiently.
Now, let's turn our attention to a detailed look at how different lease
structures shift the risk from the owner to the hotel company. The
fundamental question in a lease structure is how the owner's rent is
determined. Whether they get paid a fixed rent, a variable rent, or some
combination of fixed plus variable rent. Let's start with a fixed rental lease
or fixed rent. In this structure, the initial rent is calibrated to a return on
investment and is indexed to inflation. Historically, the initial rent has
been between 6% to 10% of the total investment, and is indexed to
between 80% and 100% of inflation. This has the effect of making rent
look like an inflation-linked bond to the owner. The lease changes, the
owner's annual cash flows from the hotel, from a risky net operating
income, to a more stable rent. While rents can increase, the increase has
nothing to do with the results of operation. It has everything to do with
inflation in the market. Rents now look like an inflation-linked bond.
Now let's consider a 100% variable lease, in which the lease is a

percentage of revenues or percentage of profits. Hotel companies acting
as tenants have a very large incentive to use variable rents as they
structure of their leases, because any fixed rents must be treated as debt
on the hotel company's balance sheet. There are two basic structures for
variable leases in the market. In the first, rent is some percentage of total
revenues. That percentage of total revenues generally attempts to mirror
the cash flow from operations from an average hotel. It is usually
between 20% and 40% of total revenues, depending on the type of hotel.
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Select-service hotels would be the upper end of the range, full-service

hotels at the lower end of the range. The second structure for a variable
lease would be for the rent to be some percentage of the gross operating
profit, or income before fixed charges. These leases are uncommon, but
they are still used in the market. Typical rents in GOP-based leases are
between two-thirds and three-quarters of the gross operating profit.
Now let's consider a lease that has both a base rent and a variable rent
portion. I will illustrate two ways this could work. In the first structure, the
base rent would be some minimum return on investment, calibrated to,
say, a 7% return on investment. Or, a percentage of total revenues,
generally between 20% to 40% of total revenues, whichever is higher. In
this case, the lease has a floor, or a minimum rent, plus the owner shares
in the upside as revenues grow over time. In the second structure, the
base rent is some minimum rent based on return on investment. Just like
before, plus some percentage of the change in revenues or increase in
revenues. If revenues go down, the base rent is paid. If revenues goes
up, the tenant will get a large portion of that increase in revenues,
generally between 40% and 60%.
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Watch: Hotel Leases Around the World

Leases are used in different parts of the world for different reasons and in
different ways. In this video, Professor deRoos discusses the U.S.,
Japan, and several European countries and explains how leases are
used in each context. For example, in Japan, rents are taxed at a lower
rate than operating income, which has led to the popularity of leases. He
also shows how different countries use different lease structures to shift
risk between the owner and the tenant.
Video Transcript
In the United States, all real estate investment trusts, or REITs, are
required by law to derive their revenues as rents, not the net operating
income from operating businesses. All hotel rates are required, therefore,
to use what I call a standard structure with one owner, one tenant, one
hotel company. All three are required to be separate legal entities with
the tenant having an economic stake in the operation of the hotel,
meaning that the tenant could lose money. In some REITs, the tenant
and the hotel company are affiliated with each other. The hotel company
is affiliated with the REIT sponsor and the tenant is also affiliated with
that same REIT sponsor. In addition to the REITs, they're a small
minority of non-RIET properties in the US that employ leases. In these
situations, the hotel company and tenant are the same entity. The owner
has a contract with the tenant who is also the hotel company and the
tenant operates that hotel under a lease rather than under a
management agreement.
In Japan, we have a structure very similar to the US REITs. There is an

owner, a tenant, and a hotel company. The reason this structure is
prevalent in Japan is that rent is taxed at a much lower rate than net
operating income. In general, the manager has an interest in having a
hotel management agreement. The owner has a significant interest in
having a lease, and earning rents. Given this, they come together and
create a tenant, which is jointly owned by the owner, the hotel company,
and by the lender. The tenant's lease transforms the net operating
income into rent. In the rest of Asia, leases are very, very uncommon.
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In Europe, leasing is a very popular form of control. In certain markets,

such as Germany and Scandinavia, and in the Spanish Resorts, lease
structures are the dominant form of control. Owners have a strong desire
to sign leases. They have very little interest in signing hotel management
agreements. This is changing over time with management agreements
increasing in use, but it will take several decades before leases become
a minority control device.
Let's take a look at some very specific situations in given countries. In

Germany, for example, real estate funds have adopted leases with a
fixed rent per room indexed to inflation giving the fund, a return that is
inflation linked with very little volatility. In the United Kingdom, some of
the banks have gotten into the business of owning hotels. They generally
use a base rent plus a variable rent. Examples include leases in which
rents are 25% of total revenues, or a 6% return on investment capital,
whichever is higher. There is a notable French company that uses
variable leases based on a percentage of revenues, with no minimum
rental. And a notable Spanish hotel company, that uses variable leases,
based on a percentage of gross operating profit.
Let's note how leases are used as risk-shifting devices. In the German
case, the hotel company has the entire risk of operating the property.
They must pay a minimum rent per room, indexed to inflation. As the
property's rent increases with inflation, they have to do a better and
better job of operating these properties. The French company that uses a
100% variable lease based on revenues has much less risk. If the
property performs poorly, rent goes down. If the property does well, rent
goes up. Thus the negotiation of lease structures is vitally important to
understand how risk is allocated between the owner and the tenant/hotel
company.
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Ask the Expert: Why (Not) Hotel Leases?

As you have seen, leases are a common form of control in various parts
of the world. In these videos, Josefin Bergqvist, an expert in hotel
asset management and valuation, discusses how her firm
structures leases to increase its control over hotel properties and
establish adequate rents and fees. She also discusses how her firm
works with tenants to build collaborative working relationships.
Josefin Bergqvist is the head of valuation for Pandox AB, a leading

owner of hotel properties in Northern Europe with a focus
on sizable hotels in key leisure and corporate destinations. Bergqvist has
more than 20 years experience in hotel operation, acquisitions, asset
management, and valuations. In her role with Pandox, Bergqvist is
responsible for the valuation of Pandox’s hotel portfolio, which is
comprised of 113 hotels with more than 24,000 rooms.
Question
In your organization, why do you use leases instead of management

agreements?
Video Transcript
Well, we prefer to have leases because we feel we have more control. If,
for example, if we had the management agreement, we don't get paid
until all the costs are deducted. But if we have a lease, we get paid in
revenue. And the way our leases are structured is that we have a
minimum rent or base fee, and then we have a percentage on room
revenue and one percentage on food and beverage and other costs.
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Question
How do you manage the relationship with your tenants?
Video Transcript
With a lease, we make sure we have a very good relationship with the
tenant. For example, in Pandox we have a lot of leases together with
Scandic, and we're almost like one big company. We work very close
together with them. We share figures and we have the same view of
where we want to take the property. If we do investments, we do them
together, to share the risk and also to share the upside. With a
management agreement, we feel that we don't have much to say
because the brand has all their whole agenda which they want to fulfill.
And that's quite often not what we want to do.
Question
What lease terms are most important to your organization?
Video Transcript
It's important for us, of course, what rent we're getting. And it's also
important what control we have. But we have it standardized in the end,
what control we have, who is in charge of what. For example, we're
usually in charge of the property on the outside, the roof, but the tenant is
in charge of everything FF&E and all that, and so it's important for us that
we have a clear structure of who is responsible for what.
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Read: Typical Hotel Lease Provisions and Issues
• The provisions of a lease are

structured to apportion
responsibilities
• Responsibilities are apportioned between

the owner (lessor) and the hotel company
(the lessee)
The provisions of a hotel lease are structured to apportion responsibilities

between the hotel owner (landlord or lessor) and the hotel company (the
tenant or lessee). The goal is to avoid a series of “moral hazards,” in
which one party has an incentive to under-invest or under-perform. Keep
this in mind as we review the major lease provisions.
Term of the lease: Leases are generally long-term

documents: 20 years is an absolute minimum; 30
to 40 years is much more common. There are
even some 84 year leases, structured as 7 distinct
12-year rolling terms, with the lease terminable
every 12 years at the option of the tenant.
Renewal: Leases with renewable terms are

generally written to be exercised at the option of the tenant, not at the
option of the owner. An owner wishing to limit the term would limit the
number of renewals.
FFE: Who owns the FFE? There are two general ways this is handled. In
the first, the landlord rents the “walls” and the tenant brings their FFE with
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them. The tenant owns FFE and is responsible for its replacement. In the
second, the tenant gets the FFE that was in the hotel when they took
over the lease, they are responsible for the FFE until the end of the
lease, and at the end of the lease they must give the owner back an
equivalent amount of FFE value adjusted for inflation. Invariably, the
tenant is responsible for FFE replacement, due to moral hazard
considerations. If the owner were to take responsibility for FFE
replacement, the tenant generally asks the owner to over-invest, desiring
new and better FFE. The long-term annual cost of FFE replacement is
usually between 3 and 4% of hotel revenues, when handled by the
tenant.
Capital expenditures: Who is responsible for

keeping the bones of the building -- the building
structure, the boiler, the pumping systems, the
exterior enclosure, the roof, the elevators – in shape
over the long term? In most cases owners are
responsible for these capital expenditures. In some
cases, the responsibility for capital expenditures is
put to the tenant in exchange for lower rent. Long-
term annual capital expenditures average 2% to 3%
of revenues.
Maintenance: In general, the tenant is completely responsible for facility

maintenance; that is, in addition to paying the rent, the tenant pays for
maintaining the building. The owner may hire an inspection team to
insure that proper maintenance is being performed. A question in many
leases is the line between property facility maintenance and capital
expenditures. A tenant who neglects water treatment for the boiler has
lower costs, but will cause the owner to have to replace the boiler more
frequently, an expensive undertaking. This is the reason for the owner to
insist on periodic inspections for proper maintenance, especially
preventive maintenance programs.
Security deposit: In general, the industry requires a security deposit

equivalent to one year of rent. In some cases, owners ask tenants for as
much as two years of rent as a security deposit. Given the large sums of
money involved, owners may accept letters of credit in lieu of the security
deposit. These funds are held in escrow to ensure the tenant's
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compliance with the lease terms, especially at the end of the lease term.
Insurance: In general, the tenant is required to carry a specific amount of

liability insurance with the minimums established by the owner and the
owner named as an additional insured. Other insurance requirements
are negotiated on a case-by-case basis.
Assignment: Does the tenant have the right to sublease the building to a
third party or to assign the lease to a third party? The answer is usually
no. The tenant is leasing the building for a specific purpose, working with
a specific hotel company and/or brand. In general, it is in the tenant’s
best interest to be allowed to sublease and it is in the owner's best
interest not to allow sublease. Owners rarely grant this right; if the
building is not right for the current tenant’s needs, it is the owner who
would like to make the re-tenanting decision, not allow this to be made by
the current tenant.
Standards: The maintenance of brand or franchise affiliation is very

important to the tenant and the owner, because the brand is often a key
component in the ability of the tenant to pay rent. Owners are very
concerned about the tenant’s ability to maintain the brand affiliations and
standards; it is often a default under the lease to lose the brand
affiliation. Owners may want some measure of reporting from the tenant
regarding brand inspections. Given that the owner has no role in day-to-
day operations, however, tenants see reporting requirements as onerous.
Reports to landlords are generally monthly, sometimes quarterly or even
yearly, but certainly not the weekly or daily reporting typical when the
owner has a HMA with a hotel company.
Audits: Owners have the right to audit the tenant’s financial statements
from time to time to make sure the tenant is properly reporting revenues,
especially if rent is based on hotel revenues. If the audit finds nothing, the
owner pays. If the audit finds the tenant has been misreporting or
violating general audit standards, the tenant pays for that audit, in
addition to compensating the owner for any rent shortfalls.
End of term: There are two separate issues here. First, does the tenant
have the option to purchase the hotel as the end of the lease term? This
is generally negotiable. It serves the tenant to have the right purchase
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the building, keep control of it, and then sell it to another owner. Owners
are understandably reluctant to provide advance purchase options, but
many of them will negotiate this point.
Second, what happens in the last, say two to three years of the lease,
especially in an environment where the tenant knows that the lease won't
be renewed? At that point, the tenant has a big incentive to under-invest
in sales and marketing, under-maintain the physical plant, or even shift
business to another hotel they operate in the market. It is vitally important
for the owner to engage the tenant in early conversation to prevent these
problems in the last years of the lease.
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Lease Structures and Provisions

