If you are dealing with a major brand as manager, there is not much you can do. There is more ability to negotiate a bit better protections with an independent unbranded manager.
How should foreign investors negotiate penalty clauses in hotel contracts?
We are a Chinese asset management company investing in several hotels that we are managing at a distance. However, we want to protect our investments. If the hotel runs over budget, we want to make sure to penalize that scenario. What are our options for doing that?
When entering into a hotel management agreement, a key clause would be the performance test. The performance test is a mechanism that enables an owner to terminate a hotel management agreement due to the operator's poor performance. The owner can terminate the agreement with the operator if it fails a two-limbed test: a) Gross Operating Profit Test, in which the hotel manager has to achieve certain percentage of the budgeted gross operating profit contained in the annual budget, usually 85% or higher; and b) Revenue Per Available Room Test in which it also has to achieve a percentage of revenue per available room Index of the competitive set of similar hotels in the similar locations, usually 85% or higher. If the operator fails to achieve the targets under the tests for two-consecutive years, as usually seen after a certain number of years after hotel opening, the owner can terminate its role as the operator. Usually in that circumstances, the operator may seek to avoid the termination by reimbursing the owner for the gross operating profit shortfall in one of the calendar years to achieve the gross operating profit hurdle. It is a principle in general that the owner shall be responsible for all costs of operating the hotel. Thus, it has the power to approve the annual budget prepared by the manager. The budget should include the operating budget (the revenue and operating expenses) and the capital budget (any improvements or alterations of a capital nature), allowing for say 10% increase for any major line item or 5% in the aggregate operating expenses as estimated by the manager. If there is any item in the annual plan that the owner and the manager cannot reach an agreement, usually there is an expert determination mechanism in the agreement that the parties will have an agreed third party expert who has no less than 10 years of experience in the hospitality sector to decide the fair position.
I am not familiar with the hotel sector. But I would suggest a fixed fee plus a variable fee based on the performance. Try to keep the fixed fee low and give more upside on the variable fee so that they are really incentivized for a good performance. But if it is over budget, then the operator won’t have any upside.