Brand or third-party managed?
Brand or third-party managed?
26 NOVEMBER 2019 8:24 AM

With the number of different brands popping up around the globe, it’s important to consider a variety of factors when choosing a management company.

Hotel owners confront many important decisions when they purchase or develop a hotel: Franchise or independent? Who will manage the hotel? Those choices have been made even more difficult today with so many new hotel brands sprouting around the globe. Once owners wade through the endless array of brand alternatives, they must then choose a hotel manager, and that brings them to the question of whether to go with a brand manager or third-party operator.

There is no right or wrong answer. It hinges on many factors, ranging from the specific marketplace to which manager best aligns with an owner’s goals. In general, consider three dynamics when picking a management entity.

Abilities: Who is the most capable manager? Brand managers and third-party operators each possess management talent, so there isn’t much difference there. A brand manager understands its brand company inside and out and knows who to call when a problem arises.

Similarly, a third-party manager employs a deep bench with an army of GMs and directors of sales across the country. Their brand knowledge will be more diversified, since they likely manage a variety of lodging flags. They know the strengths and weaknesses of the other brands in a hotel’s market.

Economics: Who has the least costly fee structure? A brand or third-party manager typically charges a base fee of approximately 3% of total hotel revenue. Hotel management contracts feature incentive clauses as well. The incentive fee is typically a certain percentage of profit over an agreed-upon threshold, such as an owner’s preferred return or a budgeted gross operating profit.

Regarding fees, “brand-managed” properties hold an important advantage. If a hotel is managed and owned by the same brand, the 5%-6% (of room revenue) franchise royalty fee that is typically charged under a franchise agreement will be waived. Under certain circumstances, that could make or break the deal. Otherwise, third-party or brand-managed fee structures are also essentially the same.

If those factors are equal, the next fact to consider is who represents the owner’s interests above all else. Again, that answer hinges on several unique elements.

Alignment: What are the compatibilities between owner and manager? When the fee structures and abilities of each type of management entity are equal, an owner then judges which one best matches their interests. In a third-party manager’s favor, for example, the manager may contribute equity in the capital stack – or puts “skin in the game.” This incentivizes the operator to make the hotel profitable, and aligns interests with ownership. There are also situations when an owner has several hotels invested in other hotels operated by a brand or third-party operator. The owner has a track record with the manager. There’s an element of familiarity and trust involved in these decisions.

The specific marketplace where the hotel operates can also influence the management company decision. In large urban markets — New York City for example — the majority of big-box full-service hotels operate under union contracts negotiated by the Hotel Association of New York City (HANYC). The contract contains an accretion clause, requiring management companies that are party to the agreement to recognize the union at all hotels they operate within the city. This may eliminate their ability to operate non-union hotels.

The accretion language virtually eliminates the brand management choice in non-union circumstances in those heavily unionized markets. Accordingly, if purchasing a non-union hotel, and trying to maintain the non-union status, brand management may not be an option.

In situations where the hotel is required to be unionized, any wage and benefit advantage of third-party operators is eliminated, hence leveling the playing field. However, the brand management contract eliminates the 5% royalty fee, which may provide a substantial savings to the owner. For example, $10 million a year on room revenue at a 5% royalty fee equates to $500,000 in annual savings, which tips the scale in favor of brand management.

Conversely, a third-party manager may oversee a number of hotels of various brands within a city and therefore is familiar with the dynamics of the marketplace.

Additionally, asset type affects the choice. An owner of a 1,000-room convention center hotel where the brand has a national sales presence provides tremendous marketing clout for the property. A brand manager for that property would make sense.

Investment timeline
Ownership’s investment timeline is yet another consideration. Third-party management contracts are typically shorter than brand-managed agreements, which enables owners to sell the property unencumbered by a lengthy management agreement. This widens the pool of potential buyers and potentially increases the value of the asset at time of sale.

In most circumstances, brands may offer the opportunity to convert the hotel management agreement to a franchise agreement after some predetermined hold period, typically three to five years. The option to convert to a franchise is not a standard feature; it needs to be negotiated and included in the initial HMA. The owner is then able to go to a prospective buyer after the hold period and offer the hotel unencumbered of management.

Perceived conflict
Unfortunately, brand managers sometimes have to battle a perceived conflict of interest. Brands insist they operate from an owner’s perspective, but their loyalty may lie with the brand. When launching a new brand initiative, the brand-managed hotels are the earliest adopters, even though the new program might cost the owner major dollars.

On the other hand, third-party managers think more like an owner because that’s who they represent. In that regard, the third-party manager may help the owner save money by postponing adoption of a new system.

An owner must weigh all of these elements when choosing a manager. Assuming brand and third-party managers are competing on equal footing and the only significant difference is the elimination of the royalty fee, the question becomes, Can a third-party operator operate this hotel more efficiently then the brand, and save the owner more than the savings in the royalty fee? Ultimately, the decision to choose a brand or third-party operator is based on circumstance, not preference.

Gary Isenberg is President of LW Hospitality Advisors Asset & Property Management Services. With more than 30 years of diversified hospitality experience in Hotel Management, Finance, and Asset Management, Gary’s expertise includes third party asset management, serving as an owner’s representative, due diligence for real estate investors, and development services to negotiate management or franchise agreements. His asset management specialties include, among other services, capital budgeting and PIP costing as well as internal control and accounting.

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