Ms. Gorman

Hospitality Law

Incentive Fees: Aligning the Owner's and Manager's Interests

Do you get what you incentivize?

By Tara K. Gorman, Partner, Perkins Coie LLP

In this economic environment, hotel owners and managers alike are doing all they can to ensure that their hotel is profitable. The structure of the Incentive Fee is a key element to aligning the interests of the hotel owner and the hotel manager. Does the Incentive Fee structure get what it is intended to incentivize?

The Hotel Management Agreement is the key document that governs the relationship between hotel manager and hotel owner. Typically, the compensation to the manager is split into two components: Base Fee and Incentive Fee. The Base Fee is usually a percentage of gross revenues of the hotel. The Base Fee percentage typically ranges from 2.5% of gross revenues to 4% of gross revenues. Some hotel managers even negotiate a minimum base fee on a dollar figure per room per annum. This way no matter how the hotel does, going into the deal, the manager knows it is guaranteed a minimum fee. Clearly, the minimum fee - or the floor - is far less than the manager expects to make, but in the event that the hotel doesn't do well, the manager has minimized its risk by negotiating a minimum fee from the outset.

Gross Revenues - No Incentive to Keep Costs Down

What is interesting about the structure of the Base Fee is that it is calculated on a percentage of gross revenues. This inherently provides the manager with no incentive to minimize the operating expenses. To illustrate the point, we will use an absurd example and strip away all the factors that make a manager a good manager, such as being fiscally responsible and capable at its job, and complying with the annual budget. For easy math, in the event that the hotel achieves gross revenues of One Million Dollars and the Base Fee is three percent (3%) of gross revenues, the Base Fee due to the manager would be $30,000. Using that same example, there is no change in the Base Fee if the manager is incredibly frugal, pinches every penny and keeps the operating expenses to $75,000, or if the manager is fiscally irresponsible, money burns a hole through its pocket and racks up operating expenses of $1,000,000. The operating expenses have no impact on the Base Fee whatsoever because the Base Fee is based on gross revenues - i.e., how much money comes into the hotel, not how much money goes out of the hotel to pay operating expenses. To go back to our example, both the penny pinching manager and the fiscally irresponsible manager are still entitled to a Base Fee of $30,000. Clearly, the fiscally irresponsible manager has failed any performance test, and is terminated, but for our absurd example, there is no change in the Base Fee. The bottom line is that the structure of calculating the Base Fee as a percentage of gross revenues gives the manager no incentive to minimize the operating expenses. Therefore, the interests of the owner and the manager are not aligned - as the owner is focused not only on gross revenues, but also on profits - simply, revenues less expenses.

Basic Structure of Incentive Fee - Profits

Unlike the structure of the Base Fee, the structure of the Incentive Fee is designed to align the interest of hotel manager and hotel owner. Over the past two decades the hotel industry has focused more on the Incentive Fee and has used the Incentive Fee as a vehicle to align the interests of hotel owner and hotel manager. The negotiation of the Incentive Fee can be quite contentious, as there are a variety of factors that can go into the calculation of the Incentive Fee. The basic structure of the Incentive Fee is a percentage of gross profits - gross revenues less operating expenses. Before we even add in the other factors, it is clear that this structure gives the manager an incentive to minimize the operating expenses. To go back to our example, in the event that the Incentive Fee is fifteen percent (15%) of gross profits, the Incentive Fee for the penny pinching manager would be $138,750, while the fiscally irresponsible manager would be entitled to nothing. The definitions of "gross revenues" and "operating expenses" are critical even in this basic Incentive Fee structure. Hotel managers and owners can spend hours negotiating which items will be included and excluded in these definitions. That discussion is beyond the scope of this article.

Incentive Fee - Raising the Bar

Many owners have raised the bar on managers by requiring the managers to meet a certain level of profits before the manager is entitled to share the wealth and earn an Incentive Fee. The "Owner's Priority" or "Incentive Fee Threshold" is designed to ensure that the owner is rewarded for taking the financial risk of developing and owning the hotel, prior to the manager sharing in the profits. Sometimes the Owner's Priority or Incentive Fee Threshold is a hard number, and sometimes it is a percentage of the debt on the property. The negotiation of the where to set the bar is often a long and arduous process. No matter how the Incentive Fee is structured, the idea is that all of the profits below the Owner's Priority or Incentive Fee Threshold belong to the hotel owner. In the event that the manager runs a tight ship and is able to meet or exceed the bar set for the Incentive Fee calculation, the manager is then entitled to an Incentive Fee.

The More the Merrier

Some owners and managers structure the Incentive Fee as a "sliding scale" -- the greater the profits, the greater the Incentive Fee percentage. This sliding scale option can be used with the basic Incentive Fee structure, or with the Owner's Priority or Incentive Fee Threshold structure. The owner and manager negotiate several breakpoints and as the manager meets or exceed these breakpoints, the Incentive Fee percentage increases. Therefore, the greater the profits, the higher the percentage of profits are earned by the manager. This structure clearly incentivizes the manager to increase the gross revenues and minimize the operating expenses, in order to increase the profits to the greatest extent possible - to increase the Incentive Fee percentage - and thereby, sharing the wealth.

