Incentivizing Innovation in the Hotel and Lodging Industry
How the Standard Hotel Management Agreement Inhibits Tech Adoption
By Jason Shames, F. Philip Lólis and Tyler Carrico | March 22, 2023
In 2011, Marc Andreesen wrote that “software is eating the world.” That same year, Gartner estimated global enterprise software spending was $269 billion. For 2023, Gartner estimates global enterprise spending will be $790 billion. The 3x growth since then and the accompanying rise of unicorns have confirmed that software has indeed eaten the world. However, the hospitality industry, the lodging sector particularly, has been slow to adapt, with some of the most well-known and valuable hotel brands still relying on legacy tech developed in the 1990s. With hotel industry revenue projected to reach over $408 billion in 2023, this represents a multi-billion-dollar opportunity for the next generation of SaaS builders.
Various factors explain, in part, the lack of tech innovation and software adoption in lodging. But what causes the most inertia is the fragmented, tripartite operational ecosystem.
The conflicts of interest in this ecosystem make selling software into it challenging. The owner’s interest is in maximizing return on investment by increasing net operating income and, in doing so, their asset’s value. While owners are most incentivized to optimize their technology stack and receive revenue through lower-cost distribution channels, this cohort is often real estate professionals who are rarely aware of the underlying systems. The manager is most interested in driving top-line revenue because that is how they are paid. The brand, if it is not also a manager, charges a franchise fee under a separate franchise agreement and is thus more interested in driving direct channel bookings and loyalty membership, often uncorrelated to property-level profit. The brand also has an interest in mandating the use of its own legacy tech stack that often has issues integrating with the latest tech. Given the short-term investment horizons and focus on top-line metrics, there is little incentive to introduce new productivity, distribution, operating or guest-facing technology.
The hotel management agreement (“HMA”) binds these stakeholders together. This document, present in nearly every hotel transaction in the world, is focused almost entirely on top-line incentives. There is an opportunity to create value for the entire industry by re-imagining the HMA to be more profit oriented.
The HMA Has Remained Largely Unchanged Since the 1960s.
Initially, there was no need for an HMA because the hotel's owner was also the manager. If the hotel owner did decide to outsource management, the structure was essentially a real property master lease. As industry leaders and visionaries like Conrad Hilton and Bill Marriott rose to prominence, these hoteliers discovered that the key to growing their brands was an asset-light, franchising model.
Franchising fragmented the unity of ownership and forever changed the way hotels operated. The first HMA was created for the Hong Kong Hilton in 1963 (also the first hotel ever to offer a “liquor-stocked” mini-bar). Hilton used the HMA to expand internationally, and Marriott and Hyatt followed Hilton’s lead. The HMA gained so much traction that it became popular domestically. Since then, this document form has remained largely unchanged.
Initially, the brands, who often were also the managers, held the most bargaining power because of their operational expertise, brand affiliation, and distribution channels. The pendulum began to swing in favor of the owners as more sophisticated players like private equity funds and REITs entered the market. However, the rise of third-party hotel managers has introduced a new power center into the mix, slowing the continual rebalancing of stakeholder interests.
The Provisions of a Hotel Management Agreement Most in Need of Reform.
The HMA is the central governing document for the relationship between the owner and the manager, who may be a brand or a third-party manager. These agreements are lengthy and complex, but there are four hotly negotiated provisions: (1) base fee; (2) incentive management fee; (3) term and early termination; and (4) annual budget.
Base Fee
The base fee is paid by the owner to the manager monthly, generally on 1-3% of gross revenue generated on the property. The base fee provides for centralized system services like financial planning, product planning, HR, and corporate executive management and the base fee may also include manager assistance with the acquisition and sale underwriting process.
In addition to the base fee, managers also charge, as a percentage of revenue, marketing, sales, implementation, design, and project management fees. At times, managers recharge for other services like accounting support, revenue management, and reservation support, which arguably could be included in the base fee.
In the past, revenue-based fees and RevPAR performance were more aligned, but because of the increased variability of room night costs based on distribution channel, the correlation has eroded.15 Today, the lack of correlation creates a moral hazard for managers who are entirely focused on top-line performance. For example, a manager could spend excessively on indirect booking channels to maximize hotel occupancy and revenue but create a loss for the owner because the marginal cost of these additional bookings is greater than the marginal profit.
