International hotel flags: an owner’s risks and rewards
15 June 2017
Many hotel owners seek to brand their properties through arrangements with international hotel brands, largely due to the increased exposure and business that often result from being part of a global marketing and reservations network. In turn, many international hotel brands are actively seeking growth opportunities on a global basis, particularly in emerging markets locations. We discuss some of the key issues a hotel owner may encounter when entering into a branding arrangement and acquiring an international hotel flag.
Acquiring a flag
A hotel typically acquires its brand name or “flag” through an operating agreement with the hotel brand. The brand will have exclusive possession of the hotel property and control of hotel operations; or through a franchise agreement, the hotel owner or an independent manager will operate the hotel with the franchisor providing the brand identity. Both a branded operating agreement and a franchise agreement will be negotiated based upon the brand’s form of agreement, which heavily favors the brand and provides relatively few rights to the hotel owner. Therefore, it is important that the owner enlists the help of experts on both the business and legal fronts who can advise on the best strategies for obtaining the most advantageous deal through such agreements.
The hotel owner should anticipate that the hotel brand will require extensive information on the owner’s structure, principals, financial condition and sources of debt and equity finance. Because transactions involving hotel properties often involve valuable business assets and so may offer opportunities for concealment of illegal sources of funds; such deals may be viewed as vulnerable for infiltration by money launderers. Most international hotel brands are legally required to perform extensive due diligence to confirm that the hotel owner complies with applicable anti-terrorism laws; particularly anti-money laundering laws that were enacted in the effort to prevent, detect and prosecute international money laundering and the financing of terrorism.
Many hotel brands conducting business on a global scale are also responsible for compliance with the anti-bribery provisions of laws such as the US Foreign Corrupt Practices Act and the UK Bribery Act. Hotel brands particularly will be attuned to how any applicable anti-bribery laws relate to dealing with local partners, local governmental officials and other parties involved in the transaction. As a result, international hotel brands typically require that hotel owner to provide detailed disclosures as to the nature of its business dealings with local governmental officials.
The fee structure of the deal will vary depending on the type of agreement. For an operating agreement, there are usually two main fee components: a base fee, expressed as a certain percentage of annual hotel revenues, and an incentive fee, which is typically a certain percentage of annual gross operating profit of the hotel (although the incentive fee structure is often negotiated). Franchise agreements commonly require payment of franchise royalties based on a certain percentage of hotel room revenues per year.
In addition, both operating agreements and franchise agreements require a number of services fees, such as covering the cost of the brand’s:
- central reservation system,
- central marketing and advertising programs,
- accounting services,
- technology hardware and software installation and upgrades, and
- personnel training. In total, such services fees can be very expensive for the owner, but they are almost never negotiable. On the other hand, the hotel stands to gain certain competitive advantages and operational efficiencies through the use of such services that are not typically enjoyed by a non-branded hotel.
As international hotel brands seek to expand their presence in particular markets, hotel owners desire a territorial restriction that protects the owner from any expansion of the brand that could have a detrimental impact on the hotel. Hotel brands routinely agree to grant such protections to the owner within certain periods of time and within a certain distance from the hotel; although the brands rarely agree to a territorial restriction for the entire term of the agreement or for significantly large areas.
Hotel owners should also anticipate that brand standards may include certain requirements that are in excess of the requirements of applicable local laws. For example, regardless of location of the property, many of the major hotel brands require that their flagged hotels worldwide comply with specific disabled access requirements and “green” standards applicable to hotel design, construction and operation. Therefore, hotel owners need to make sure that their feasibility studies and project budgets take into account the cost of various brand requirements that may exceed the standards mandated by local law.
The concept of brand standards offers both advantages and challenges for a hotel owner. Generally, the concept includes criteria that define all aspects of the hotel brand (for example, physical design, standards for furniture, fixtures and equipment, standards of operation and maintenance, life safety standards, and levels and types and standards of services and amenities). Operating agreements and franchise agreements often allow the brand maximum flexibility to revise and upgrade the brand standards over time. From the brand’s perspective, this ability to change and improve brand standards is crucial to the brand’s ability to stay competitive and produce optimum profits for its hotel owners. While the owner and the brand are aligned in their desire for the hotel to succeed, the owner’s concern is that the ongoing cost of compliance with these standards may ultimately reduce the owner’s return on investment. In many cases a balance is achieved in practice (if not in the agreement itself), as hotel brands are generally not incentivized to deal arbitrarily or unreasonably with their hotel owners on this front.
A final word
While we have given a brief overview of certain major issues involved in branding a hotel with an internationally recognized flag, there are many other considerations that need to be addressed by the parties to any hotel operating agreement or hotel franchise agreement.
For more information on the issues outlined in this article and to discuss possible expansion opportunities please contact Ellen Smith or Susan Samuel using the details below.