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As investor appetite for hybrid hospitality projects continues to grow, it is important to identify and implement an operating model that ensures the commercial goals of the project owner can be achieved. There is no one-size-fits-all approach, as every hybrid hospitality project is unique. Often, these projects include residential components (for example, co-living, serviced apartments, and whole-ownership units), transient units (traditional hotel rooms), a variety of food and beverage concepts, co-working spaces, and other entertainment and wellness offerings, all housed in a single structure. This article will consider a range of possible structures available to a project owner to balance the requirements of diverse uses with the imperative of creating and maintaining an optimal governance, financial, and operating model for the overall project.
The structures considered in this article assume the project owner either (a) does not have all of the necessary in-house expertise to operate the project itself and/or (b) desires to outsource all or portions of the operating responsibility of the project to third parties. We will explore three primary operating models available to a project owner: (1) engagement of a third-party operator or operators via a management agreement; (2) leasing of components of the project to third-party operators; and/or (3) licensing of components of the project to third-party operators. We will also highlight some of the considerations a project owner will need to take into account when considering whether to associate the project with a brand or brands offered by certain third-party operators. A project owner could choose any of the above options or a combination of them as it determines how best to balance its ownership interest in the project with the project’s varied operational requirements and, ultimately, its overall commercial aims.
Under a management agreement, the owner contracts with a third-party manager to operate a specific area of the project on behalf of the project owner. In return for taking on day-to-day management and operational responsibilities, the manager will earn a fee based, generally, on gross revenues and net operating income of the component being managed. Importantly, the ongoing financial obligations and legal liabilities associated with the operating business remain the responsibility of the project owner, as the manager receives a fee for service but does not take on the financial and liability risks associated with the underlying real estate.
Management agreements are often structured as long-term contracts, particularly if the project owner is contracting with a large, branded management company. This limits the ability of the project owner to change the manager. Furthermore, the management agreement typically would remain in place after the sale of the property. A project owner would need to consider whether its commercial aims for the project align with these long-term arrangements.
A manager would have control of, and discretion over, day-to-day operational matters for the managed component. This arrangement often aligns with a project owner’s commercial aims, namely to retain a manager with the appropriate expertise to handle day-to-day management. Importantly, however, the manager would still be required to report to the project owner on a regular basis and seek approval for various matters such as annual budgets, appointment of key staff members (for example, a hotel general manager in the context of a managed hotel), and contracts over a certain value. These approval rights provide meaningful control to the project owner while erecting guardrails that limit a manager’s autonomy over operations, particularly with respect to matters that have a material financial impact on the operating component.
Another structural option for a project owner is to enter into a traditional lease of one or all of the project components with a third-party operator. If only a part of the project is leased to a third-party operator, the lease will need to be structured in a manner that takes into consideration the other operating components of the project. For example, the use restrictions, access rights to non-leased areas, service charge regime, and ongoing maintenance obligations will need to be considered, not just with respect to the leased premises but also with respect to the impact those provisions could have on the balance of the project. These considerations are important to ensure that the leased area does not prevent the project as a whole from operating in a seamless and qualitatively consistent manner.
Leasing the individual components of the project to separate operators allows the project owner (a) certainty of income through a fixed rent and (b) to off-load certain financial obligations and legal liabilities associated with the operating business as the operator takes on these risks under the terms of the lease. This is a key distinction between the management agreement model and the lease model. Furthermore, the project owner may look to include an element of turnover rent in order to benefit from the upside of the operation, but that will come at a cost to the project owner, as the operator will expect the project owner to take a share of the financial obligations of the business (whether that be through initial capital expenditure or contributions to future refurbishments).
The lease structure gives the project owner less control over how the project is operated on a day-to-day basis, although there would be certain control for the benefit of the project owner via the terms of the lease in areas such as use restrictions, ongoing maintenance obligations, and the service charge regime, combined with approval rights for the benefit of the project owner in respect to alterations and alienation.
Any lease of a large component of a project (such as the hotel or co-living spaces) is likely to be for a term similar to that of a management agreement because the operator/tenant would not want to invest potentially large sums of money in fit-out costs if it does not have security of a long-term lease. Conversely, the project owner may be able to negotiate shorter terms for stand-alone offerings such as restaurants, co-working spaces, or wellness spaces, giving the project owner more flexibility should its business model or requirements change.
The advantage of the lease structure is that it allows the project owner to take a more hands-off approach to day-to-day management and off-load certain financial obligations associated with the operating business.
Licenses to Occupy
License agreements are the most flexible of the options available to the project owner, as they are generally short-term arrangements that are personal to the licensee. Given the nature of a license, they are unlikely to be suitable for permanent components of the project, but they afford the project owner some flexibility to explore other revenue streams and uses of parts of the project such as a pop-up restaurant, shop, or experience, possibly with a view toward entering into longer-term arrangements if these uses prove operationally successful.
Key Considerations About Branding
The project owner will also need to consider whether it wishes to associate the project with brands offered by certain third-party operators. This consideration is relevant for each of the operating models discussed here and introduces a series of further questions such as the following:
(a) If the brand would be applied only to one or more components of the project, how would the chosen brand influence or impact the other components of the project from a use, cost, and guest-experience perspective?
(b) If multiple branded operators will be associated with the project, do the various brands align in a manner that delivers a consistent experience across the project from a qualitative and guest-experience standpoint?
(c) What are the financial implications from associating all or part of the project with a brand, including relative to revenue and cost?
Structuring and implementing an operating model for a hybrid hospitality project, whether on a branded or unbranded basis, requires the balancing of myriad factors. There is no one-size-fits-all approach. Rather, it is common to see a mix of the operating models discussed in this article as well as a mix of brands across the various operating components. The final structure will depend on factors such as the nature and range of operating components, the project owner’s appetite for risk and overarching commercial aims, the role that a single brand or multiple brands can play in achieving these commercial aims, and the project owner’s operational experience and resources as well as its desire to be involved in day-to-day operational matters. This mixed approach to operating models and, at times, branding is complicated, but if it is well conceived and implemented, the overall project can drive outsize financial returns with a stable and cohesive operating environment.
Matthew PohlmanPartnerCo-Chair, Hospitality & Leisure