Incentive Management Fees and Condo Hotels – Is It Time for a New Formula?
In U.S. management agreements for traditional (non-condominium) hotels, incentive management fees are generally structured as a share of the profits. Under that scenario, the operator receives a percentage, usually between 10 percent and 20 percent, of “profits.” For this purpose, profits may be gross operating profit, net operating profit, or some hybrid referred to as adjusted operating profit, incentive fee income, or other contractually defined terms.
Far less common, but occasionally seen, are incentive fees based on numerical hurdles based on gross revenues alone, or in conjunction with gross or net operating profit formulas, such as a sliding scale that provides a higher incentive fee as the operating profit percentage increases. The hurdles that must be achieved may be absolute numbers, or base numbers subject to adjustment by reference to an index or percentage of adjustment every so many years. The specific formulas are limited only by the imaginations of those negotiating the management agreement.
Accounting Definitions Galore
Hotel management agreements contain definitions for virtually every material business term. This is especially so with respect to accounting definitions. Uniform System Of Accounts and Generally Accepted Accounting Principles (GAAP) definitions are modified to fit specifically negotiated business terms. In dealing with the incentive fee, many definitions come into play: gross revenues, operating expenses, gross operating profit, net operating profit and a category often referred to as “owner expenses” which includes items relating to asset ownership, rather than hotel operations. Most, if not all, owner expenses are carved out of the operating expenses definition. These include items such as taxes, insurance and debt service. The importance of characterizing an expense as an owners expense vs. an operating expense is that it will determine whether that expense is deducted from gross revenues in calculating the incentive fee. This results in considerable negotiation of the characterization.
Owner expenses frequently become factored back into the adjusted operating profit formulas and allow the owner to recover these expenses before the operator receives a share of the net operating profit, for example, as the incentive fee. Another item that is factored in is what is described as the owner’s return on equity. That is, the owner recovers a return (10 percent is most often used) on the cash it has invested in the hotel (“owner’s equity”). Management agreement definitions are specific in setting a limitation on the amount used in this calculation. We see this in both new build and reflag circumstances, which may include capital expenditures to satisfy property improvement requirements or other operator imposed expenditures.
All of this works quite nicely in the traditional hotel context. However, in dealing with a condominium hotel, owner expenses and owner’s equity no longer apply in the same way. This provides some challenges in appropriately rewarding good performance by the operator.
What Makes a Condominium Hotel Different?
A pure condominium hotel (where all of the hotel rooms are condominiumized and sold to the public) is typically structured in one of two ways. Both structures are designed to maximize control by the hotel owner of all areas of the project necessary to operate, maintain and manage the hotel and provide hotel services in accordance with brand standards, while passing through the costs of the operation and maintenance thereof to the condominium unit owners or the owner of the hotel operations. In this way, the value of the hotel operations is maintained as all facilities which impact the hotel guest experience are controlled by the owner of the hotel operations. The choice of one structure over the other depends on local law (including the condominium or common interest ownership act in the relevant jurisdiction), the elements of the project (will there be core hotel, condominium hotel, branded residences, and/or fractional components?) and the interrelationship of these components.
It’s All in the Structure
To the extent permissible under local law, the preferred structure is accomplished by creating a separate parcel or parcels of real estate outside of the condominium regime and therefore not subject to the condominium statutes and regulations, to include all (or depending on local law, most) of what would otherwise be common elements of the condominium (e.g., the underlying real property, all structural, mechanical and electrical components of the building, walls, hallways, roofs, balconies, entry area, public spaces, elevators, back of the house, front desk, parking, commercial and retail facilities, outdoor landscaped areas, any required ADA-compliant units.) This parcel is typically referred to as the “hotel parcel” and is retained and owned by the owner of the hotel operations. There can be a further segregation of the hotel parcel in the event that some portion of the parcel may be transferred, e.g., a restaurant, spa or casino. A condominium is then created on the remaining project components, consisting of airspace condominium units intended primarily for transient occupancy use, to be sold to and owned by third-party purchasers, and minimal condominium common elements, to the extent required under local law. This entire structure is governed by an over-arching recorded covenant or declaration, referred to as a “shared facilities covenant” or “resort declaration” which serves to grant use and access to condominium unit owners of certain “shared facilities” within the hotel parcel, and to pass an allocated portion of the costs of the operation and maintenance of the shared facilities to the condominium unit owners. In the event this structure is not permissible under local law, the hotel parcel is included as a commercial unit within the condominium, with the shared facilities covenant recorded over the entire condominium regime.
As you can see, under the condominium hotel structure, the main hotel facilities (i.e., the hotel parcel) are owned by the owner of the hotel operations, and the hotel “rooms” are owned by individual condominium unit purchasers. This is a very different structure than a traditional hotel, where there is one owner of the entire hotel.
How Complicated Can It Get?
The first question that arises under a condominium hotel structure in figuring out how to calculate the incentive management fee under the above-referenced formulas is, “Who is the owner?” Another fair question is, “What number really reflects the owner’s equity?”
The first question has several possible answers. For purposes of calculation of the Incentive Fee, the Owner could be the developer. It could also mean the Owner of the Hotel Parcel, referring to the entity that holds title to the lobby, front desk, back of the house, and common and service areas of the hotel – essentially everything except the interiors of individual condominium units. The last possibility is that it refers to the owner of any condominium unit and the owner of the hotel parcel. The answer will be influenced by whom and by what mechanism the base management fee and incentive fee are calculated and collected under the hotel management agreement. Where the hotel operator is separated from direct contracts with the condominium unit owners and the condominium association, and looks only to the developer/hotel parcel owner for payment of its management fees, the operating expenses will be handled as in a traditional hotel and the incentive fees are directly or indirectly passed through to condominium unit owners through the condominium association by virtue of a management agreement between an entity controlled by the developer and the condominium unit owners, or through a document requiring contributions for maintenance of “shared facilities.”
Complicated enough? It gets worse when looking at the owner’s equity part of the incentive fee equation. For this purpose, owner means the developer. In the traditional hotel project, the developer would have invested equity for land acquisition and construction. Hotel management agreements generally will have an agreed number for the owner’s equity that will be used in calculating the incentive fee.
Where’s All the Equity?
Think about those same acquisition, development and construction equity contributions in the condominium hotel situation. Developers love doing condo hotels because there is a self-financing, built-in exit strategy. Rarely, at least in a successful project, does the developer have a long-term, significant, captured equity investment. The sales of the condominium units has taken out the construction loan and returned the developer’s equity dollars, plus a profit. Does this mean that in calculating the incentive fee, the owner’s equity number should be ignored or count as zero? If so, is 20 percent of net operating profit too high to reflect a true recognition of the operator’s successful management of the hotel?
There Are No Absolute Answers
The management agreement, with its many resolved business issues, determines what is fair or appropriate as a management fee package. Deal points like the base fee, key money, term of the management agreement and restricted territory are only a few of the factors. Like with most contract terms, creativity and knowledge of the current market are critical to resolution of the incentive fee formula in a condominium hotel management agreement. In a given case, perhaps an amount agreed as “deemed equity investment” will work to bring about the desired result. In another, a series of hurdles for gross revenues or operating profit percentage may satisfy the parties.
As in so many things relating to condominium hotels, the industry is working through challenges in a product type that while not truly “a new thing,” is one that is booming, becoming extraordinarily popular with developers and individual real estate investors, and has not yet been tested by running through the litigation gauntlet. Until that is all settled, careful analysis of transactions and cooperative negotiation of management agreements is essential.