Answer the following questions about lease structures and lease
provisions.
You may take this quiz as many times as needed to achieve 100%.
You must score 100% on this quiz to complete the course.
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Module Wrap-up: Control of Hospitality Assets

A critical decision facing hotel owners and hotel companies is who will
control the hotel on a day-to-day basis and whether to affiliate with a
brand. There are a variety of ways both owners and hotel companies can
approach this decision, and the right choice depends on their individual
objectives and interests.
In this module, you examined the different options around who controls
the operation of the hotel and examined the factors that influence this
critical decision. You connected the interests of owners with the available
branding and operating options. You defined the key attributes of
contemporary hotel leases and determined how leases are used in
different international settings.
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Module 2: Negotiating
Contemporary Hotel Franchise
Agreements
1. Module Introduction: Negotiating Contemporary Hotel Franchise
Agreements
2. Watch: Franchising Around the World
3. Read: Deciding on a Franchise Affiliation
4. Read: Analyzing the Business Mix
5. Tool: Process for Analyzing a Franchise Affiliation
6. Read: Assessing the Benefits and Costs of Affiliation
7. Ask the Expert: How Brands Can Add Value
8. Tool: Calculating Franchise Fees
9. Watch: Evaluating the Benefits and Costs of Affiliation
10. Watch: Completing the Franchise Affiliation Analysis
11. Evaluating Franchise Affiliation
12. Read: Addressing Qualitative Matters in Franchise Decisions
13. Watch: Why Be An Independent Hotel?
14. Read: Outlook for the Future
15. Module Wrap-up: Negotiating Contemporary Hotel Franchise
Agreements
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Module Introduction: Negotiating Contemporary

Hotel Franchise Agreements
Franchise agreements are often used by owner-operators
to benefit from the recognition, distribution, and reach of a
brand. Making a wise franchise affiliation decision
requires a thorough understanding of the costs and
benefits of affiliation.
In this module, using quantitative and qualitative

methods, you will evaluate the franchise affiliation decision, including the
financial costs and benefits of franchise affiliation for owners. There
are other non-quantitative factors associated with franchise affiliation,
and you will explore the implications of these potential issues. You will
explore the ways in which franchising is changing and what factors
may drive this change in the future. Finally, some owners prefer to
operate their hotels independently and you will examine in what
circumstances operating without a franchise affiliation makes sense.
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Watch: Franchising Around the World

Franchising occurs when a party (franchisee) signs an agreement with
a business (franchisor) to use their brand name and processes to
produce and market a good or service according to certain specifications.
In this case, a hotel owner or operator signs a franchise agreement with
a franchisor to operate a hotel under the franchisor's brand name.
Franchising offers opportunities and benefits to owners, and there are
certain factors to be aware of in terms of costs, efficiency, and control. In
this video, Professor deRoos explains the primary reasons for franchising
and describes trends in franchising around the world.
Video Transcript
Franchising offers opportunities and benefits to owners. And there are

certain factors to be aware of in terms of cost, efficiency, and control via
a range of franchise affiliation options. To understand franchising we
open by exploring the four fundamental explanations or stories for why
franchising exists. The first is moral hazard. Hotel companies have the
choice between operating hotels themselves or with working with
franchisees to operate them according to brand standards. If the hotel
company chooses to operate their own hotels, the moral hazard comes
from the fact that the hotel company's manager does not have a big
incentive or economic stake in the profitability of any given hotel.
At the extreme, problems include shirking by managers or excessive risk

taking by managers. Because the manager does not receive the profits
from the hotel they have little financial incentive to work hard. At the
same time, they don't bare the cost of their decisions so they may take
excessive risk. By franchising the brand the franchisor creates an
environment where there franchisee receives the residual benefits of the
operation. The franchisee won't take excessive risks and they work hard
because they get the benefits of their work. Franchising helps remove the
moral hazard.
The second is search costs. Franchisees can search for good

opportunities much more efficiently than hotel companies can. Consider
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the bustling market of Boise, Idaho. A franchisor based in Atlanta,

Georgia has very little incentive to incur the cost of sending their talent to
Boise to search for the best sites. On the other hand, a local hotelier who
lives in the Boise market knows where the area is growing and knows
where the best sites are likely to be located. Franchising leverages the
search efforts of franchisees who can search at much lower cost than the
franchisor or brand owner. Lower search costs remove barriers to growth
for the franchisor by creating opportunities for franchisees.
The third area is distribution. Does the hotel company distribute the
product themselves directly to consumers or do they distribute their
product through an intermediary? Franchising exists because people who
own the brands feel that they are financially better off distributing directly
to consumers via franchising versus distribution through intermediaries
such as tour operators or wholesalers, as is common in Europe. As the
industry matures, hotel companies will be increasingly directed to market
to consumers and use their own distribution systems with franchising
having a large role in the success.
The fourth argument for franchising is financing. And here the argument
is the hotel company can use the borrowing capacity and equity of their
franchisees to expand quickly, because the franchisor might be cash
constrained. There is not much empirical evidence to support this. And
when you consider companies such as Intercontinental, Marriott, or
Accor, you can see why. All of these are multi-billion dollar firms with the
cost of capital that must be significantly lower than the cost of capital for
their franchisees. While this argument may have had some truth in the
early stages of some firms, it is no longer a valid argument for
franchising.
Over the past two decades, two clear trends have emerged in
franchising. In most areas of the world, hotels have become increasingly
branded, while in North America the shares remain relatively constant.
North America is roughly two thirds, or 66%, branding, branded, currently
with this share remaining constant over the last decade. Europe and
South America are about 40% branded to this point, with huge variation
between countries. This is up from 25% a decade ago, however. But, the
huge variation is countries like France are about 60 to 70% branded,
whereas Switzerland and Italy have less than 20% branded hotels. The
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Asia Pacific region is about 50% branded, with the brands doubling their
share over the past decade. The conventional wisdom in the industry is
that Asia will look very much like North America over the long term.
The last markets I'd like to discuss are the Middle East and Africa. The
Middle East has experienced explosive growth in brands, with the
markets really adding a lot of rooms over the last two decades. Brands
are a large and increasing part of these markets. Africa remains the
world's smallest but fastest-growing continent for hotels. In the most
highly branded countries in Africa; there are the relatively mature markets
like Morocco or South Africa.
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Read: Deciding on a Franchise Affiliation
• There are five affiliation options
• Deciding on a franchise requires

thorough quantitative and
qualitative analysis
Once you have decided to pursue a franchise affiliation, what are your
options? And how might you systematically evaluate an affiliation
decision? Consider both questions and arrive at an evaluation agenda.
Options for Franchise Affiliation
To begin, we need to chart the playing field of affiliation options. There

are five affiliation options.
One way to operate a hotel is independent of a franchise license or

brand. In this case, the owner bears the responsibility for creating the
hotel’s image, distributing the hotel’s room inventory to the relevant
booking channels, establishing a website, and the myriad of other
services provided by the franchisor.
In the dominant form, an owner-operator enters into a standard franchise
agreement with a brand. The vast majority of affiliations happen this way.
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Another way to affiliate with a brand is to enter into a management

contract with a branded hotel company. A few of the branded hotel
companies will sign a “manchise,” a combination of a management
contract and a franchise agreement, with the intent that the management
agreement could be terminable before the end of the license term but the
franchise agreement would survive for the term, generally 20 years.
A fourth model is a “master franchise.” Hotel companies eager to grow

internationally may sign a master franchise agreement for an entire
country, giving a local firm the rights to franchise hotels on behalf of the
hotel company. This is a way for hotel companies to grow brands and
expand into a market very quickly. The master franchisee has the right to
operate hotels within the market and to sell franchises to others in the
market. The franchisor is prohibited from competing with the master
franchisee, so long as the master franchisee meets agreed growth and
quality goals over a time horizon.
A final model is a strategic marketing alliance in which the brand is lent to

a third party for use in other ancillary areas. Brands may license their
name for use in marketing various hotel-related goods such as beds or
lifestyle goods. This option is almost exclusively used in the five star
domain.
Analysis of Franchise Alternatives

Now we consider the steps to take in analyzing franchise affiliation
alternatives. How does an owner go about deciding on a brand
affiliation? The process can be summarized through a series of steps:
1. Analyze the business mix of the property, searching for a brand that
matches the owner's needs.
2. Assess the potential benefits of the affiliation.
3. Determine the costs of the affiliation.
4. Compare the costs to the benefits. This includes performing the
relevant net present value calculations or estimating the internal rate
of return and making a decision. Collectively, the first four steps allow
us to quantitatively evaluate whether a brand is a good affiliation.
5. Make a qualitative evaluation of the benefits and costs of affiliation. In
this step, you evaluate potential conflicts of interest and what is called
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the "softer" side of the business. These are very difficult to quantify in
dollars and cents, yet remain important considerations.
We will consider each of these steps in greater detail and you will be able
to download a summary of the steps later in the module.
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Read: Analyzing the Business Mix
• The first step is to understand

the target customers and why
they choose the hotel
• Next, you should understand the

key demand generators
• Finally, consider how rooms are

booked and whether a brand
could help with booking
The first step in evaluating a potential franchise affiliation is to analyze

the business mix of the relevant hotel property. Examine the relevant
considerations that help guide an evaluation of what franchise best
matches with the hotel’s customer base.
Each hotel has a different mix of attributes that make up the formula for
success. Understanding the business mix for a hotel helps determine the
answer to two key questions. First, is this hotel well suited for a brand, or
is it better off operating independently? Second, if it is suited for a brand,
which brands best match the needs of the hotel?
Determine Target Customers
Analyzing the business mix begins by understanding the target

customers for the hotel. Are they travelers making the journey along an
adjacent interstate highway? If yes, the brand can add a great deal of
value, especially a brand with good distribution along the relevant travel
corridors. Are they loyal business travelers looking for a "brand promise"
in many different cities? If yes, a brand can deliver on the promise,
especially a brand well known for maintaining consistent brand
standards. Are they pleasure travelers looking for a distinctive hotel
experience? If yes, a brand with the flexibility to adapt to a distinctive or
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unique physical space may be required, or it may be necessary to forgo

affiliation and operate the hotel independently.
Understand Why Guests Stay
A second, related factor has to do with why guests stay at the hotel.
There are many reasons to book a room in a hotel—its location, the
hotel's amenities, the hotel's service. The owner needs to determine the
mix of reasons in the prospective client base, and answer this question:
can a specific affiliation influence the customer's decision to stay in the
hotel?
Examine Demand Generators
Third, where is the hotel's business coming from? What are the specific
demand generators? If guests demand proximity to specific local demand
generators, affiliation may not be necessary or advantageous. On the
other hand, highway properties have a strong need for affiliation to
"capture" customers from the road via signage, billboards, and the
recognition a brand provides.
Process of Hotel Booking

The fourth factor concerns how the hotel rooms are booked. Does the
central reservation system (CRS) of the brand, including the website and
1-800 number, add important value? If the business can efficiently be
booked by the hotel’s staff, there may be little need for a brand. But
brands are able to manage customer flows from multiple sources and can
save a great deal of the time and effort that must be put into booking.
This is a simplified diagram from distribution expert Dr. William Carroll, of
Cornell's School of Hotel Administration, showing the myriad of channels
used by hotels to allow customers to book rooms. Even this simplified
version of the diagram is very complicated, but the point is that there is
no need for a hotel owner to work at this level of complexity if the brand
can handle distribution and booking for the owner.
Understand Seasonality of Business
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Finally, a less important consideration. Is the hotel's business seasonal?

