This Article first appeared in The Oath, Middle East Law Journal for Corporates in April 2018/.
Joby Beretta, Founder of The Bench, explores the alternatives of hotel franchises, ‘manchises’ and leases and shares his take on the expected model of choice in the Middle East.
The Middle East hospitality industry has faced numerous challenges in recent years including political (e.g. the Qatari boycott), economic (e.g. increased hotel supply and currency fluctuations) and technological (e.g. the rise of online travel agents) etc. In Dubai, for example, hotels recently witnessed the lowest level of RevPar (revenue per available room) in a decade.
In light of these challenges, hotel owners should be questioning which model of hotel operation is the most suitable and profitable for them. Assuming that it is going to be a third party branded hotel, the main options available are as follows:
hotel management agreement (HMA);
franchise agreement;
‘manchise’ agreement; or
lease.
HMAs
The vast majority of hotels in the Middle East are operated under a HMA whereby the hotel owner appoints the operator, as its agent, to run the hotel. These are typically for a long duration (approx. 10-25 years depending on the brand) with very limited rights for the owner to terminate (e.g. a performance test). The operator receives various fees (base, incentive, reservation, marketing etc) for running the hotel and the owner takes the risk of the downside (when under-performing) but also benefits from the upside (once the fees have been paid).
Under this model the owner essentially hands over the running of the hotel to the operator who negotiates and enters into all relevant service contracts, employment contracts etc. in the name of the owner. The owner retains only certain limited approval rights e.g. annual budget, contracts over a certain value, senior appointments etc. The operator benefits from a wide indemnity in relation to the operation of the hotel excluding certain liabilities such as the operator’s negligence, fraud etc.
One of the advantages of this model is that the hotel owner can invest in the hotel sector without any hotel experience. The main disadvantage being the long lock-in period, during which the owner takes the risk of underperformance.
Franchise
Whilst franchising is common for restaurants its popularity hasn’t yet extended to hotels like in other parts of the world (such as the US and, more recently, Europe). Examples of hotel franchising in the region includes Dusit, Ramada and the Landmark Group. However, most groups are at least considering this option for the regional budget or mid-scale hotels.
Franchises are normally shorter term than HMAs (typically around 5-15 years) and the royalty fees are normally lower than HMAs. Under this model the franchisor provides the brand, distribution channels etc., but the owner remains responsible for the operation, subject to certain restrictions and approval rights of the franchisor e.g. in terms of the location, fit-out, etc.
This model therefore requires a higher level of sophistication from the owner in terms of operational ability. Where the owner does not have sufficient expertise, one option is to bring in a third-party operator (TPOs) or ‘white label’ operator to run the hotel under the franchise brand. We are already seeing the growth of TPOs in the region such as Aleph Hospitality, Riyad and fÁCIL. This requires the owner to enter into two contractual arrangements (i) the franchise agreement with the brand and (ii) a management agreement with the TPO. These TPO agreements are however typically shorter in duration (3-10 years), include lower fees and are more owner-friendly than a full-blown HMA.
In terms of advantages, the franchise model can be more profitable for both operator and the owner (even when paying double fees of a franchise and a management fee) if run correctly. It also enables the owner to retain control of the operation of the hotel (including OPEX) whilst still benefitting from the brand association.
Manchise
Manchises, as the name suggests, are a hybrid of a ‘management’ and ‘franchise’ agreement but the term is a fairly recent invention so the definition is rather fluid. Some operators perceive this as a franchise with a general manager or additional management support. The more common interpretation appears, however, to be a HMA, which then morphs into a franchise agreement after a certain period of time.
Manchises are common in China, India and Europe but are still rare here although Citymax Hotels publically announced their adoption of manchises back in 2014 stating, “Citymax will fully manage the new property for 3 years, establishing the brand concept, operating procedures, marketing mix, training procedures and run the hotel. After the 3 year period, once the hotel is established and successful, the owner will be able to resume management under a franchise.”
One disadvantage of this model is the legal complexity because it requires either (i) one complex agreement to deal with the management and the morphing into the franchise or (ii) two separate agreements (an HMA perhaps with an agreed form franchise agreement annexed). In addition, a TPO management agreement may be required. One key advantage is that the owner receives training during the initial years to enable it to then take over the reins, whilst retaining all the benefits of the brand association throughout.
Leases
Hotel leases are common in some European countries, such as Spain and Germany, but still fairly rare in this region. One example is the Grand Central Hotel Apartments in Dubai, which we understand was leased to the operator.
In this structure the owner leases the hotel to the operator on a fairly long-term basis (often around 10 - 20 years) in return for monthly rent payments. The lease is very similar to other commercial leases but with certain tweaks for hotel operations (such as opening hours, serving of alcohol etc.). A variation is a ‘sandwich’ lease whereby a lease of the hotel is combined with a TPO management agreement.
One key advantage of this model is that it provides hotel owners with a stable (often index-linked), long-term return on investment. The operator however assumes the risk of operational losses but with the potential upside of higher returns. One disadvantage is that commercial leases are often subject to registration fees (e.g. 4 per cent payable on long term leases in the UAE), VAT and/or similar taxes (depending on the jurisdiction).
Conclusion
We would recommend that hotel owners and operators in the region consider the above alternatives before launching down the traditional HMA path. The most suitable solution will depend on numerous factors such as the location and type of hotel and the risk appetite, operational expertise and financial expectations of the owner. Each model has its own pros and cons and the choice needs to be carefully made as it can have a major impact on both the profitability and valuation of the hotel.
Our expectation is that we will see an increase in the use of franchise and manchise models (coupled with TPO agreements where necessary) – at least in the Middle East budget and midscale sectors. HMAs are however likely to remain the model of choice in the luxury sector, with hotel leases remaining fairly rare.