The Four Cornerstones of a Successful Hotel Contract

The infrastructure and day-to-day running of a hotel is where its worth lies. To increase profits, they focus less on capital expenditures and more on marketing, sales, and operational efficiency. Consequently, if you want to make the transition from Big Four CRE to hotel investment, you need to have a solid grasp of the structure of hotel deals.

Successful commercial real estate investments are predicated on well-run businesses and well-organized capital systems. Deal terms in the hotel industry are very sensitive to the players involved, as well as to the hotel's current market and operational standing. Working parties, capitalization, market positioning, and contract encumbrance are the four levers that a savvy deal sponsor knows how to pull in order to maximize the value of the assets under their control.

Collective Efforts

From a high level perspective, the framework of a hotel deal is not dissimilar to that of any other real estate sale. The sponsor acts as a go-between between the deal and the investor(s) and lender(s). Throughout the course of an investment's lifespan, several other parties, such as attorneys and outside consultants, may be involved. The asset class is unique, however, because of the need of everyday operations.

Brief Background

Investments in hotels have developed through the years to spread out the associated risk and to cater to the specialized needs of a wide range of parties. Before the 1970s, hotel chains such as Marriott and Hilton ran their own properties. Everything from branding to managing day-to-day business and assets was covered.

In the 1980s, the first change occurred when brands were decoupled from their management in order to franchise and expand their sales and marketing platform. Hotel real estate investment trusts (REITs) originated in the 1990s to help large hotel chains further compartmentalize their financial and operational risks.

New cash was injected into the sector and the separation of roles was sped up thanks to the proliferation of private equity in the 2000s, laying the groundwork for the current hotel transaction structure.

Three Major Players Involved

Included in a typical package offer at today's hotels are the following:

Owner - The deal sponsor is in charge of the ownership group, which consists of a joint venture partner and/or a syndicate of limited partners. This position is analogous to that of a conventional hotel owning company.

Operator — The operator is in charge of all operational aspects of the hotel, from ensuring the comfort of guests to overseeing the collection of income to coordinating repairs and upkeep. The management firm might be directly associated with the deal's backer, or it could be an independent entity.

Brand—Adding value through sales, marketing, quality standards, and training are all ways in which a brand may be described. Hotel positioning in the market is determined mostly by how guests feel about the brand.

Each investing approach requires a unique combination of these and other significant players. You may combine these three in any way you choose to get the results you want.

The administration of many newer companies often includes a small stock stake in the company. This grants you elevated command over customer interactions and product branding. Once the sponsor has established a tried and true brand and operating platform, pure third-party brand management or franchising can begin.

Compatible Objectives

Stakeholders' interests need to be aligned in every real estate transaction. Alignment is often created by stock contributions (also known as "skin in the game") in most agreements. However, it is not always feasible for brands and purely third-party operators to act as investors in every agreement. As a result, they employ various mechanisms to increase responsibility.

Under the current system of revenue-based pay for brand and management firms, owners are at a disadvantage. Revenue maximization isn't free, and a company's success is measured by how well it can attract new customers. After all, regardless of top-line growth, owners care only about bottom-line profitability.

Many different promotional methods are available to brands nowadays. They pay for these with an equivalent amount of payments under the license agreement. The system/marketing charge and loyalty program fee are the most significant costs beyond the royalty fee. Brand expenditures can be controlled by setting a cap on these as a share of total room revenue.

It is the operators, not the brands, who have the most say over the bottom line. They have a number of knobs they can turn to save money on marketing and streamline operations. Balanced interests can be achieved through incentive payments and other contractual procedures.

Accordingly, it is the duty of the owners to provide the brand and operator with an asset of sufficient quality to warrant the maximum potential return. An investment of money and effort is needed to make this happen, but it will help showcase the hotel at its finest. As a result of their ability to rearrange the hotel deal's components, owners play a significant role.

Capitalization

One must have a lot of money to open a hotel. On a daily basis, hotels are bombarded with incoming and outgoing guests and hardworking staff members. This is on top of the regular deterioration that happens from exposure to the environment and passing time.

Brand-mandated property improvement plans (PIPs) are a sort of periodic capital investment that help keep standards high. In most cases, the minimum required capital reserve is insufficient to fund a PIP in its whole, and maintaining such a reserve isn't the best use of investment earnings. Therefore, the best moment for companies to encourage a buyer to make expenditures that would increase revenue is during a sale.