If so, can affiliation boost occupancy during slow and shoulder seasons?
If so, the affiliation may add important value. Once hotel owners have
considered each of these factors, they are in a much stronger position to
pursue a beneficial affiliation.
You can download a summary of this information on the next page.
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Tool: Process for Analyzing a Franchise Affiliation
• Use this summary of the process

for analyzing franchise
affiliation when you are
considering a franchise affiliation.
On the previous two pages, you read about the options for franchise
affiliation and reviewed the process for analyzing a potential franchise
affiliation. There are many quantitative and qualitative factors that must
be considered to make a sound decision about franchise affiliation. Use
this summary of the steps for analyzing a franchise affiliation to guide
your own analysis of a potential franchise opportunity.
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Read: Assessing the Benefits and Costs of

Affiliation
• Assess all the potential benefits

and costs over time
Once you’ve analyzed the business mix, and determined that a franchise
affiliation is worth pursuing, you need to make a careful assessment of
the benefits and the costs of the franchise affiliation. The goal is to
estimate the expected benefits and costs over a series of years. Let’s
begin with the benefits.
Benefits of Affiliation
Increase in occupancy. The franchisors’ basic story is that they “put

heads in beds.” This comes from a recognized brand that is coupled to a
well-developed reservation and distribution system.
Increase in the average daily rate. There is a great deal of evidence

that shows that the average rates that are booked via the franchisor’s
central reservation system (CRS) are higher than the average rates the
hotel is able to achieve through its own selling efforts. It is clear that the
hotel companies have the ability to sell hotel rooms at very attractive
rates.
The reduction of on-site marketing expenses and quality of

franchisor efforts. With the franchisor’s reservation system and group
selling efforts, you don't need as large a marketing staff to run your hotel.
You also don't need investments in Web technology, which comes from
the franchisor. It is difficult to model these savings, but it is clear that
costs are lower and the quality of materials produced by the franchisor
are helped by the higher level of expertise found in most franchisor’s
central offices.
The brand's preferred purchasing system. Purchasing goods and
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supplies for the hotel at very attractive rates provides a significant benefit.
The supply chain management technology of the franchisors is well
developed both for operating supplies and for goods needed in
renovations.
Costs of Affiliation
What about estimating the costs of affiliation? Let’s look at the specific
costs involved. The first two are upfront costs:
The initial fee. This is either a lump sum or a cost per room fee. If you
are a very good franchisee with a long and successful relationship with
the franchisor, the initial fee may be negotiable (it is one of the few fees
that is negotiable).
Product Improvement Plan (PIP). The Product Improvement Plan (PIP)

is the cost of the initial conversion to the franchisor’s current brand
standards. The cost of conversion ranges from a minimum $2,500 to
$20,000 per key and in some cases can exceed $20,000 per key for
hotels in significant need of renovation.
The remaining fees are ongoing.
Royalty fees. This is the fee for the use of the franchisor’s brand name.
There are no additional services that flow from this fee. The royalty fee in
general is anywhere from 1% to 7% of room revenues. For most of the
very high-quality brands, the range is 5% to 7% of revenue. Some
franchisors are willing to negotiate a reduced royalty during the initial
years of a property, generally for the first two or three years.
Marketing fees. Including internet, print, and other media, these fees
cover the actual cost of creating brand identity. The franchisor can
leverage franchisee contributions to establish and maintain a national
and global identity. Marketing fees are about 2% of room revenues.
Reservation fees. These include the cost of purchasing the reservation

system, training staff to use the system, and the costs of operating the
system. Reservation fees are also typically about 2% of room revenues.
Frequent-traveler fees. The franchisor receives a fee for every guest

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that checks in using the franchisor’s loyalty program. Generally, the

charge for running the frequent traveler royalty program is about 3% to
5% of the room revenues generated by guests using the loyalty program.
Other fees. These may include sales representation fees, technology

fees, and fees for changing brand standards (for instance, a change in
bedding, or internet access).
These are the costs of operating the franchise over a number of years. If
the agreement is terminated before the end of term, the franchisee may
have to a pay termination fee or a liquidated damages fee. In general,
these fees are quite large. It is usually the cash value of all the fees that
the franchisor expected over the remaining term of the agreement.
Later in this module, you will download and use an Excel spreadsheet
that will help you analyze the costs and benefits of franchise affiliation.
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Ask the Expert: How Brands Can Add Value
As you have seen, affiliating with a brand has many benefits and costs. In
this video, hotel developer Mark Wolman talks about the evolution in the
use of brands and the benefits that they have provided to his
organization.
Mark Wolman is a Principal and Director of Waterford Group, a leading

hospitality company specializing in the development, ownership and
management of hotel, gaming and venue projects. He has more than 30
years of experience in land development, residential and commercial
construction, hospitality development and operations, as well as asset
management. In his role with Waterford, Wolman has been integrally
involved in the development and supervision of projects totaling more
than $3 billion. Waterford has successfully owned and/or operated more
than 80 hotels and convention centers, from small to large, as well as
independent to virtually all major national brands. Notable projects
include the world-renowned Mohegan Sun; the Front Street District, a
$775 million mixed-use development in Hartford, CT; as well as,
numerous Marriott, Hilton, and Starwood branded hotels throughout the
United States..
Question
How do brands add value to your hotel investments?
Video Transcript
So it's interesting, a few years back, brands were ultimately everything to

the hotel business, in our view. And brands really create huge support,
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whether it be, it's first the identity, the loyalty programs, the marketing,
the training and the just general recognition, they're a true partner in the
process. And the flip side is the internet's growth and impact has created
a challenge for the brands. And one creates your independent brands
today. So, without paying all the huge funds out to a large corporation,
people have created their smaller, more independent brands. And that's
the interesting evolution in the business. But branding and being part of a
bigger group, it clearly helps and supports one when you have so much
competition out in the market.
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Tool: Calculating Franchise Fees
• U.S. Hotel Franchise Fee Guide
The ability to accurately calculate the costs of hotel franchise fees is

crucial in making informed franchise affiliation decisions. HVS, a global
consulting and services organization focused on the hospitality industry,
publishes a guide that provides a comparative review of the franchise
fees associated with various hotel brands. The U.S. Hotel Franchise Fee
Guide will help you to:
Benchmark the fees charged by different hotel companies offering

franchises, broken down into economy, mid-rate, and first-class
categories
Analyze how the different fees (including royalty, reservation,
marketing, frequent traveler, and miscellaneous) influence the overall
fee structure
You can see all HVS publications, including this one, by clicking here.
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Watch: Evaluating the Benefits and Costs of

Affiliation
Now that we’ve considered the different costs and benefits of affiliation,
we need to put the numbers to work in an analysis tool and perform an
analysis. In these videos, Professor deRoos demonstrates an Excel-
based decision support tool that looks at whether or not it makes sense
to convert an independent property to one that is affiliated with a
franchise. You will download and use this tool later in the module.
Benefits
First, Professor deRoos reviews the assumptions for the hotel's operation
with and without affiliation. Based on these assumptions, we can analyze
the benefits of affiliation. In this analysis, the average daily rate goes up
when affiliated with a brand, while the occupancy rate stays the same.
Video Transcript
We know we need to quantitatively assess the benefits and costs of a

potential franchise affiliation. Here we look at how to put this together. We
will use an Excel-based decision support tool that focuses on converting
an independent hotel to a franchise hotel. We have a franchise in mind,
so how do we decide if the conversion to the franchise makes financial
sense? Keep in mind as we go through this that this is a made up
example to illustrate the use of the decision tool, not an example that
should be used in practice. All assumptions should be calibrated to a
specific case.
We begin with a number of assumptions for analysis. In this right hand
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set of assumptions, we have what would happen if we made no change

to the property. We have the year of the analysis, the room count, the
occupancy with no change, and the anticipated average daily rate with no
change. Additionally, we have some assumptions about the property
itself, such as the percentage of revenues that come from food and
beverage and other revenues such as gift shops, room rentals, business
center, etc. We have an inflation assumption and then finally we have a
desired rate of return, should the owner make this change.
In this case, the owner is looking for a 14% return on investment. On the
right hand side, we have a set of assumptions that what would be the
hotel's operating characteristics if we franchised. We start with our
occupancy. If we affiliate, what will our occupancy be? What will our
average rate be? Next, there's a calculated cell which shows the change
in RevPAR or revenue per available room, which comes from the
changes in occupancy and or rate. In this case, we are looking that all of
the change in RevPAR comes from the average daily rate. Note that the
occupancy stays fixed at 63%, 63% this year, 63% last year. All of the
change comes from the change in average daily rate. From $131 last
year to $153 this year. The average daily rate increases by 16.79%. The
flow through on this increase in revenues is 90%. What that means is that
90% of the marginal change in revenues flows through to the bottom line.
Because all of our increase in revenues is coming from average daily rate
not occupancy, we expect the majority of revenues increases to flow
through.
On the other hand, if the increase came from occupancy, it would be

added marginal revenues plus the cost for room cleaning, laundry, and a
much smaller percentage would flow through in the range of 50% to 70%
of the increased revenues. Next, we assume operating cost reductions of
2%. This comes from the reduction in marketing expenses and through
purchasing benefits. We assume a 1% increase in cost due, in this case,
to the franchise we have in mind has a costlier free breakfast
requirement. And then lastly, there's a capitalization rate assumption. In
this case, it is 8%. We assume the hotel will increase in value, due to the
affiliation, and we use an 8% capitalization rate to calibrate that increase
in value.
Now, we consider all of the assumptions about the costs of the franchise
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on the very right hand set of cells. The first is the PIP, or product
improvement plan. In this case, we think that our product improvement
plan will be $5,000 per room for our 200-room hotel, means we will spend
a total of $1 million converting the hotel to new brand standards,
including room upgrades, logo goods and a general refresh of the lobby
and exterior landscaping. In addition, there's an additional fee, or initial
fee for affiliation of $500 per room, royalties for this franchisor, 5% room
revenues. There's an advertising marketing fee of 2%. Reservation fee of
1.75%. All of these are calibrated to room revenues. Next, we have a
loyalty program cost, which is 4.75% of the revenue coming from guests
using the loyalty card. We have an additional assumption that says 40%
of all guests will use their loyalty cards when they stay at the hotel.
Lastly, we have a catchall cell, or category, for all other fees that are not
estimated above. All of these costs are easy to obtain from the
franchisor's franchise disclosure document or FDD, or from tabulated
industry data.
Costs
Next, Professor deRoos considers the costs of affiliation, which

