How COVID Changed the Nature of Hotel Management Agreements

The onset of COVID left the hotel industry in disarray, as travel basically shut down nationwide overnight. But looking at the sector now, occupancy numbers have been rising rapidly, with expectations setting in that the sector could return to pre-pandemic numbers by 2024, according to CBRE. Partner Insights spoke with Michael Kosmas, a partner at Stroock & Stroock & Lavan LLP and head of its global hospitality and leisure practice, for insight on where the sector stands today, and how the pandemic has affected hotel management agreements.

 Commercial Observer: What is the status of the hotel industry today, and where does it stand compared to 2019 levels?

Michael Kosmas: There is a small subset of hotels that did better than ever during the pandemic in places like Miami and Scottsdale, where they didn’t go into full lockdown. New York is recovering — New York will always be New York — but most other big cities are seeing a much slower recovery. Business travel has not returned to what it was, and group business is recovering slowly. In a lot of core cities — Detroit, Baltimore, to some extent Washington, D.C. — business is climbing back, but it’ll be a few years before they get back to where they were.

Does Stroock represent owners, operators, or both?

We are an owner-side shop, and we primarily represent institutional and high-net-worth owners, investors and developers. It’s kind of like union law in that you typically don’t represent both. There are just too many issues that you don’t want to be on different sides of on a daily basis.

What were some of the more common situations owners and operators found themselves dealing with under hotel management agreements during COVID?

One huge issue was, who has the right to make the decision to shut down the hotel, whether partially or fully, and what does that decision-making look like? Operators wanted to protect the hotel, but they also wanted to protect the brand. Owners tended to be more focused on the bottom line. They may have wanted to shut down immediately to stop the hemorrhaging, where brands might say, look, we need to keep the hotel open to the greatest extent we can because if we shut down fully, and the hotel two blocks down keeps 20 percent of their rooms open, our customer base will shift to that brand. So there were points where the owners’ interest and the managers’ interest diverged. There was also the issue of the types of benefits to offer hotel employees. You have great employees who have been there for decades. Do you tell them to go get unemployment, or does the hotel do something in that area? No one was contemplating this in advance.

So when you started going through these agreements, who did have the right to decide to shut down a hotel?

It’s different in every agreement. COVID was so unprecedented that not too many people had negotiated agreements with this thought in mind. So the agreements were all over the board.

How did you help owners get past that?

We have deep experience and relationships everywhere. I represented Marriott for my first 10 years of practice, so I know how brand managers think. We were able to leverage that experience and say to our hotel owner clients, look, this is the conversation they’re having inside the building at Marriott right now. We helped owners manage requests and expectations considering what management companies would consider reasonable.

What were some other problems that arose from these agreements?

 Capex and maintenance issues — obligations under the agreements to spend so much money each year on hotel improvements, driven by the brand standards requirements. None of the brands behaved in a heartless way and most acted in a spirit of partnership with owners, but as the situation with COVID dragged on, you had to have often difficult conversations with your brands. For well-capitalized owners, this was a chance to improve and retool. For others, it was an effort to survive. So figuring out the owners’ long-term obligations for capital improvements and other projects was one issue. Also, guiding clients through insurance issues. Business interruption insurance was by and large not available to deal with COVID issues. There were also issues with lenders, since there was no money coming in the door, but debt service was still due each month. Our hotel management agreements typically provide that owners have to set aside around 3 to 5 percent of total revenue each year into a capital reserve fund, and the manager gets to use that fund for capital improvements — especially for FF&E (furniture, fixtures, and equipment). We were able to negotiate deals with a lot of our management companies and lenders to let us take money out of those reserves to allow the hotels to survive the worst of the pandemic, with promises to replenish the funds in the future. And to date every single one of our clients has lived up to those promises.

Given the circumstances hotels have faced through COVID, do you foresee permanent changes in the way these agreements are approached?

 During the pandemic, owners and management companies spent a lot of time thinking about their relationship, focusing on how everyone’s interests can be more closely aligned. To offer one example, before COVID, hotel management companies were almost always compensated with base fees that were solely a fixed percentage of top-line revenue. Now, base fees in many deals are moving away from compensation based on top-line revenue, to compensation based on actual revenue to the owner.  This has typically been the way of calculating incentive fees, but now a bigger portion of the overall management fees are being determined by bottom-line performance. Then there are employee considerations. Before COVID, when you had hotel transitions, nobody really thought too much about whether the employees should stay at the hotel or go with the management company. After the “great resignation,” and with a labor market tighter than it has been for decades, we’ve been seeing a very strong tension lately between owners and operators on what happens to good employees. So when we negotiate agreements today, we’re spending a lot more time thinking about that aspect of it because of the effect that COVID has had on the workforce.

Many owners are also looking for more meaningful opportunities to participate in planning for and reviewing hotel operations. They want to be more involved now than they were historically. So when we negotiate agreements, we’re looking for meaningful ways for ownership to asset-manage these properties, and to make sure they’re comfortable with how the hotel is being operated to drive both short-term financial performance and long-term value.

What advice do you have for hotel owners, operators and attorneys about how they have to approach these agreements today?

Stay focused on the issues, because there will be circumstances like this again, whether it’s something that looks like COVID or something else. It’s important not to say, well, COVID was once in a lifetime, now let’s go back to business as usual. We should always be flexible and creative, think outside the box, and guide our owner clients to protect against the unknown and unseen risks as best as we can foresee them.