Given the trend towards shorter management agreements, especially with third party managers, performance tests become less and less necessary, particularly if the manager can be terminated without cause. However, this should be carefully evaluated on a case by case basis.
As a general rule, owners should try to negotiate a termination for “no cause” with a third-party manager (operators that manage a franchised or independent hotel). This is typically extremely difficult if not impossible to achieve with brand managers. At a minimum, the third party manager should be open to a termination for no cause after a certain time has elapsed in the contract, and after the manager was able to re-coup their start-up costs to take over management plus a reasonable profit.
Operators prefer a performance test that includes both a RevPAR index and GOP test (a ”two prong test”), while owners prefer that the performance threshold be solely profit based. The test generally starts once a hotel is deemed stabilized, which could be in the first year of the contact or after a couple years of operation. Although it is not uncommon to negotiate tests that ramp up during the stabilization period.
The test thresholds should be set before entering into the hotel management agreement. In order to set fair thresholds, the owner should not only rely on the operator’s underwriting but also complete their own feasibility and a thorough underwriting. The underwriting process needs to include defining the appropriate competitive set to determine the RevPAR index goals.
The reason why operators typically want a “two prong test” is to protect against market volatility due to an economic recession. If an unpredictable economic downturn occurs, operators might not be able to hit GOP targets while the hotel’s topline (RevPAR) performance is in line with or exceeds the competitive set’s performance. The rational being that performing at or above the competitive set is considered a good performance.
Operators typically propose a RevPAR index threshold between 85% and 90% against the established competitive set. However, the RevPAR index test should be set at a slight discount to the agreed upon underwriting, since missing the topline has an accelerated negative impact on the bottom line: 1% shortfall in revenues represents typically a 2% shortfall of net income for a full service hotel. That is why it’s so important to set the RevPAR index targets correctly.
The Competitive Set
Owners generally do not focus enough on defining the appropriate competitive set. The RevPAR index is calculated by dividing the hotel’s RevPAR by the RevPAR of the competitive set. Ideally, the index should range anywhere between 90% and 110%, depending upon the strengths and weaknesses of the hotel versus the set. If such a range is not achievable, it could mean that the competitive set is not totally relevant. For example, if the subject hotel is the only full service property in a predominantly limited service market then the expectation is for the asset to significantly outperform the market, in excess of 110%. If a comparable competitive set cannot be determined, it may be best to avoid the RevPAR index test and focus instead on establishing a measurable GOP test only.
Operators prefer GOP performance tests based on the current year budget, whereas this is not in ownership’s interest because 1) budgets can be very different than the initial underwriting upon which the owner makes his investment decisions and 2) this would encourage operators to propose a very conservative budget that would ensure their compliance with the performance test. A test based on a percentage of budget would then result in unnecessarily lengthy and potentially disruptive negotiations with ownership, at a time where all efforts should be focused on achieving results. That is why it is highly recommended that the GOP test be tied to an underwriting proforma which the manager and the owner agreed upon. It will be the same underwriting that the owner will use to set clear income expectations to determine available financing and investment returns. It is perfectly reasonable to hold the operator accountable to meet those income expectations and be able to terminate them if expectations are not met. The GOP threshold could be set at a slight discount to the underwritten GOP, such as 90% for example. It would also be considered good practice to include a minimum GOP margin % to be achieved.
Brand Audit Test
Another performance test that should be considered is passing the Quality Assurance / Brand Audits, excluding failures which are not in control of the operator (such as due to lack of renovation or lack of funding for capital by owner). It should be considered for both branded and franchised properties. These tests would be structured so that the operator needs to pass the majority of consecutive audits over a certain test period, such as one year or two years, giving therefore the operator the opportunity to rectify any shortfall after one failed audit.
Lastly, performance tests are one of many contractual terms that should be compatible with the owner’s strategy for the asset, in particular the exit strategy, as these terms have a material impact on the liquidity of the asset, its potential buyer pool and consequently its market value.
About Nele Breitbart:
Nele Breitbart, Vice President, has more than 14 years of hospitality industry experience. She is responsible for overseeing a portfolio of hotels, including luxury and resort properties, identifying and monitoring strategic value enhancement opportunities, completing asset valuations and negotiating management and franchise agreements. Prior to joining hotelAVE in 2007, Ms. Breitbart worked with Hyatt Hotels and Resorts where her duties were generating proforma operating statements, analyzing hotel operating statements, organizing project costs, completing financial analysis utilizing different valuation techniques, and compiling market research.
Ms. Breitbart’s international experience is an asset to our clients as well. She worked at Hyatt’s EAME (European-African-Middle Eastern) corporate office as a development analyst and also served with Jones Lang LaSalle as an intern assisting in the valuation of four-star and three-star properties within Germany. Previous to that, Ms. Breitbart served as the Interim Manager in the Accounting and Banquet Sales Department of the Relexa Hotel Bellevue, a renowned four-star hotel in Hamburg, Germany after successfully completing a three year rotational apprenticeship program at the Relexa Hotel Bellevue. She is a graduate of Cornell University's School of Hotel Administration.
- Hyatt Hotel and Resort: Analyst, Acquisitions and Development
- Jones Lang LaSalle Hotels: Intern, Investments and Advisory Group
- Relexa Hotel Bellevue – Hamburg Germany: Interim Manager, Accounting and Banquet Sales
- Relexa Hotel Bellevue: Apprentice for hotel Manager
DESIGNATIONS, AFFLILIATIONS AND AWARDS
- Cornell Hotel Society (CHS): Member
- Hospitality Asset Managers Association (HAMA): Member
- Bachelor of Science - School of Hotel Administration, Cornell University
- Hotel Manager Certificate – Hotelfachschule Hamburg, Hamburg, Germany
SPEAKING ENGAGMENTS AND PUBLICATIONS