include royalty fees, advertising and marketing fees, reservation fees, and
frequent traveler costs.
Video Transcript
Now we are ready to take a look at the annual benefits. For each year
over a 10-year period we model both the pre-franchise and post-franchise
revenues. In this case, let's take a look at year 1. Pre-franchise revenues
total $9,037,035. Post-franchise revenues total $10,048,815. The
difference in revenues is $1,011,780, with a 2% reduction in cost equaling
$200,976 we have a total affiliation benefit in the first year of
$1,212,756. This needs to be adjusted for flow through, however. We are
modeling in this case a 90% flow through, which means a 10% reduction
in the revenue differences made, resulting in a total adjusted benefit for
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the first year of $1,111,578, in the first year.
Now let's take a look at the costs. In the first year, there are the royalty,
advertising and marketing fees, reservation fees, frequent traveler costs,
and other fees. The total cost in the first year, total $897,872. Thus, the
total net change in annual cash flow for the first year, is $213,706. Similar
calculations are done each year over the entire 10-year analysis period.
Note that there are no lines in this out-year cost to meet franchise
standards line. This line allows for budgeting any anticipated additional
compliance costs, including new brand standards, for example, a new
bed standard, new reservation system, new guest amenities. These can
be explicitly added to the analysis in this row. We have now looked at the
annual benefits and the annual costs. To complete our analysis, we have
to add those costs that occur only at the beginning of affiliation and the
increase in the hotel's value at the end of the 10th year.
Let's look at year 0. So for the first year, we have to pay an initial fee,
$500 per room, times our 200 rooms, or $100,000. Enter our initial
product improvement plan, $1 million. At the end of the analysis period, in
this case year 10, we have the increase in the property's value. Note that
the total benefit, or net benefit, in the 10th year is $293,467. If we apply
our 8% capitalization rate to this, the hotel with a franchise is worth
$3,668,339 more than if we didn't make the change. We now have all the
information we need to perform an analysis and determine if the
franchise affiliation is financially supported.
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Watch: Completing the Franchise Affiliation Analysis

Now that we've analyzed the benefits and the costs of franchise
affiliation, Professor deRoos finishes the analysis by calculating the net
present value (NPV) and the internal rate of return (IRR) of the benefits
versus the costs of affiliation with a franchise. He also presents another
scenario in which all of the benefit of the franchise comes from increases
in the occupancy, not the average daily rate. You will be able to
download and use this tool on the next page.
Video Transcript
We start by noting that we have just completed our annual estimates of
benefits and cost, and the change in hotel value associated with
affiliation. We are now ready to perform an analysis. To make a decision
we need to estimate the net present value, or NPV, and the internal rate
of return, or IRR. If the NPV is zero or greater, the franchise decision is
supported. If the IRR is greater than or equal to the hurdle rate, the
franchise decision is supported. The hurdle rate is a desired rate of
return, 14% in this case.
Let's return to our tool, convert independent property to franchise

affiliated property. Recall that we have a set of assumptions about this
property. We have estimated the expected annual benefits and costs of
the affiliation. We simply sum up these benefits and costs. Now each
year, from the spreadsheet, we include the initial one-time cost and the
increase in value at the end of our holding period, as well. Once we have
entered all this data, Excel calculates the net present value and the
internal rate of return. In this case, our net present value is exactly
$166,301, internal rate of return is exactly 17.5%. The punchline? Based
on our assumptions, the decision to convert to franchise is positive.
In the real world, the assumptions should always be based on a market

study justifying the change in operating metrics from a 63% occupancy
and $131 ADR to the new figures of 63% occupancy, and $153 ADR, a
16.79% increase. If the market study does not support these figures, the
analysis is flawed. Now let's take a look at a scenario in which all of the
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benefit from the franchise comes from increases in occupancy, not the
average daily rate. We have created a scenario that produces roughly the
same NPV and IRR as the base ADR-increase-only case. In this
scenario, we keep the average daily rate fixed at $131, and increase the
occupancy from 63% to 74.6%, an 18.41% increase in RevPAR. Note
that with the increase in occupancy comes an increase in food and
beverage and other revenues due to the fact that more guests are
staying at the property.
In this case, the flow through drops to 55%. It's not 90% as before. The
increase in occupancy comes with several marginal revenues and costs,
additional food and beverage revenues, cleaning and re-supplying the
rooms, laundry, and the cost of food and beverage services. In general,
these marginal costs are about 25% for room revenues, 85% for food and
beverage revenues, and 50% for other revenues. We have assumed a
55% flow through here, meaning overall costs are 45% of revenues. We
assume that everything else remains the same and we run the numbers.
Here are the NPV is exactly $170,428 and the IRR is exactly 17.6%,
similar to our base case. Here, however, because the flow through went
from 90% to 55%, the RevPAR needs to increase by 18.4% versus the
16.8% in the base case.
Again, the right answer to occupancy and ADR assumptions should

come from a thorough market analysis. In the real world, a franchise
affiliation would produce some combination of rate and occupancy
increase. A proper market study would determine the appropriate
combination of rate and occupancy that might be achievable in this
market. Once the market study is complete, we can perform the analysis
of the benefits and cost. What we have done here is to characterize that
decision and have given the decision maker a practical tool to help
facilitate that decision.
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Evaluating Franchise Affiliation

Download the two versions of the franchise evaluation spreadsheet to
complete this assessment.
Version A
Version B
Begin by opening Version A.
An independent hotel plans to convert to a franchise affiliation. You are to

solve for certain changes that make the NPV equal to zero. In these
questions, assume that all of the franchise costs and the assumptions in
cells D6-D13, cells I12-I14, and cells M6-M13 are known with certainty;
the questions are over the changes in revenues and the flow through that
will support the decision to become franchise affiliated. Note that the
initial conditions of the sheet assume no changes to the occupancy or
rate; note also that the initial NPV has a large negative value.
Keep this spreadsheet tool for future use when you have to evaluate a
franchise affiliation decision.
You must achieve a score of 100% on this quiz to complete the

course. You may take it as many times as needed to achieve that
score.
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Read: Addressing Qualitative Matters in Franchise

Decisions
• Consider areas of potential friction between franchisor and

franchisee
• Negotiation may be necessary
We have considered the quantitative analysis of franchise affiliation. But

it is also necessary to consider the qualitative aspects of the franchise
decision. The relationship between the franchisor and the franchisee
contains many areas of negotiation and possible contention. Let’s
consider some of the major issues. We begin with topics where both the
franchisee and the franchisor have concerns.
Area of Protection
Consider a franchised Holiday Inn in a given location. Another franchisee

is proposing a new Holiday Inn in the same market, maybe five miles
away. The hotel company would like to approve the new property, but
the existing owner is very worried about the impact of this new hotel on
their existing property. Both the franchisee and the franchisor see this as
a hot button issue. First, a bit of vocabulary; franchisees are worried
about impact and ask for territorial protection; if the franchisor agrees,
this is written into the franchise agreement as an area of protection.
Why do franchisees view impact as an important issue? The original
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franchisee objects, claiming the new Holiday Inn will have a negative
impact on the property. First, the new Holiday Inn will reduce occupancy,
reduce profits, reduce returns, and reduce the value of the original
property. Second, the impact is cumulative. Each new competitor in the
market hurts the original hotel unless hotel demand grows at a faster rate
than hotel supply. Third, the threat of impact impairs the relationship
between the franchisor and franchisee. The mere fact that the franchisor
allows new hotels to be built in an area, that the franchisor will not give
territorial protection (or gives limited territorial protection), can damage
the relationship between the two.
Why do franchisors view impact as an important issue? Well,

fundamentally the value of the hotel company is a function of franchise
fees. More franchises, equals more units, equals better distribution,
equals more effective marketing, equals more fee income. Franchisors
often claim that franchisees have an ulterior motive for claiming impact
and may use it to limit legitimate competition. If demand in the market is
growing by, say, 4% or 5% a year and new hotels are needed in this
market, then why should the franchisor be limited by an area of
protection?
Additionally, the franchisor knows that if their brand does not meet
growing demand, another brand will. If a new Holiday Inn is not built,
someone will likely build a Hilton Garden Inn, or a Marriott Courtyard. If
new hotels are going to come into the market, the franchisor can
demonstrate some advantages to the franchisee that the new hotel be
the same brand. For example, another Holiday Inn offers co-marketing
advantages and cross-selling opportunities.
Termination
When a franchise is terminated, the amount of liquidated damages can
be contentious. The franchise agreement is written so that the franchisor
is owed the cash value of all expected future flows over the term of the
license. If the franchise has, say, over 10 years remaining, this can be a
very large sum. In the case of an underperforming brand or a brand that
has allowed significant new competition, the franchisee may legitimately
believe they are being penalized for keeping the agreement. Hence,
there can be negotiations around performance termination, especially in
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a situation where a number of new, same-brand, competing hotels have

been brought into the market. Although each additional hotel may have
had little impact, the cumulative effect can be significant.
Additional means of termination are "bilateral reaffirmation" provisions

that provide both sides with a window to continue or discontinue the
affiliation. These provide one means by which potential conflicts can be
managed, giving the franchisee the ability to exit under certain
circumstances at specific points during the franchise term.
Data
A smaller issue, but one that is increasingly contentious, is the question

of data ownership and data mining. Does the franchisor have the right to
sell customer data? Does the franchisee have the right to sell customer
data? Can the franchisor sell large account data to a competitor? Can
the franchisor provide a list of all the guests in one market to a hotel in
another market, especially if the franchisee is in a resort market? What
are the franchisee's rights over their property’s data in the event of a
merger when former competitors are now part of the “brand family”? All
of the items cited above are known examples from contemporary
practice. Contemporary agreements generally specify that the franchisor
owns the data, but the franchisee has the right to use the data for guests
at his property.
Having considered areas of concern to both parties to a franchise

agreement – the franchisor and the franchisee – we can now consider
issues that are particular to each side. We begin by looking at two
matters that concern franchisees.
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Programs
The franchisor offers a number of programs that must be paid for by the
franchisee. These include required programs, such as marketing and
loyalty programs, and optional programs such as "participating hotel"
programs. In some cases, franchisees see these programs as benefiting
the franchisor or certain franchisees more than others. Franchisees have
two specific issues. First, there is no incentive for the franchisor to make
the program cost-effective if the costs are borne by the franchisees. As a
result, the franchisees are increasingly asking for the ability to opt out of
these programs. Second, the franchisees want some input into the
design of programs that have a real impact on the franchisees' bottom
lines. They do not want programs that boost revenues, but do little to
boost cash flows.
A brief look at specific programs illustrates these concerns. Consider

marketing programs. Franchisees want to have input via the franchisee
committee on the direction and content of national, regional, and local
marketing programs. For the loyalty programs, on the other hand, the
concern is different. Everybody knows these programs work. The
questions here are the cost versus the benefits of the program and the
manner in which it is implemented, especially franchisee control over the
number of rooms that need to be allocated to the program on any given
night.
Brand standards and capital investment
Franchisees agree the franchisor has the right to change the brand
standards from time to time. The issue of contention centers on these
questions: How much can the standards change? How often can they
change? Who benefits from the changes? How quickly must existing
franchisees implement any required changes? And a related question:
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Are the changing standards being implemented uniformly? This last

concern can generate considerable debate and rancor at annual
franchisee meetings. Consider a brand that has 1,000 hotels, 200 of
them owned by the company. If the company-owned hotels are seen to
be dragging their feet on implementing new brand standards while the
company is pressuring the franchisees to meet the standards, this is
cause for significant concern. Franchisees frequently bristle at perceived
double standards. Franchisees look for clear and flexible guidelines. Is
the new standard optional? Can implementation be spread out over a
couple of years to stay in line with the franchisees' capital budgeting
process?
Now let’s look at an issue of franchisor concern.
Free riders on the brand

Franchisors today are much less tolerant of franchisees who don't meet
brand standards, who fail inspections, or who underperform. Franchisors
have a set of tactics that they use to prevent "free riding" on the brand.
First, franchisors are offering shorter license terms. One large company
has reduced 20-year licenses to 10-year terms renewable at the option of
the franchisor and subject to a product improvement plan, or PIP. If the
franchisee runs a good hotel, meets the brand standards, and is a good
team player, the renewal is a formality. But if the franchisee is
problematic, the shorter term provides an easy exit. At renewal,
franchisors often conduct a strict property inspection and ask the
franchisee to institute a substantial PIP to meet current brand standards
or new market needs.
Potential parties to franchise agreements need to be aware of each of the

areas of potential concern before they enter into an agreement.
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Watch: Why Be An Independent Hotel?