There aren't so many hotel ventures that would qualify as "core risk" investments. Venture capital, over and beyond the purchase price and closing fees, is often required for a hotel investment.

Most property deals are compatible with a capital-efficient strategy. What differentiates apart hotel transaction structures is the timing and manner in which capital is invested in the asset.

Spending on things like new paint, carpet, and furniture, fixtures, and fittings (FF&E) that are visible to guests yields the most return in terms of increased income. Guests will continue to enjoy the same high standard of service for many years to come thanks to upgrades to the building's systems and envelope.

Make sure that your investment capitalization strategy is consistent with your business strategy.

Ultimately successful businesses have well-thought-out capital structures that take into consideration not just ordinary and preferred shares but also debt maturities and prepayment charges. A high-octane bridge loan that allows for free prepayment is well-suited to a fix-and-flip plan but would be a hindrance to a long-term hold strategy.

Establishing a Strong Foothold in the Market

Due to the accessibility of customers via social media and online travel agencies like TripAdvisor and Yelp, hotels in big markets are relying less on brands than they formerly did (OTAs). Although, the brand is still very important to hotels in secondary and tertiary regions.

Regardless of the real quality of the hotel given its location and physical attributes, the quality of the visitor experience is determined by the hotel brand. As a result, the strength of your brand in the marketplace is a limiting factor in the rates and occupancy you can achieve.

The Art of Dividing Up the Market

When it comes to hotel sector data, no one does it better than Smith Travel Research. Every year, based on the previous year's worldwide system-wide average daily rate, they compile a list of brands to place in a certain peer group using a chain scale (ADR). In order of decreasing average daily rate (ADR), with examples (2018):

Luxury – Four Seasons, Fairmont, JW Marriott, Ritz-Carlton, W Hotel

Upper Upscale – Marriott, Hilton, Kimpton, Renaissance, Sheraton

Upscale – Courtyard, DoubleTree, aloft, Residence Inn, SpringHill Suites

Upper Midscale – Holiday Inn, Country Inn & Suites, Hampton Inn, Home2 Suites

Midscale – La Quinta Inn & Suites, Ramada, Wingate by Wyndham, Candlewood Suites

Economy – Motel 6, Red Roof Inn, Super 8, Extended Stay America

You probably notice some critical distinctions between the brands listed, aside from cachet of the brands in the luxury and upper upscale chain scales. Most of the economy and midscale brands are limited/select service or extended stay offerings, while brand flagships are usually in the upper upscale segment.

Customers' impressions of a hotel and their choice to stay there vs another similar establishment are heavily influenced by the brand's standards. While loyalty programs do play a role for many vacationers, customers largely place brands in their minds based on how consistent the chain is.

Adoption of a Brand Widespread

Both upper midrange and luxury brands are in demand among travelers and are relatively inexpensive to create. It's expensive to construct luxury and ultra-luxury residences, and their service offerings are better suited to city and resort settings. Thus, most recently built hotels cater to the upper middle class and the affluent.

There is competition among hotel chains to provide their products. The more locations they have on the map, the more likely they are to attract new customers and build their loyalty program. Therefore, they see the establishment of new chains as a crucial component to their expansion goals.

Having the right product at the right place at the right time is crucial to your market positioning. As time goes by, guests' tastes evolve. Even if there is more supply than demand, a savvy sponsor might adapt existing facilities to optimize profits.

Encumbrance of Contracts

Hotel rooms are rented out on a nightly basis. In this way, the owner might benefit from the rising cost of living as the economy improves rapidly. However, the prices in many service and labor contracts are locked in for at least a year. This inflation arbitrage may result in substantial gains during prosperous times but pose significant difficulties during recessions.

Your real estate taxes, insurance, and debt service payments are owed regardless of your income situation.

It's not just your bottom line that contracts affect, but also your standing in the market. Costly modifications to take advantage of market movements may be required if the brand license agreement and management contract impose such limitations. In addition, rooms that might otherwise be accessible during peak demand are used by revenue contracts, such as those with large business visitors or social groups.

An often-overlooked source of market value, contract planning is crucial.

Whether they are paying to stay or invest, visitors and financiers alike want to know they are making the most of their money. When it comes to making money, it's crucial that the hotel be able to draw in the ideal clientele and charge premium rates. The same is true with hotels; their resale value hinges on whether or not the next owner can increase profits.

You should provide the buyer with as much wiggle room as possible in the contract. Try to create mutually beneficial contracts with revenue and service suppliers or at least restrict contract terms and give termination alternatives upon sale.