Hotel Performance Tests During Periods of Geopolitical Uncertainty

In recent months, the operating performance of upper-upscale and luxury hotels has been tested by economic challenges arising from global geopolitical unrest. This has brought renewed scrutiny on a core commercial element of hotel management agreements — the hotel performance test. Generally, a well-structured performance test allows a hotel owner to terminate the hotel management agreement with a hotel operator if the hotel fails to satisfy the performance test over an agreed-upon period of time. This article sets out the core elements of a hotel performance test and provides specific key action items for stakeholders if a hotel is at risk of failing the test.

Key Elements of the Hotel Performance Test

A hotel performance test is generally structured as a “two-prong” test, with both prongs needing to fail (typically for two consecutive calendar years) for the hotel owner to have a right to terminate the hotel management agreement on account of a failure of the performance test. The two prongs are generally referred to as the “budget prong” and “market prong.”

Budget Prong

The budget prong measures whether the hotel’s net operating income (or a similar metric) has achieved an agreed-upon percentage of the net operating income in the annual budget. Typically, the percentage threshold is set between 80% and 90% of the budgeted amount of net operating income, and if the actual net operating income is below the percentage threshold, the hotel will be deemed to have failed the budget test.

Market Prong

The market prong measures how the hotel is performing relative to “comparable hotels.” This requires the hotel owner and hotel operator to mutually agree upon the set of comparable hotels — hotels in the same geographical market that are generally similar in size, facilities/amenities, and overall product quality. Once the comparable hotels are established, the market test will generally use a metric such as “RevPAR” (revenue per available room) to compare how the hotel performs against the comparable hotels. For example, (i) the hotel must be in the top three in achieved RevPAR when compared with the comparable hotels, or (ii) the hotel must exceed the average RevPAR of the comparable hotels. If the hotel fails to meet the performance thresholds, it will be deemed to have failed the market test. The parties will agree upon a third-party source of data to use in determining the performance of the comparable hotels. The most frequently used source of data is Smith Travel Research, a hotel analytics company.

Performance Test Period

As noted above, the test period for a hotel performance test is typically two consecutive calendar years, but this can be varied to two out of three consecutive calendar years or even three consecutive calendar years. Single-year performance tests are generally not used.

Operator Cure Rights

If a hotel has failed the performance test, the hotel operator will typically have a right to “cure the failure” by paying to the hotel owner an amount equal to the amount by which the hotel failed to achieve the budget prong of the test. For example, if the percentage threshold of budgeted net operating income in the budget prong was set at 80% and the hotel only achieved 75% of budgeted net operating income, the hotel operator could cure the performance test failure by paying the hotel owner the five-percentage-point shortfall in budgeted net operating income. The items that often get negotiated between the parties with respect to cure rights are (i) how many times a hotel operator can cure (typically, twice during the initial term and once during each extension term of the hotel management agreement) and (ii) whether the hotel operator must cure for both calendar years the hotel failed the budget prong (assuming a two-calendar-year performance test) (typically both calendar years).

Exceptions to Applicability of the Performance Test

A hotel performance test generally exists to ensure the hotel operator is driving a level of operating performance that aligns with the commercial expectations of the parties. If those expectations are not met, the hotel performance test gives the hotel owner the right to terminate the hotel management agreement and engage a different hotel operator. Given this context, to the extent circumstances arise during the test period that are outside of the control of a hotel operator, these circumstances provide an excuse to the application of the performance test if (and this is an important “if”) those circumstances actually caused the hotel to fail the performance test. These exceptions are typically well defined in a hotel management agreement and, perhaps not surprisingly, cover the following type of events:

• Force majeure events. This includes natural disasters, pandemics, governmental actions, war, or other civil unrest — generally, events outside of the control of the hotel operator. These events stand in contrast to mere diplomatic tensions or challenges that are unlikely to rise to the level of a force majeure event until those tensions or challenges elevate to more measurable events or actions, such as governmental actions, war, or other similar unrest.
• Owner defaults. If a default by the hotel owner under the hotel management agreement has occurred and has caused the hotel to fail the performance test, then the hotel owner would not have a right to terminate the hotel management agreement on account of the performance test failure.
• Unbudgeted damage or destruction to the hotel. If the hotel suffers damage during the test period (such as a fire or other casualty event) and the impacts from such an event were not budgeted, this event would excuse the hotel operator from satisfying the performance test.

Actions for a Hotel Operator if the Hotel is at Risk of a Performance Test Failure

In the event a hotel is at risk of a performance test failure, the hotel operator should consider taking the following actions:

• Develop tracking systems. Rather than waiting until after the test period has concluded, hotel operators should immediately and robustly develop forecasting tools to measure the probability of the hotel failing one or both prongs of the performance test. These tracking systems should also seek to understand the cause of such suppressed operating performance.
• Ensure tracking systems align with the performance test provisions in the hotel management agreement. This involves a review of test dates, metrics being tested, cure rights/structure, notice, and reporting obligations in the performance test provisions in the hotel management agreement. This step ensures the efforts to track performance and the associated risk of failure align fully with the actual performance test.
• Consider whether any exceptions to the applicability of the performance test apply. This is a critical piece of the analysis, particularly in today’s operating environment. If, for example, force majeure events have arisen and continue during the test period, the impacts from these events should be measured and documented in real time to ease the data-gathering and reporting burden if, ultimately, the hotel’s failure to satisfy the performance test is caused by such force majeure events and if the hotel operator will seek to rely on this exception to the performance test to avoid a termination event.
• Establish a communication plan with hotel owner. This is particularly important if the hotel operator anticipates relying on an exception to the application of the performance test. Achieving early, initial alignment with the hotel owner that the event/circumstance qualifies as a potential exception will then allow the parties to focus on whether such event/circumstance is actually causing the failure of the performance test. The work to develop tracking systems that align with the actual performance test provisions, as noted above, will greatly assist hotel operators in their communications with hotel owners.

Conclusion

As operating performance of upper-upscale and luxury hotels around the world faces continued headwinds from the economic challenges due to global geopolitical unrest, hotel performance tests will come under close scrutiny. A clear and early understanding of how the performance test is structured, together with proactive assessment of the probability of a performance test failure, will help frame discussions between hotel owners and hotel operators and lower the risk of any disputes between the parties during these challenging periods.