Hotel Structures in the Middle East - All Change

The hotels market in the UAE has historically been dominated by the traditional hotel management agreement (“HMA”) structure between the hotel owner and their chosen operator. The past few years has seen an increasing appetite for owners to move away from that traditional model, instead demanding more flexibility to be built into the relationship with the operator.

More eye-catchingly, there have been a number of well reported cases in the UAE over the past twelve months where the owners of high profile hotels have taken steps, sometimes quite drastic, to remove their operator at an early stage in the life of their management agreement.

This note explores some of the drivers for this and the alternative models which are being used more frequently in the UAE and wider Middle East, and also explores some of the practical considerations which should be borne in mind during a “de-flagging” or “re-flagging” exercise.

A shift in focus – alternative models on the rise

The traditional HMA model places the entire management control over the hotel into the hands of the operator for a minimum period of typically 20-25 years (although some operators insist on a longer term). In the past, perhaps owners have focussed more on what the immediate five year timeline looks like without giving proper consideration to the longer term relationship, how their requirements may shift over time and how the owners’ other business operations might evolve and impact on the hotel. As a result, the traditional HMA model has proven attractive, and as it is the most familiar to most operators and owners in the region, there has been little reason for owners to consider alternative structures.

However, the HMA structures are relatively rigid and often do not allow the owner the degree of control or flexibility they might require in future to maximise their returns on their assets. Common issues which we have witnessed arising include:

• The owner becomes aware that the interests of the operator and owner, while generally aligned, do depart in some critical areas and often at the cost of the owner. One example of this is where the operator, having control over the marketing budget for the hotel, decides to spend capital promoting the operator’s brand in association with the hotel. That promotion may have more value to the operator’s brand generally, and might not necessarily increase room occupancy or RevPAR for the hotel itself;
• The owner, which in many cases is a well-known multinational with a sophisticated infrastructure in place in the UAE already observes that it does not necessarily need the management expertise of the operator to run the hotel; and
• Where the owner has its own brand which has a lot of local recognition and goodwill, the owner may decide that it would prefer to promote its own brand with the hotel, rather than a third party brand.

After a long-term HMA is signed, it is often very difficult for owners to address issues such as this unless the operator is willing to renegotiate the structure of the hotel. Renegotiation in this situation means the owner is more often than not negotiating from a position of weakness as the HMA is already binding and in place.

As a result, we are increasingly seeing owners giving more thought to alternative structures at the stage of operator selection, in particular around the use of franchise and “manchise” models and the use of white label operators.

Under a franchise model, the owner takes the benefit of the operator’s brand and sales platform, but retains full control over the management of the hotel (subject to compliance with the operator’s brand standards manual). The owner also typically pays a lower fee to the operator; under a franchise model, the fees typically comprise a franchise fee and sales & marketing fee, meaning the owner retains more of the profits from the hotel compared with a HMA model. There is also less control by the operator over how and when the owner must deploy capital on marketing and hotel improvements. So for owners with the relevant infrastructure and expertise in place to take on the management role, a franchise model is often more appealing.

A “manchise” model is essentially a traditional HMA, but with an option granted in favour of the owner to convert the HMA into a franchise agreement on pre-agreed terms. Manchise models would often give the operator a reasonable period of management control before the option to convert kicks in – typically around 7-10 years. This could be attractive where the owner might be new to the hospitality sector and may not be ready to take on the management role itself just yet, but expects to develop its knowledge and infrastructure over the coming years.

A “white label operator” (“WLO”) is a hotel management company which does not have a brand. The WLO would manage a hotel asset in exactly the same way as a normal operator would, but as it does not have its own brand or label to protect, the nuance around marketing budgets described above does not feature, meaning the WLO’s commercial interests are more closely aligned with those of the owner.

Franchise, manchise and WLO arrangements are very common across North America and Europe largely due to the reasons described above, and now hotel owners in the Middle East are beginning to explore these options for their assets in the region. These options are not mutually exclusive either; it is perfectly possible (and in some places, quite common) to have a franchise arrangement and WLO in place in respect of the same asset. For hotel owners who might be pure financial investors, this could be the ideal model.