While engaging with a franchise is appropriate in many situations, there
are times when it might not be the best choice. In this video, Professor
deRoos provides four different examples that exemplify the reasons for a
hotel to remain independent and not affiliate with a brand. For example,
there are situations when a brand will not contribute any additional value
to the hotel's marketing or distribution systems.
Video Transcript
There are many reasons to remain an independent hotel. Let's illustrate

by taking four scenarios. I'm going to be playing Let's Make a Deal and
we'll look behind door number one, two, three, and four. Behind door
number one, we have a suburban hotel. So, the suburban hotel is selling
out four days a week, every Monday through Thursday, due to its
proximity to local office parks and regional highways. We know that we'll
be slow on the weekends. In this case, the brand affiliation is limited to
increasing revenues via increased occupancy, only on the three-day
weekend and, perhaps, a higher rate during the sellout days. If we know
we're going to be full four days a week, why affiliate? Why share
revenues with a third party if it is difficult for that third party to contribute
to the value of the property?
Similarly, say you own a hotel that derives the majority of its occupancy
from a local cluster of businesses on their rates that are negotiated
annually. The hotel could be located adjacent to a large manufacturing
facility, a regional medical center, a large office complex, or a major
university. The hotel guests that come through your hotel largely come
from your location relative to the businesses or destinations. Your job as
a hotel owner and operator is to have a great relationship with the
demand generators. They will fill your hotel. Here there may be no
reason to be affiliated with a brand if the brand is constrained from
adding value. In this case, franchisors have limits on their ability to
increase rates, and to drive occupancy. So as long as the hotel owner
can create and nurture long-term or local relationships, this loyalty and
set of positive relationships is a substitute for the brand.
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Now let's take a look behind door number two, where we have a hotel
that sells itself at a discount, to the branded hotels in the market. The
strategy for the hotel is to take the 7% to 10% in franchise fees that will
be paid to the brand, and give this as a discount to its customers instead.
The customers receive lower rates and in return become loyal customers.
The real world is filled with examples of this method. A firm called Joie
De Vivre hotels centered in San Francisco, California runs a collection of
distinctive independent hotels and markets them at very reasonable
prices.
Now door number three. Another reason to remain independent is if you

have other means of distribution other than the brand. Instead of relying
on the hotel company's distribution system, you embrace tour operators
or wholesalers or the internet as your distribution mechanism.
Traditionally, other distribution channels were limited. Hoteliers would sell
their inventory to tour operators and wholesalers, who in turn would sell it
to their customers. This is a very European model. The more recent
model is to embrace the internet as a way to reach customers directly
and easily.
Finally, we have door number four. A great reason to remain independent

is to attract customers who want a different experience. Independent
hotels often sell themselves as different, and attract clients who come
because the hotels are different. This model works very well for one-of-a-
kind hotels that attract a very exclusive clientele, such as Noble Hotels or
the Independent Collection, hotel companies that specialize in boutique
hotels worldwide. In summary, there are situations in which brand
affiliation is the right decision, and other situations, in which brand
affiliation is not necessary, or cannot provide the distinct virtues that
independence provides.
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Read: Outlook for the Future
• Franchisors are looking for new

ways to support franchisees
• Franchisees are looking for more

programs, better metrics, and
more flexibility
Let's take a look into the future of franchising and see how franchise
agreements are likely to change in order to better serve both franchisors
and franchisees.
Fee Structures
New fee structures are likely to spread through the industry, especially
more pay-for-performance clauses. What might this look like? The
franchisee will pay a small royalty on all guestroom revenues.
Franchisees will have the option to opt in or out of specific programs that
have the potential to deliver additional heads in beds; these programs will
have financial incentives for the franchisor to perform. Instead of being
forced to take all franchise programs, franchisees will choose from a
menu of services offered by the franchisor.
Another change that is finding some interest in the industry: we may see
higher royalties for short-term agreements, and lower royalties on longer-
term agreements that allow the franchisor to terminate early.
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Flexible Agreements
We are likely to see more flexibility in agreements, especially with respect

to conflicts of interest in shorter terms. A notable example is the area of
protection. The franchisors have begun compensating their franchisees
for impact. The franchisors won't stop building competing hotels, but they
will compensate the existing franchisees in the market for the financial
impact of new competitors from the same brand.
Standardizing Performance
Hotel companies and owners are starting to standardize around the way
they measure brand performance. An important performance metric is
known as the Central Reservation System (CRS) contribution. This is the
percentage of all guests who made a reservation using the hotel
company’s central reservation system from computer, mobile and the 1-
800 reservation systems. How is this measured? One is able to compare
the CRS contribution across brands and the difference in RevPAR
generated by the CRS vs. individual hotels. The best brands obtain a
CRS contribution of over 50% and it is widely established that the CRS
gets higher average daily rates than the local selling efforts.
What franchisees want to know is how their franchise benchmarks with

other franchisees of the brand and how it compares across brands.
Franchisees want data on booking pace, numbers of rooms sold to
different market segments, and average daily rate by market segment.
Online Choices
The hotel companies have been out in front in embracing the expanding
role of the internet, with offerings such as ease of booking via mobile
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platforms, best-price guarantees, and discounts for loyalty members. As

franchisees become increasingly Internet savvy, the brands need to
continue to answer the following question from their franchisees: Why do
I need the affiliation when I can market my rooms myself? The brands
have been answering this question by creating sophisticated revenue
management engines and by training their franchisees to use their
systems. These systems require massive investments, which cannot be
matched by individual franchisees.
New Programs
New program offerings are a way for the brand to bring more value to the
table. Some possible examples:
Yield management: The franchisor can help the franchisee sell their hotel
more efficiently.
Operational support via the franchisor's face-to-face and online training
materials: The franchisor can help the franchisee operate more efficiently
once revenues flow in.
Better training programs: The hotel companies have academies that
provide excellent training, and online training holds great promise for
lowering their training costs and increasing their efficiency of operation.
Prototypes
Prototypes are designed to expand new product offerings. In an effort to
enhance service and lower operating costs, the brands are in the
business of developing well-targeted, efficient prototype hotels.
Interestingly, some of the innovations in prototype and product have
come out of the franchisee community. Rather than punish departures
from brand standards, franchisors are more willing to see if these
departures might sensibly be folded into developing brand standards.
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Module Wrap-up: Negotiating Contemporary Hotel

Franchise Agreements
There are a variety of reasons why hotel owners may want to affiliate with
a hotel brand, but there are also issues around costs and control that
should be considered. Owners need to consider both the quantitative and
qualitative aspects of the franchising decision using the appropriate tools.
In this module, you used quantitative and qualitative methods to evaluate

the franchise affiliation decision. You analyzed the financial costs and
benefits of franchise affiliation for owners using a decision support tool.
You examined other potential issues with franchise affiliation. You
explored the ways in which franchising is changing and what factors
may drive this change in the future.
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Module 3: Negotiating
Contemporary Management
Agreements
1. Module Introduction: Negotiating Contemporary Management
Agreements
2. Watch: The Continuum of Power
3. Watch: The Preliminary Negotiating Objectives
4. Tool: Owner and Hotel Company Negotiating Objectives
5. Read: Bargaining Strength
6. Watch: Negotiating the Letter of Intent
7. Read: Negotiating Key Provisions: Contribution, Term, and Fees
8. Read: Negotiating the Final Provisions
9. Tool: Key Provisions of the Letter of Intent
10. Watch: Strategy in Negotiating the HMA
11. Analyzing a Letter of Intent
12. Changing the Letter of Intent Provisions
13. Crafting an Advantageous Agreement
14. Tool: Control of Hotel Real Estate Action Plan
15. Module Wrap-up: Negotiating Contemporary Management
Agreements
16. Read: Thank You and Farewell
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Module Introduction: Negotiating Contemporary

Management Agreements
When owners hire a hotel company, they commonly sign
a hotel management agreement, or HMA. These
agreements are the product of negotiations that
determine the control over the property, the relationship
between the owner and the manager, and the rights and
responsibilities of each party. The agreements also act as
risk-shifting devices. Negotiating an adequate
management agreement is critical to the success of both the owner and
the manager.
In this module, you will examine contemporary management

agreements from the perspective of owners and hotel companies.
Exploring the balance of power between owners and managers, you will
determine how this balance influences the management
agreement negotiations, including the key aspects of control that each
party wants to include in the management agreement. You will
identify the key provisions of management agreements, and determine
how owners and managers negotiate letters of intent that protect their
interests.
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Watch: The Continuum of Power

The hotel management agreement (HMA) results from a series
of negotiations between a hotel owner and hotel company. In this video,
Professor deRoos explains how the relative power of the hotel company
and the owner play an important role in shaping the negotiations and the
terms of the agreement. Using an example, Professor deRoos shows
what happens when one party has a much stronger bargaining position
than the other party.
Video Transcript
A signed hotel management agreement is the end result of a process of
negotiation between a hotel owner and the hotel company as manager.
In the negotiations, each party is seeking an agreement that helps them
achieve their own goals. A completed hotel management agreement
requires both a measure of negotiating skill, but it is also the result of the
relative bargaining strength of each party. The relative power of each
party, owner, hotel company, plays a crucial role in determining the
overall shape of the agreement. Hotel companies and hotel owners come
to new projects with very different expectations. Understanding the
relative power of each party is the first important step in managing
contract negotiations. Power lies on a continuum with one pole defined
by the hotel company having power, and the other defined by the owner
having most of the power.
Imagine two scenarios with the same very desirable hotel on Central
Park South in New York City. First, consider hotel company that owns a
property thinking about selling the property subject to a management
agreement. Who has power in this case? Well, obviously it's the hotel
company. Given the likely, desirability of owning a hotel in one of the best
locations in New York, potential interests from hotel owners would be
strong. The hotel company would offer the property for sale, contingent
on a management agreement. You don't get to own the asset unless you
consent to the management agreement terms. In this case, the hotel
company drives the negotiation by incorporating management agreement
terms the hotel would be subject to into the sale of the property.
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Now consider the same site, same hotel but now owned by a life
insurance company whose vision is to redevelop this hotel into one of
New York's premiere hotel properties. They are seeking a global hotel
company to manage the property under a specific brand and they will
offer a long-term agreement. Who has power in this case? Well,
obviously, now it's the owner. The owner has the 100% to die for site in
New York. The owner is looking to sign a hotel company to a long-term
agreement. In this case, the owner is confident that there will be many
hotel companies bidding for this agreement and the owner would be able
to drive the terms of the agreement.
These are the poles, obviously most situations are much less clear cut.
However the power levers are generally clear to the two parties to the
agreement. Where each party lies on the continuum plays an important
role in the negotiation of key management agreement terms. Irrespective
of their relative power, the hotel company and the owner each enter the
agreement negotiations with certain objectives and certain preconceived
notions about the relationship between the owner, the hotel company and
the hotel company's on-site manager. Let's take a look at each in turn.
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Watch: The Preliminary Negotiating Objectives