Incentive Management Fee
Increasingly, incentive management fees (“IMF”) are being included in HMAs to better align interests between the parties. IMFs are commonly expressed as a percentage of net operating income in excess of an owner priority hurdle. This motivates the manager to earn a higher payout by maximizing the hotel's net operating income by increasing operating efficiency. However, IMFs are not omnipresent in HMAs, and even when IMFs are present, they do not appear to be strong enough, as research shows, that managers rarely generate such fees.
Term and Early Termination
The term of an HMA can be anywhere between five and thirty years, followed by a series of renewals that can potentially create an aggregate term of over fifty years, especially in the luxury category. The inherent issue with such long-term agreements is that it can be difficult to remove underperforming managers. Overall, the general trend has been to shorten the term, but issues with terminating underperforming managers remain.
To keep interests aligned over time, a performance test provision has emerged to provide for early termination. The performance test is normally based on the manager’s failure to achieve both a percentage of pre-approved budgeted GOP and a percentage of RevPAR for an agreed-upon competitive set for two consecutive years. This competitive set is usually selected by considering location, property type, number of rooms, brand affiliation, amenities, and conference or meeting spaces. But again, this benchmark is based entirely on top-line performance figures.
Even when the manager fails these performance tests, there is usually a right to cure, sometimes without limitation. Early termination was impossible in the past, but it's only nearly impossible today.
Annual Budget
One of the most defining elements of the relationship between manager and owner is the annual budget provision. A once-annual budget review disincentives optimizing operations, particularly if there is little or no IMF. After the budget is negotiated, the manager has almost absolute authority over day-to-day operational matters. So, the owner’s annual budget review and approval rights are critical to keeping incentives aligned and controlling costs. The cost constraints of a budget force managers to seek out immediate ROIs and limits spending on SaaS products that can improve profitability. Shunning software innovations hinders improvements within the industry as to both profitability and guest experience. To avoid budgetary restrictions, management will often license new products not as ongoing operating costs (SaaS) but instead as a take rate or commission model.
Four New Operational Models Have Emerged in Response to HMAs’ Ineffectiveness.
The HMAs’ focus on top-line success leaves little incentive for managers to maximize bottom-line NOI or implement guest-facing technology. Implementation risk is high, and there is little to no upside for these managers to experiment. This is concerning because the managers are the stakeholders best positioned to implement change. They are in the thick of operations and can understand the value of the technology investments quickest; they are the ones in charge of implementing these technologies at the property level and are major constituents of the big brands with the ability to lobby for the adoption and integration new technology.
While HMAs have yet to adapt quickly enough, alternative operational models have risen to reflect the disequilibrium. First, unity of ownership has resurged in popularity demonstrated by CitizenM, which by being both owner and operator, gives the company the freedom to focus on profitability, efficiency, and guest satisfaction. Because it was only founded about 15 years ago, CitizenM designed its tech stack from scratch and made it completely modular and cloud-based to maximize flexibility. Their tech is divided into four silos: (1) on-premise and networks; (2) hotel systems; (3) revenue management; (4) and guest-facing tech. Each room has a CPU room controller that links to a network that is connected to the hotel system. These CPUs are guest-centric and not room-centric like a traditional PMS. This allows CitizenM to capture micro details like lighting, temperature, and any other specifics that are stored into the guest profile upon check-out, allowing for a truly personalized experience. The results have been high guest satisfaction, net promoter scores in the 60s, and a recent $1 billion dollar capital raise for global expansion.
Second, there is the return of the master lease agreement with short-term rental managers like Sonder opting for a lease arbitrage approach. This gives managers all the upside but also all the downside of operations. At first glance, this makes sense; if your operations and tech are more efficient and profitable, you should bet on yourself. However, holding a master lease makes operators asset-heavy with upfront working capital and capital expenditure requirements. Asset-heavy operators will be focused on profitability. But the heavy capital expenditure undermines tech investment, and the scalability of these business models has yet to be proven.
Third, distribution costs are a significant factor that impacts hotel profitability. Looking at Gross RevPAR or ADR29 without determining the distribution costs associated with direct and indirect channels (like Online Travel Agencies) is not enough. With distribution costs ranging up to 35% per reservation, all bookings are not created equal. Kalibri Labs uses analytics to determine Contribution Profit, which helps hoteliers simplify channel cost reporting to optimize profitability. Startups like Skipper further assist hotels in driving increased direct reservations, the channel with the highest profit margin. Combining the knowledge of net distribution costs and the ability to improve direct distribution is an important value proposition for ownership and management.
