When a developer decides to increase its property portfolio with a hotel project, a number of factors should be taken into account, and a number of preparatory phases should be considered as essential elements for the future project.
Regardless of the rationale behind the developer’s plans, extensive homework should precede the hotel operator selection process.
One of the greatest and most widespread mistakes made by hotel developers is the appointment of the operator only by reference to the operator’s market profile and perceived reputation. However the operator’s success in any particular project and in any particular market should not be viewed as a guaranteed prerequisite of high performance in other upcoming hotel projects. This article is designed to outline the steps to be taken by a developer prior to and in the course of the hotel operator selection process, in order to achieve the optimum balance between the operator’s (and the chosen brand’s) reputation, and the economic feasibility of the hotel project.
STAGE 1: FEASIBILITY STUDY
A lot of developers underestimate the importance of a proper feasibility study relying too much on their own knowledge of the market and extensive experience in real estate development. Although a developer may indeed be successful in the development of commercial real estate, the hospitality industry has its own particular operational specifics, neglect of which may result in under-performance of the hotel and, consequently, the developer’s return on investment.
A feasibility study performed by an independent professional hotel consultant should precede any operator selection process, even where the developer may already have existing relationships with hotel operators. This is because what may be working well for one hotel may not be suitable for another, taking into consideration the hotel location, positioning, construction costs, existing competitions and likely guest profile.
The feasibility study will include a market study of existing and future demand and supply on the market among existing and upcoming accommodation facilities. Based on this, the consultant may recommend a particular hotel segment which suffers undersupply, and then convert the results of its market research into estimated performance of the project, taking into account the existing competition of lodging facilities with interchangeable accommodation services. Thereafter, based on the projected performance, and taking into account projected development costs and operating expenses, the hotel consultant can estimate the owner’s return as the annual net operating profit. Based on such measures the hotel consultant may recommend an increase or decrease of the number of guest rooms, adjustment of the optimum room rate, a focus on additional services to be provided in the hotel (such as conference, spa/leisure, or F&B facilities etc.), which may substantially contribute to the increased profitability of the project.
As soon as the hotel segment, room count, economics and concept of the project have been identified based on the feasibility study, the developer can move on to the next stage.
STAGE 2: PREPARATION OF REQUEST FOR PROPOSAL
At this stage it is crucial to determine the developer’s areas of leverage/advantage and major points of concern as the benchmark for further negotiations with candidates for the operator’s position. Particularly, the following issues may in whole or in part represent the developer’s key areas of concern:
Alternatively, but less common, a developer may consider benchmarking of the hotel’s occupancy rate against targeted occupancy or comparison of the hotel’s performance with the performance of other similar hotels in the region managed by the operator. Even with such tests in place, a hotel developer should be aware that such tests may be subject to a certain amount of manipulation on the operator’s side. In order to find the best solution for the performance test base, and to eliminate possible deficiencies and reduce the risk of manipulation, the hotel developer should take advice and closely cooperate with its hotel consultant and legal advisor. Otherwise the performance test may remain only on paper and may not be enforceable in practice.
STAGE 3: DEFINING THE SET OF COMPETING OPERATOR CANDIDATES AND HOLDING THE BIDDING PROCESS
Even where a developer knows for sure that a certain operator and certain brand is perfect for its hotel project, it may be fatal to focus on just one operator, letting them know that this brand is a “must have”. The best way to get the best deal is to create a competition between 3-5 operators and have them bid for the project in several bidding stages, screening candidates for elimination along the way, bearing in mind the developer’s key areas of concern and ensuring a transparent discussion of these areas as part of the process.
As soon as the operator is selected, the achieved arrangements should be documented in the form of Letter of Intent or Memorandum of Understanding (LOI/MOU), and subsequently further reflected in the hotel management agreement and concomitant contracts.
The better the LOI/MOU is drafted on major commercial and financial issues, the smoother will be the drafting of the main hotel management contracts, and the quicker (and cheaper) the process of finalizing same.
The above issues are merely examples of some key issues that may be subject to negotiation at the early stage of discussions with an operator, and which should always be considered as part of the operator selection process. These issues will of course vary, depending on the developer’s and operator’s concerns, market conditions, location of the project, the projected profitability of the hotel, the existing competition in the market and other factors.
Regardless of what particular issues are the key points of concern for a certain developer, all issues should be, by all means, thoroughly considered at the stage of preparation of the Request for Proposal, together with the developer’s negotiation position and benchmarks for further negotiations with operator candidates.
In this process one should not underestimate the importance of active engagement of hotel experts and legal advisors. A widespread mistake is inadequate attention to such considerations at this stage, and signature by a developer of a Letter of Intent/Memorandum of Understanding in haste, without having taken commercial and legal advice.
Although developers may consider the LOI/MOU to be a non-binding document, in practice re-negotiation of express commercial terms already agreed and set out in an LOI/MOU is very difficult and will be strongly resisted by an operator. The risk is that, by re-opening negotiation of a particular term in the LOI/MOU, the developer will introduce bad faith and bad feeling, and may ultimately lose the operator, which might have been the perfect operator for its hotel project. This is why undertaking extensive homework and obtaining the right advice before and during the operator selection process is so important for a developer. It will often be too late to look for such advice after the operator has been selected and an LOI/MOU signed.