The hotel owner and the hotel company each come to the negotiation of
a hotel management agreement (HMA) with some basic objectives
around items such as control, risk, and fees. In this video, Professor
deRoos describes the preliminary objectives of owners and hotel
companies during negotiations. When you better understand the position
of the other party, you are better positioned to craft an agreement that
meets your needs, as well as the needs of the other party.
Video Transcript
Here we introduce the preliminary negotiating objectives. The hotel
company and owner begin negotiations seeking the following traditional
objectives. I've organized these in parallel to illustrate the tensions
between the parties. First, the owner wants the sole and exclusive right to
manage the hotel without undue ownership interference. In the
agreement, this is known as a non-disturbance clause. What the owner
wants is some operational influence and control over the asset, generally
through aggressive asset management. Next, the manager wants the
owner to assume all, if not most of the financial risk. What the owner
wants is some financial risk to be borne by the hotel company, generally
through the agreement's incentive management fee structure.
Next, the manager wants to be indemnified except for gross negligence,

fraud or willful misconduct. What the owner wants in return is clear
monitoring and evaluation mechanisms, including the right to meet
regularly with the hotel company personnel to review performance. Next,
the manager wants the right to manage the property consistent with the
approved annual budget. What the owner wants in return is a hotel
company to demonstrate appropriate and reasonable flexibility when
times are tough, especially as it relates to brand standards. The owner
knows that this flexibility does not extend to the fee. Good owners make
sure the managers' fees get paid. The next term the manager wants is
the right to be properly funded for the approved capital expenditure
budget and for any annual budgeted operating shortfalls. What the owner
wants in return, the right to approve the annual operating budget and the
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right to approve the long-term capital expenditure budget.
The next item, the manager wants the right to operate the property
according to brand standards. What the owner wants in return is the right
to asset manage the property and to set strategic direction independent
of those brand standards. The next item, the manager wants the right to
earn a fair management fee. What the owner wants in return is the hotel
company to put the hotel owner's interest ahead of the hotel company's
interest when it comes to the operation of the hotel. And lastly in parallel,
what the manager wants is the owner's embrace of a working relationship
with a hotel company's corporate office. What the owner wants in return
is the right to have input to system-wide initiatives, and to understand the
cost associated with system reimbursable charges.
Additionally, the manager wants two things that are traditional negotiation
objectives. The right to make all personnel decisions at the property,
subject to owner input to the general manager, and the right to very
consistent strategic direction from the owner. On the owner side, the
owner wants two additional things. The right to inspect the financial
records of the hotel at any time and the willing participation of the hotel
company in the creation of the hotel owner's annual audited financial
statements. And secondly, the owner feels that they have the right to all
cash in excess of working capital requirements.
So now let's explore the relationships. The hotel company wants most of
the exchange of information to go from the owner to the corporate or
regional office, who in turn communicates with the on-site general
manager. Hotel companies seek to minimize the hotel owner's
involvement directly in the property. The owner sees a far more robust
relationship with the hotel's on-site general manager than the hotel
company's corporate office. Especially as it relates to the owner's right to
actively asset manage the hotel. The exact nature of the relationship
between the owner, the hotel company, and the on-site manager lies
somewhere between these two polar positions. The specific relation in
any given agreement is the result of the negotiation between the owner
and the hotel company.
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Tool: Owner and Hotel Company Negotiating

Objectives
• Use the negotiating objectives to

better understand each party's
position when crafting an HMA.
When negotiating an HMA, the hotel owner and the hotel company each
have many objectives around items such as control, risk, and fees. It is
useful to understand these objectives because when you better
understand the goals of the other party, you are better positioned to craft
an agreement that meets your needs, as well as the needs of the other
party. Use this information when you negotiate your own hotel
management agreements.
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Read: Bargaining Strength
• Key factors for the hotel company

are: reputation, capability,
responsiveness
• Key factors for the owner

are: commitment, stability and
experience, opportunity
What are the factors that influence the relative bargaining strength of an
owner or a hotel company?
We can begin by examining those factors that influence and enhance the
hotel company’s bargaining position. Affirmative answers to the following
questions mean greater leverage for the hotel company.
Factors that improve the hotel company's bargaining

position:
Reputation: Do the public, other owners, and lending institutions

regard the hotel company as excellent?
Size: Does the hotel company have an adequate number of properties
to support a centralized staff and to indicate a sufficient level of
experience?
Growth: Does the hotel company have a stable and continuous history
of growth?
Services: Does the hotel company offer complete and competent
marketing, sales, reservations, operational controls, financial reporting,
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and pre‑opening management and technical services?

Contribution: Is the hotel company willing to make a significant
financial commitment?
Supervision: Does the hotel company have experienced and thorough
national and regional staff supervision?
Flexibility: Will the hotel company be flexible in contract negotiations?
Owner's perception: Does the owner perceive the hotel company as
responsive to the owner's goals?
Now let’s consider the owner’s bargaining position. Affirmative answers

to the following questions will mean greater leverage for the owner.
Factors that improve the owner's bargaining position:
Holding period: Does the owner intend to maintain ownership for an

extended period of time?
Experience and capability: Does the owner have a record of sound
experience and capable management?
Financial commitment: Can the owner make an adequate financial
commitment to the project and does the owner have a stable financial
background?
Institutional owner: Is the owner a stable institutional owner rather
than a more risky entrepreneurial owner?
Potential: Does the owner have the potential to achieve the hotel
company’s financial and other goals?
Opportunity: Does the owner’s property provide an excellent
opportunity for the hotel company to enhance its market posture,
visibility, and competitive position in the industry?
Competition: Is there likely to be substantial competition among hotel
companies for the property?
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Watch: Negotiating the Letter of Intent

Establishing a management agreement between a hotel owner and a
hotel company involves an important set of negotiations. Before the
agreement is drafted, the parties negotiate a letter of intent, which
includes the major provisions of the agreement. In this video, Professor
deRoos explains the three-step process of negotiating a management
agreement and describes the provisions that are covered in the letter of
intent. These major provisions include the hotel company's financial
contribution to the project, the term of the contract, the renewals, the
termination rights, and the management fees.
Video Transcript
The process of negotiating hotel management agreement consists of

three distinct steps generally in the specific order listed below. First, the
owner and the hotel company come to terms over the numbers. They
agree on the projections of revenue and cash flow, as well as the cost to
develop or renovate the hotel to the hotel company's brand standards.
This is usually an owner-driven process because the owner has a vision,
they have engaged consultants to do a market study and they've
produced their own projections of future revenues and future cash flows,
as well as what they think of the cost of investment in the property. The
owner asks the hotel company to develop their own projection using the
owner's market study and their understanding of the owner's vision. The
hotel company and the owner then share their financial projections. If the
numbers agree, they proceed to the second step. If they can't agree on
the numbers, the owner will approach a different hotel company. There is
no reason to proceed to a letter of intent unless the owner and the hotel
company have a clear understanding of each other's financial goals.
Secondly, the hotel owner and the hotel company negotiate a letter of
intent, which includes the major provisions of the agreement. This is
generally a five- to 10-page document written in very plain language
describing the major areas of agreement between the parties. The
preparation of this document is where the key negotiations between an
owner and a hotel company take place. Third, the legal teams, for each
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party, convert the letter of intent into a management agreement, typically

a 50-to 100-page document. Because the letter of intent is the crux of the
negotiation between the owner and hotel company, we will devote a great
deal of time to understanding the process by which it is negotiated and its
major provisions. As we have previously discussed, both parties come to
the letter of intent negotiation with a set of expectations about what they
would like to achieve. The parties pursue their objectives through the
negotiation of these major provisions. In this module, we will follow a
stylized order that is very common in the hotel industry.
First, the parties negotiate whether the hotel company will make a
financial contribution to the project. This could be in the form of key
money, an equity contribution, a loan, or a cash flow guarantee. Until the
hotel company knows how much money they're asked to invest, they're
very unwilling to make a commitment about term, its length or to the fees.
The second term to be negotiated is the term, the renewals and

termination rights. How long is the initial term of the agreement, how
many renewals are there and for how long, and under what
circumstances can the owner terminate the agreement? Until the hotel
company knows the term and the strength of the owner's termination
rights, they are generally unwilling to make a commitment to the fee
structure.
The third item to be negotiated is a fee. There are two components to be

negotiated, the size of the base fee and the size and nature of the
incentive fee. Each of the major provisions, the financial contribution, the
term, and the fees is related. For example, a hotel company that makes
no contribution in a long-term agreement would expect to obtain only an
average, or perhaps even below average fee. On the other hand, a hotel
company willing to make a sizable contribution to the project, and is
willing to be subject to a strong performance termination clause, can
expect an above average market, above market fee.
Not until you know how much the hotel company will contribute, how long
they have the hotel under control and what fees will be paid are the other
provisions such as personnel, financial reporting and territorial
restrictions negotiated. Until agreement is reached on the three key
provisions, there is no reason to consider less important provisions. Once
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the letter of intent has been negotiated, the decision makers step away
from the table, and we enter this final stage. The legal teams come
together, take over the process, and produce the hotel management
agreement. The legal teams are generally given very little latitude to
renegotiate any provision of the letter of intent. Their job is to turn that
letter of intent into a legal document.
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Read: Negotiating Key Provisions: Contribution,

Term, and Fees
• The letter of intent outlines key

provisions to be included in the
management agreement
Negotiating the Letter of Intent: The Hotel

Company's Financial Contribution
The first specific provision to be negotiated between the owner and the
hotel company is the investment contribution the hotel company is asked
to make in the form of “key money,” a loan, a cash flow guarantee, or
equity investment. Until the hotel company knows the amount and the
structure of the contribution, they are unwilling to make any commitment
on the HMA’s term or fees. In general, if the hotel company invests in the
property, they would expect a long-term agreement with very reasonable
management fees.
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Overall, investment contributions are found in a minority of HMA’s.