Fourth, is the potential rise of tech-enabled property management companies that strive to maximize operational efficiency and profitability. Ideally, these tech-enabled property managers would be able to remove or reduce revenue management and finance department personnel at the property level and automate general hotel operations to allow front-line employees to do what they do best: host. Life House is a company that is doing this by creating a singular hotel operating system (“OS”) that today layers on top of a hotel’s existing system (for example, a property management system like Opera), and over time replace all systems. The clean hotel tech architecture allows for integration with industry-agnostic software products that otherwise can’t be used in the industry. Theoretically, these tech-enabled property managers should be able to charge lower base fees and back-up efficiency claims by demanding higher IMFs.
It Is an Exciting Time to Be a Part of the Travel and Hospitality-tech Ecosystem, and HMAs Should Not Stand in the Way.
The current market represents an ideal opportunity for stakeholders to push forward more profit oriented HMA terms. As travel is experiencing a strong recovery, even without significant inbound Asian tourism, and given the expectation of continued rate hikes by the Federal Reserve, hotel demand growth is expected to continue to exceed supply growth over the next four to five years as the cost of capital remains high.30 This mismatch will shift more negotiating power into the hands of owners who have record levels of dry powder waiting on the sideline.31 With that said, owners should also have the foresight to properly incent managers by structuring better IMFs and consider allowing managers to participate in liquidation events.32
Most of the change will initially start with the independent hotels as the brands retain strong negotiating leverage through their distribution channels. However, players like CitizenM, Sonder, Kalibri Labs, Skipper, and Life House are a direct reaction to the lack of innovation in space. If they can show significant, sustained success and eat away at the incumbent market share, the brands will also agree to more profit oriented HMAs. The pandemic was a near-death experience for many legacy players and has been a wake-up call. Given the massive tech opportunity and shifting market dynamics, the next few years will be an exciting time to be a part of the travel and hospitality-tech ecosystem. We should not let the traditional HMA, with little change in over 50 years, stand in the way of this progress.
Disclaimer & Disclosure The views and opinions of authors published on this site do not necessarily reflect those of NYU, Skipper, or Derive Ventures. Reference to any specific products, processes, or services by trade name, trademark, manufacturer, or otherwise does not necessarily constitute or imply its endorsement, or recommendation. Nor shall any information or statements contained in this article be used for the purposes of advertising, or to imply an endorsement or recommendation.
The authors have beneficial positions in the shares of Life House and Skipper either through stock ownership, convertible note agreements, or other securities. The authors wrote this article themselves, and it expresses their own opinions. The authors are not receiving compensation for the article.
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16. Id.
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21. Id. at 32. 22. Id.
23. Ira Vouk, Hospitality 2.0: Digital Revolution in the Hotel Industry (2022), at 256.
24. Id. 25. Id. 26. Id. 27. Id. 28.
Id. at 253; Cameron Sperance, CitizenM Targets U.S. for Next Wave of Expansion, Skift, Jan. 13, 2022. https://skift.com/2022/01/13/citizenm-targets-u-s-for-next-wave-of-expansion/.
29. Average Daily Rate.
30. Bryan Wroten, Rates Drive US Hotel Recovery but Lag Inflation in Most Cases, CoStar & Hotel News Now, Jun. 10, 2022. https://www.costar.com/article/2002172162/rates-drive-us-hotel-recovery-but-lag-inflation-in-most-cases.
31. Bryan Wroten, After Slower Year, Expectations for Hotel Deals Pace Rise in 2023, , CoStar & Hotel News Now, Dec. 27, 2022. https://www.costar.com/article/502286567/after-slower-year-expectations-for-hotel-deals-pace-rise-in-2023?utm_source=newsletter&utm_medium=email&utm_campaign=hospitality&utm_content=p1.
32. KSL Capital Partners and other private equity (PE) firms in the space do this already through management incentive programs. Essentially, this is a promote paid to the manager if the property produces cash flow (both interim and at exit) above the PE’s base-line return hurdle based on the cost basis. For example, if the property achieves above an 8% internal rate of return (IRR) the general manager and other senior level employees at the management company will receive 13% of the gain above the 8% IRR. This is in addition to the IMF. Because it is tied to the original acquisition price it deters the manager from encouraging the owner from overpaying for an asset. This is a structure more relevant to PE and owners with limited investment horizons. Unfortunately, the limited time horizon does not incentivize tech adoption that may take longer to integrate and create value.