Incentivize Stability

Another approach is the Income Before Fixed Charges (IBFC) calculation for Incentive Fee. This approach is widely used in Europe and Asia. Income Before Fixed Charges generally is calculated by deducting from gross profits manager's Incentive Fee, debt service on any mortgage, capital repairs and other expenditures which are normally treated as capital expenditures under the Uniform System or GAAP, insurance, taxes and deposits into the reserves. In order to incentive managers to keep the hotel stabilized in distressed hotel situations, the Incentive Fee may be based on an improved IBFC. Therefore, much like the Incentive Fee Threshold, the Incentive Fee is based on a hard number or a threshold that the manager must meet or exceed prior to earning an Incentive Fee. The idea is to incentivize the manager to improve the situation. So even if the IBFC is negative, if there is an improvement from the prior year, an Incentive Fee is earned.

No matter how owners and managers structure the Incentive Fee, taking into consideration operating expenses, and profits aligns the interests of owners and mangers and therefore incentivizes the managers to minimize operating expenses and to be fiscally responsible. The often difficult negotiation the Incentive Fee structure and calculation is well worth the effort to ensure that owner's and manager's interests are aligned and that both parties are incentivized to make the hotel profitable.

Real estate attorney Tara Gorman represents sellers, owners and licensors in the acquisition, disposition, finance, development, management and leasing of major hospitality, resort and commercial properties. Her property deal portfolio includes domestic and international hotels, office buildings, condo-hotels, water parks, casinos, restaurants and retail stores. Additional areas of practice depth include telecommunications and finance. Ms. Gorman can be contacted at 202-654-6253 or tgorman@perkinscoie.com Extended Bio...

HotelExecutive.com retains the copyright to the articles published in the Hotel Business Review. Articles cannot be republished without prior written consent by HotelExecutive.com.

Receive our daily newsletter with the latest breaking news and hotel management best practices.
Hotel Business Review on Facebook
RESOURCE CENTER - SEARCH ARCHIVES
General Search:

APRIL: Guest Service: The Power of a Smile

Adrian Kurre

When it comes to an exceptional customer experience, it’s not just what you offer, but how, when and why you offer it. Employed thoughtfully and effectively, efforts to drive customer service to new levels become infectious throughout a hotel organization, down to each individual property and team member. Easy to say, harder to execute. To stay on the forefront of providing the ultimate experience for business and leisure travelers takes continuous innovation. Integrating new technology, continuously improving team member training, and striving for targeted and personalized customer interactions remain essential to success now and going forward. READ MORE

Sue Garwood

In the hotel industry, excellent service is vital, as customers’ expectations continue to evolve, raising the bar and setting a higher standard. These days, a smile, “please” and “thank you”, just doesn’t cut it. Customers want to have memorable experiences they can walk away with, which is why hotels are implementing new programs to improve and monitor clients’ satisfaction. A good program today should highlight not only the importance of customer care, but also for each employee. Below are key aspects to keep in mind in order to build an outstanding customer satisfaction program. READ MORE

Naomi Stark

8,600,000. That is the number of results Google returns in .39 seconds on the search, “how many studies on smiling are there?” Scientists have explored every aspect of smiling. Apparently, it even was used in predicting the life span of baseball players in 1952 – extending the life of those with “beaming smiles” seven years!. Wow. Research studies prove every which way that our brain, our emotions, our body, our children’s development, our stress level, blood pressure - you name it - just about everything is benefited by the all-powerful smile. READ MORE

Jim Maguire

We know that guests always expect the absolute most from us. I would ask you before reading this article to think back to the last time you had a great customer service experience. I would bet it started with a warm and friendly smile that made you feel good. How we can win guests over with a service smile is quite simple in theory, not as easy to execute. It starts with a culture, a service smile, the positive actions that follow - I call this service the "Wow Factor" The "Wow" is all about how we make a guest feel when he/she is staying at the hotel. The end goal is to make your guests feel as though you went above and beyond to exceed their wants and needs. READ MORE

Coming Up In The May Online Hotel Business Review


{300x250.media}
Feature Focus
Eco-Friendly Practices: Doing Well by Doing Good
The hotel community continues to embrace sustainable development as a means not only to protect our environment, but also to optimize efficiency, realize cost savings, enhance guest satisfaction, improve employee morale, and manage investor expectations. Despite the lack of universally accepted metrics, the leading chains have incorporated eco-friendly policies, procedures, programs and training into their operations - both internally and externally - and their successes have been impactful and dramatic. In addition to more standard implementations such as LED lighting, waste recycling, reusing guest linens, and low-flow water regulators, some hotels have adopted more far-reaching solutions - commitment to the use of renewable energy; use of eco-labeled products; reduction of paper usage; purchasing of locally sourced and seasonal produce; ongoing measurement of carbon emissions; monitoring and analyzing energy consumption, the selection of suppliers and sub-contractors based on their own commitment to protect the environment; and compliance with all international environmental design standards. Remarkably, this comprehensive approach has resulted in enormous savings for some hotel operations. One major chain is projecting that it will realize US$1 billion in savings across the company's portfolio in less than 10 years. In addition, sustainability has become an important factor for guests when choosing a hotel. They want to know that a hotel has made a commitment to sustainable practices, and they expect honest and transparent communication about what steps a hotel is taking to produce a smaller carbon footprint. The May issue of the Hotel Business Review will document how some hotels are integrating eco-friendly practices into their operations and how they and the environment are benefiting from them.