Historically, equity investment contributions were a common component
of a HMA. Not so today. Today’s owners are reluctant to allow hotel
companies any equity stake due to the implications of the hotel company
as the owner’s partner. Hotel companies do not find the alternative of
‘key money,’ a loan, or a cash flow guarantee to be compelling
investments and have become reticent to fund these requests.
If required to make a contribution, the hotel company’s preferred order is:
Offer a loan, often structured as a mezzanine loan with commensurate

returns,
Offer a cash flow guarantee with a ‘claw back’ provision from future
profits, or
Offer a small amount of ‘key money’
Owners asking for a loan or key money signal that they are missing some
of the capital necessary to complete the project; this causes the owner to
be perceived as less powerful and puts them in a poor negotiating
position relative to the hotel company. Hotel companies will consider key
money in situations that have a location that the hotel company is
extraordinarily interested in securing or to induce the owner into signing
an agreement with this particular hotel company instead of a competitor.
The owner’s preferred order of financial contributions is:
Ask for a 'key money' contribution, generally structured as a loan with

zero interest and a provision that forgives the payment of the loan if the
HMA survives the full initial term.
Ask for the contribution as a loan from the hotel company, generally
structured as a mezzanine loan.
Ask the hotel company to guarantee cash flows during the initial years of
the investment and provide this guarantee in a form acceptable to the
senior lender.
The fourth option, an equity contribution, has essentially gone out of the
industry. Any significant equity contribution from the hotel company
makes the hotel company a partner with the owner. This has the legal
effect of making the agreement extremely difficult to terminate, as one
cannot terminate one’s partner. Owners are extraordinarily reluctant to
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sign a non-terminable HMA.
Financial contributions are usually small relative to the total capital that’s
needed for a project. They generally make up less than 10% of the total
capital, with the more typical range between 0% and 5%. Despite the
diminishing prevalence of investment contributions, they remain the first
step in negotiating a letter of intent. If there is to be an investment
contribution, the details need to be arranged before the negotiations turn
to the length and fees related to the agreement.
Negotiating the Letter of Intent: Length of Term and

Termination Rights
Now that we’ve negotiated the investment contribution, the negotiations

move to a discussion of the term of the agreement. Two questions are
crucial: 1) Under what circumstances can the agreement be
terminated? And 2) How long does the agreement last? In practice, these
two questions are not treated separately.
Owners that obtain strong termination rights, such as termination-at-will

or termination-on-sale, are less interested in the initial length of term and
renewal matters. Owners that do not obtain these rights negotiate very
intensely over the initial length-of-term and renewal matters. The
influences on negotiation over the length-of-term and renewal are the
relative power of the parties and the relative desire of the owner to be in
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the project long term or short term. Short-term owners negotiate very
hard about termination-on-sale rights. If they don't obtain good
termination rights, they will negotiate a very short term. If they do have
termination-on-sale rights, the initial term and renewals are somewhat
less important. In general, the best hotel companies have very strong
power to limit the owner’s desire to terminate at will or terminate upon
sale. They feel that negotiations over the initial term and renewals create
a time period over which they will have control over the hotel and
negotiate to limit termination other than for poor performance.
The initial terms have historically been for 20 years, with two 5-year or
two 10-year renewals; thus giving an overall term of 30 to 40 years. For
the high-quality, branded hotel companies, the initial terms have gotten
shorter across the industry. Today, a good agreement might be a 15-year
initial term, with one 10-year renewal or two 5-year renewals.
Independent hotel companies generally obtain shorter terms than the
branded hotel companies. A typical agreement has a 5-year to 10-year
initial term, with two 5-year renewals. The best hotel companies are able
to negotiate very long terms. One branded hotel company is able to
obtain a 30-year initial term with four 10-year renewals on a regular
basis. This illustrates that term is highly dependent on the perceived
quality of the hotel company.
There are three broad categories of termination clauses:
1. Termination without cause. This is usually restricted to independent

hotel companies. The quality branded hotel companies will generally
not allow an owner to terminate the agreement without cause.
Independent hotel companies may agree to a termination without
cause as a means to secure the agreement. There are, however,
certain owners who require a termination without cause agreement.
Unless they have the ability to terminate, at any time, they will not
sign the agreement. A termination without cause clause is
universally accompanied with a notice requirement (90 days is
typical) and a termination fee, generally one-to-four times the most
recent annual management fee.
2. Termination upon sale. Termination upon sale has essentially two
flavors. In the first, the owner has the right to terminate upon sale
without offering the hotel company the right to purchase. In the
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second, the owner offers the hotel company the “right of first offer”
(called ROFO rights). In general, when you negotiate termination
upon sale, giving the hotel company the right of first offer is not seen
as an undue burden for the owner. Generally, the hotel company is
given 20 to 60 days to make an offer. If the sides do not reach
agreement, the owner can put it on the market. A termination upon
sale clause is universally accompanied with a notice requirement (90
days is typical) and a termination fee, generally one-to-four times the
most recent annual management fee.
3. Performance termination. These are extremely complicated clauses,
which essentially give the owner the right to terminate the agreement
if the hotel company fails to meet agreed upon performance
thresholds. In a typical clause, if the hotel company doesn't achieve
80% to 90% of the budgeted gross operating profit (GOP), for two
consecutive years, they are subject to termination. The owner wants
to be able to distinguish between a good hotel company and a bad
hotel company. The owner wants to be able terminate a poor hotel
company that has not benchmarked well, that is not providing
expected cash flows. If, on the other hand, it is a good hotel
company in a poor market, the hotel company wants protection
against termination. For this reason, protections are built into this
clause. The agreement usually contains a force majeure clause
revoking termination if “bad” things happen in the market which have
harmed the performance of every hotel. This is typically in the
agreement as a RevPAR comparison. If the hotel company
benchmarks well relative to competitors, indicating that the entire
market has sunk, the termination clause is not operative.
Negotiating the Letter of Intent: Fees
After agreeing on contribution, length of term renewals, and termination

provisions, the owner and hotel company are now ready to discuss fees.
There are three kinds of fees in every management agreement. There is
the base fee, there is the incentive fee, and there is a set of system
reimbursable charges. For negotiation purposes, only the base fee and
the incentive fee are relevant. The system reimbursable charges are
fundamentally non-negotiable. The fee structure is negotiated backwards.
The owner and the hotel company negotiate the incentive fee first, and
once the incentive fee is negotiated, then they agree on the base fee.
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The reason is that the incentive fee is a risk-shifting device, generally

shifting risk from the owner to the hotel company, but also providing the
hotel company with the ability to earn high fees from good performance.
Both the hotel owner and hotel company are reluctant to settle on the
base fee until the incentive fee is somewhat settled.
Incentive fees are generally one of two flavors:
1. Traditionally, incentive fees have been some percentage of the

GOP, after a set of adjustments, we’ll call this AGOP for adjusted
GOP. A typical incentive fee might be 8% to 10% of AGOP. In this
case, the hotel company is not being asked to take on much financial
risk. The hotel company receives a base fee, operates efficiently,
receives an incentive fee, and whatever is left over goes to the
owner. A more contemporary version has a stepped incentive fee
that incentivizes the manager to operate efficiently as defined by the
GOP margin; the manager earns a below average incentive fee for
below average GOP margins, an average incentive for average GOP
margins, and an above average incentive fee for above average
GOP margins.
AGOP is usually defined as GOP minus the following: the base fee, the system
reimbursable charges, and less commonly, property taxes, property insurance, and the
reserve for replacement deduction.
2. In North American hotel management agreements, owners have

asked for the incentive fee to be subordinated to an owner’s priority
return, thus shifting some of the financial risk to the hotel company.
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The owner’s priority return is generally a return on investment,

generally in the range of 6% to 10%. Let’s consider an example
where the owner buys a hotel for $50 million and there is $6 million
of cash flow from the hotel. Say the owner wants an 8% priority
return; in this case it is 8% of the $50 million investment or $4
million. After that $4 million is paid, the incentive fee is a significant
share of whatever is left over, usually 20% to 30%. If the hotel
company is willing to take that kind of financial risk by essentially
guaranteeing a return to the owner prior to taking the incentive fee,
they would expect a healthy base fee in return and a strong
possibility that the incentive fee will grow over time, perhaps
exceeding a GOP-based fee.
Once the incentive fee is negotiated, the owner and hotel company
negotiate the base fee. The base fee is, in general, 2% to 3% of total
revenues. The specific size of the base fee is related to the negotiated
agreement on incentive fees. It is not uncommon for the base fee to be
discounted in the first two to three years, say 2.5% in year 1, 2.75% in
year 2 and 3% in all remaining years. Once the fees are negotiated, the
major provisions of the letter of intent have all been agreed to. Now it is
time to negotiate the remaining provisions.
You will be able to download a summary of these provisions later in this

module.
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Read: Negotiating the Final Provisions
• The remaining provisions must be agreed upon
• The final deliverable is the letter of intent
• The letter of intent will become the management agreement
After you’ve completed negotiation over the big three items, financial
contribution, term and termination, and the management fees, you can
move on to the remaining provisions of the management agreement.
These can be negotiated in any order.
Personnel and Labor Matters
Almost universally, employees are employed by the owner, not the hotel
company. There are some instances of the hotel company employing
hotel personnel in the United States, but this is generally not lawful
outside the USA. The owner usually wants the right to input on the
selection of the general manager, and possibly other managers such as
the Controller or the Director of Marketing. This can range from approval
of the hotel company’s choice or, more commonly, an active role in the
selection process. The hotel company is responsible for negotiating union
agreements. The owner then has the right to approve or disapprove these
agreements negotiated on behalf of the hotel companies.
Budgeting and Spending Limitations
Owners are increasingly involved in the budgeting process. Owners want

to secure and negotiate the right to approve the annual operating budget,
not just to review the budget. In addition, the owner wants the right to
negotiate over and approve the reserve replacement budget and the
capital expenditure budget. The reserve replacement budget would be 3%
to 4% of total revenues, while the capital expenditure budget would be 1%
to 2% of total revenues, so total reserves are 4% to 6% of
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revenues for most hotels (often these are handled in one single capital
budget).
Financial Reporting
The owner wants annual, certified (or audited) reports from the hotel
company; although increasingly the owner is asked to prepare the
audited statements. The standard three reports are the balance sheet,
the income statement, and a statement of changes in financial position.
Additionally, there should be a reconciliation of the base and incentive
management fees, and a reconciliation of the system reimbursable
expenses. Owners will also negotiate a number of monthly, non-certified
reports that are prepared for the owner’s review.
The other financial reporting issue negotiated today is the owner's ability
to look inside of, and pull information out of, the hotel company's financial
information systems. In general, hotel companies have taken a very
proactive approach to allowing owners to have at least a limited look
inside their financial information systems.
Area of Protection or Territorial Restriction Provisions

Does the hotel company have the right to put additional, same-brand,
properties in the same market as the existing hotel? Hotel companies do
not want to be precluded from bringing new hotels into the market,
especially if a competitor will build them in any case. Owners don’t want
to face unreasonable levels of competition. Together, they must negotiate
the size of a protected area, the term of the restriction, and any
conditions placed upon new properties inside the restriction zone. Hotel
companies are often allowed to open new properties if, through an impact
study, they can show no incremental harm to an owner’s hotel.
System Reimbursables
There is very little negotiation here. System reimbursable expenses were

extraordinarily contentious over the past 20 years, but litigation
unfavorable to hotel companies has caused this area to become
extremely transparent. Owners now know what they are paying for.
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Though they may not like it, it is clear that the owners need to pay their
fair share of the hotel company's systems.
System reimbursables include payments for marketing and sales officers,

the reservation system, group purchasing of operating supplies,
replacements of capital expenditures, a centralized accounting function, a
centralized training function, and the reimbursement for corporate
personal, their travel and room and board while they are at the owner’s
property. In general, system reimbursable expenses are in the range of
1% to 3% for the branded hotel companies and from 0.5% to 1% for the
independent hotel companies.
At this point, all the key provisions have been negotiated, and they can
be formalized in a completed letter of intent. Both sides may go back and
forth on the specific provisions of the letter of intent. Once agreement has
been reached, the letter of intent is ready to go to the lawyers and be
turned into a management agreement.
You can download a summary of these provisions on the next page.
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Tool: Key Provisions of the Letter of Intent
• Use this summary of the key

provisions of the letter of
intent when negotiating a hotel
management agreement.
The owner and the hotel company must negotiate many provisions in the
letter of intent and the hotel management agreement. It is critical to
understand how these provisions are related and which provisions are
most important to achieving your objectives. Use this helpful summary of
the key provisions when you negotiate a letter of intent and management
agreement.
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Watch: Strategy in Negotiating the HMA

Now that you understand the major provisions of the letter of intent, you
can consider the strategy involved in negotiating the HMA in different
contexts. In this video, Professor deRoos provides several fictional
examples that show the ways these provisions can be packaged in
negotiations between different types of owners and hotel companies.
Professor deRoos demonstrates that the owner must have clear
objectives about what they want included in the HMA but they also
must craft an agreement that meets the needs of the hotel company as
well.
Video Transcript
I was teaching my graduate students in the hotel asset management

course several years ago. I had two very senior executives from a hotel
real estate investment trust come speak to the class. I asked each to
describe the most important clause in their management agreement, and
the reason why it was most important. Executive A said the most
important clause in our agreement is the ability to have input on the
selection of the general manager. We want GMs to share our vision of
the hotel and to have our objectives in mind as they manage the hotel on
a day-to-day basis. Contrast that to executive B who stood in front of the
class, pounded the table and said the most important clause in our
agreement is termination without cause. We want to be able to terminate
the hotel company whenever we wish. In that environment, the hotel
company will listen to us very carefully, because we have the ability to
terminate at any time. In exchange, we agree to a termination provision
that compensates the hotel company if they are terminated.
The takeaway from this story is that each of these executives had very
clear objectives about what the firm wanted. They entered negotiations
with these objectives in mind and would craft their agreements to meet
these objectives. When you design and negotiate your agreements, you
really need to think about designing the outcomes strategically and think
about what's really important. The letter of intent, in the end, will reflect
the outcome of bargaining without clear objectives. What you attain is
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what you negotiate, not necessarily what you want.
Let's illustrate with two examples. We'll consider hotel A, owned by

Alexandra who works for Tar Heel Development, a regional hotel
developer. What are Alexandra's objectives? First, let's assume that Tar
Heel needs some capital to complete their new development. Well,
Alexandra doesn't want to admit this to the hotel company, she needs
funds to help her complete her capital stack. In addition, Alexandra wants
the hotel company to take significant risk via the incentive fee. Tar Heel
intends to own the property for the long time, however, and is willing to
offer a very long-term agreement. The outcome of their bargaining might
look like this. The hotel company makes a significant key money
contribution that completes Alexandra's capital stack. The hotel company
obtains a very long management agreement in exchange. The
termination of provision looks like this. Termination without cause, no.
Termination on sale, no. Performance termination, yes. The fees would
look as follows. A base fee would be above market fee of approximately
3% of total revenues. The incentive fee, however, would be a substantial
percentage of cash flow available after an 8% return on Alexandra's
investment. In the end, what has Alexandra achieved? She got the hotel
company to take on significant financial risk, so the incentive fee, and she
obtained needed funds. In exchange, the hotel company obtains a very
long-term agreement with very weak termination rights.
Now, contrast this with hotel B. In this case, John, our real estate equity
fund investment officer, wants to buy a troubled hotel, improve it, and
then sell the hotel once the property stabilizes. John wants the ability to
quickly exit his investment and redeploy his capital. What might he put
together as a set of initial terms? John doesn't need any financial
contribution from the hotel company, putting him at a strong negotiating
position. He's willing to give the hotel company an initial term of average
length. He doesn't need termination without cause, but must have the
right to terminate upon sale. Within the termination upon sale clause
would be the right of first offer to the hotel company. His hope is that the
hotel company then sees the average term as not being a deal killer. In
exchange for termination on sale and an average term, John is willing to
pay the hotel company a very fair base fee and he will not ask the hotel
company to take significant financial risk in the incentive fee. John has
the ability to exit quickly, redeploy capital, and give the hotel company a
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very fair set of terms in exchange.
What are our takeaways here? First, note how the bundle of terms is
assigned to achieve each owner's specific objectives. Both Alexandra
and John negotiate to their key objectives. Second, note that if the owner
insists on the best outcome in every category, this might result in an
absolute deal killer for quality hotel companies. Our third takeaway is to
note how fees are used as a risk shifting device. For hotel A, Alexandra is
asking the hotel company to defer, or subordinate, their incentive fee to
an 8% return on the owner's total investment. Lastly, note how the hotel
company is treated. In each case, the owner is trying hard to craft a set of
provisions that would induce a great quality hotel company to operate this
hotel. Keep in mind, keep this in mind as you negotiate your hotel
agreements. In addition, each owner wants to have a great hotel
company running the property. In general, great hotel companies are
used to getting their way in negotiations, meeting them half way
strategically is a key competency for any negotiator.
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Analyzing a Letter of Intent

You are now ready to analyze representative letters of intent from the
perspectives of both the owner and the hotel company. Use this quiz to
demonstrate your understanding of the provisions of the letter of intent.
This will help you to craft negotiating proposals during the next activity.
To complete this activity:
Download and review the BrookEden Case Study.
Next, review two letters of intent. The provisions of one letter of intent are
more beneficial to the owner; the provisions of the other favor the
hotel company.
Download the Management Agreement Letter of Intent A
Download the Management Agreement Letter of Intent B
Answer the following questions.
You must achieve a score of 100% on this quiz to complete the

course. You may take it as many times as needed to achieve that
score.
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Changing the Letter of Intent Provisions

You are now ready to analyze representative letters of intent from the
perspectives of both the owner and the operator. For this project, you will
put together negotiating proposals in an effort to successfully shape a
letter of intent that meets your needs, first as an owner, then as a hotel
company.
How to complete this project:
1. Be sure you have read the case study and term sheets from the
assessment activity Analyzing A Letter of Intent. You
can download those documents again:
BrookEden Case Study
Management Agreement Letter of Intent A
Management Agreement Letter of Intent B
2. Download the Changing the Letter of Intent Provisions Project and
complete both parts.
3. Save your work.
4. Upload your completed course project here for instructor review and
credit.
Before you begin:
Before starting your work, please review the rubric (list of evaluative
criteria) for this assignment, and eCornell's policy
regarding plagiarism (the presentation of someone else's work as your
own without source credit).
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Crafting an Advantageous Agreement

Instructions:
You are required to participate meaningfully in all the discussions in this

course. Do not to complete this discussion until you've received feedback
on the "Changing the Letter of Intent Provisions" exercise.
Discussion topic:
Share with your colleagues a brief summary of your response to either

Part I or Part II of the "Changing the Letter of Intent Provisions" exercise.
After the summary, answer the following:
1. What did you learn from the exercise?

2. Would you accept your own offer?
To participate in this discussion:
Click Reply to post a comment or reply to another comment. Please

consider that this is a professional forum; courtesy and professional
language and tone are expected. Before posting, please review
eCornell's policy regarding plagiarism (the presentation of someone
else's work as your own without source credit).
Cornell University
Tool: Control of Hotel Real Estate Action Plan
• Use the Control of Hotel Real

Estate Action Plan to guide your
efforts on the job.
In this course, you examined contemporary hotel leases prevalent around

the world. You analyzed the costs and benefits of franchise affiliation. You
also considered how management agreements are negotiated and you
learned to prepare letters of intent considering the perspectives of both
owners and hotel companies.
This action plan provides a valuable opportunity for you to consider how
you might apply your new skills to challenges in your own career. Will you
be able to make an informed decision about who should control the daily
operations of a hotel? Will you be able to evaluate a proposed franchise
agreement? Use the Action Plan template provided to map out your
approach to your real estate project.
Cornell University
Module Wrap-up: Negotiating Contemporary

Management Agreements
Hotel owners may want to hire a hotel company to manage the day-to-day operations of a hotel
using a management agreement. Negotiating these agreements can be a delicate process that
requires a thorough understanding of the key provisions included in the agreement. Successful
negotiations result from a clear statement of your own objectives and an appreciation for the other
side's perspective.
In this module, you examined contemporary management

agreements from the perspective of owners and hotel companies. You
explored how the relative power of owners and hotel
companies influences the management agreement negotiations. You
examined the key aspects of control that each party wants to include in
the management agreement. You determined the key provisions of
management agreements and how owners and hotel
companies negotiate letters of intent that protect their interests. You also
analyzed management agreement letters of intent from the perspectives
of different owners and hotel companies.
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Read: Thank You and Farewell
Jan A. deRoos
Associate Professor and
HVS Professor of Hotel Finance and Real Estate
School of Hotel Administration
Cornell University
Congratulations on completing Control of Hotel Real Estate.
Obviously, hotel investments may take many forms. All hotel
investments involve risk. By now, you should be able to fruitfully
analyze the different control relationships best suited to a particular
investment. You should also be able to identify and describe how risk
is apportioned between the owner and the hotel company through
these control mechanisms.
I hope you found this to be a stimulating and informative introduction
to hospitality real estate. I hope the material covered here has met
your expectations and prepared you to better meet the needs of your
organization.
From all of us at Cornell University and eCornell, thank you for
participating in this course.
Sincerely,
Jan A. deRoos

Control of Hotel Real Estate

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SHA612: Control of Hotel Real Estate

SHA612: Control of Hotel Real

The control and management of hotel real estate has

Professor Jan A. deRoos, on the faculty of the

we examine the two major control decisions faced by owners.

Module 1: Control of Hospitality Assets

Module 2: Negotiating Contemporary Hotel Franchise

1. Module Introduction: Negotiating Contemporary Hotel Franchise

11. Evaluating Franchise Affiliation

Module 3: Negotiating Contemporary Management

1. Module Introduction: Negotiating Contemporary Management

Module 1: Control of Hospitality

Back to Table of Contents

Module Introduction: Control of Hospitality Assets

This module introduces key concepts around control decisions and

Back to Table of Contents

Watch: Who Controls the Operation of the Property?

further their interests. In general, owners seek a sufficient return on their

Back to Table of Contents

Watch: Different Structures of Control

Consider the hotel owner's investment structuring decision. The question

At the other end of the continuum is an owner-operator who both owns

So for hotel companies, the question of control is twofold, who controls

Back to Table of Contents

Tool: Hotel Control and Brand Options

• Use this summary of control and

Back to Table of Contents

Watch: The Hotel Income Statement

We start with the example of the BrookEden Hotel. The income

each department has exercised proper control. Once these departmental

Back to Table of Contents

Watch: Hotel Company and Brand

Alexandra feels that having a branded hotel company manage their

They recently acquired a large convention-oriented hotel that was subject

pay below-market management fees. It is important for the hotel

Back to Table of Contents

Read: If the Owner Operates, What are the

• Owners can operate the hotel themselves

• Owners can operate independently, as a referral, or as a franchise

As an independent hotel, the owner manages

A referral provides a middle ground between independence and a

World. The referral organizations provide marketing and a

The most extensive branding relationship for owners

Back to Table of Contents

Read: If the Owner Doesn't Operate, What are the

• The options are a management agreement or a lease

Owners bear the financial risk and rewards

goods they purchase and having preferred vendor relationships. And

Rents come in a variety of forms. Rent can be fixed, meaning that it is a

Back to Table of Contents

Driving the Negotiating Process

You are required to participate meaningfully in all discussions in this

To participate in this discussion:

Click Reply to post a comment or reply to another comment. Please

Back to Table of Contents

Watch: Introduction to Leases

conditional on the right to continue to operate the property. If they choose

The sale-leaseback is seen as an attractive alternative to a sale-

Now let's consider a 100% variable lease, in which the lease is a

Select-service hotels would be the upper end of the range, full-service

Back to Table of Contents

Watch: Hotel Leases Around the World