The prevalence of franchise and manchise models in North America and Europe is also partly due to the wide choice of WLOs to support those owners who do not have the management capability themselves. The number of WLOs with significant operations in the Middle East is currently more limited, but appears to be growing fast, making these structures a more viable option for those owners who don’t have their own management platform.

“De-flagging” and “re-flagging”

A hotel is “de-flagged” when the brand above the door is taken down and not replaced. It is “re-flagged” when it is replaced by a different brand. De- or re-flagging is becoming increasingly common in the UAE, and the drivers for this can come from both the owner and the operator side.

The operator is naturally incentivised to ensure the hotel performs well. Operators typically have multiple brands within their portfolio (and increasingly so following the spate of mergers/acquisitions the industry has seen amongst operators of late). For example, some brands may be designed to cater towards family holidays, some to business travel and others to millennials. For some hotel assets, the location and format of the hotel might lend itself to a particular demographic/clientele, and as cities evolve, the most effective brand for that location and demographic may change over time.

If a hotel asset is underperforming, the operator may decide that this is because the brand assigned to the hotel is no longer the most appropriate brand for the current market. Alternatively, the operator may decide that a general refresh and refurbishment of the hotel would help boost performance, but keeping the same (or similar) brand. These are examples of how an operator may drive a re-flagging process, and there is often financial upside for the owner in such processes.

On the other hand, an owner may drive a process to de-flag or re-flag a hotel where, for example, the operator is under performing and breaches its performance test, in which case the owner would seek to terminate the HMA and then either appoint a new operator under a different brand, or to re-flag the hotel with the owner’s own brand/name. In recent examples in the press, the de- and re-flagging of some hotel assets have occurred by mutual consent of the owner and operator, or in one well reported case, by the owner forcibly removing the operator in breach of the HMA.

Any transition period from one brand to another, however that is driven, is not a decision to be taken lightly. Some key aspects that should be considered during the process include:

• Capital expenditure is the first consideration, as the costs of rebranding can be huge. In addition to amending signage above the door, there will often need to be an entirely new set of linen, crockery, stationary, staff uniforms, interior décor and soft furnishings to align with the brand standards and approach of the incoming brand. If this process is driven by the operator, then often the owner will accept this only where the operator agrees to bear some or all of the capital cost of the rebrand;
• Timing and planning is of the essence. Market feasibility studies should be commissioned to gauge whether the proposed rebrand is likely to have the desired effect. If the studies indicate a positive result, then a carefully planned execution strategy needs to be put in place to minimise disruption, maintain the customer base and schedule any refitting works to occur during a time of year which has least impact on the hotel’s revenue/performance. Existing future bookings will also need to be considered and managed appropriately;
• Cash flow is an important consideration based on the first two points above, as customer numbers are likely to decrease as soon as the brand name is removed or as parts of the hotel close during the rebranding exercise. This is exacerbated where the operator is changing as well as the change of brand, as the hotel would normally be removed from the outgoing operator’s loyalty club and sales platform meaning there could be some vacant period during which there is little or no infrastructure driving bookings. This will impact on cash flow at a time when there is likely to be significant capital deployment as part of the rebranding process;
• The hotel staff will need to be carefully managed through what can often be a difficult and unsettling process. Maintaining a talented staff base through the process will help mitigate any costs/dip in revenues as a result of the rebranding. Existing staff may need to be re-trained, for example, in software and revenue systems as the brand related training may no longer be appropriate. It is common for the General Manager and Financial Controller to be employees of the management company, meaning new management with sufficient expertise may need to be sourced as well as other new staff; and
• Valuation – the underlying value of the hotel property is often linked to its brand and it is important to understand leverage available and any issues that they may be facing. There may be an impact on existing financing arrangements, who are likely to have taken the value of the management agreement into account when offering financing and de-flagging could result in a breach of the terms of any such agreement.

Conclusion

The appetite for owners to explore alternative options for their hotel assets in the Middle East is encouraging and is a sign of the regional market evolving well. Franchise, manchise and WLO structures are set to become more prevalent in future, which will be another step towards the development of a genuine hotels M&A market in the region. However, where this involves a change of brand, it is imperative that both owners and operators do not take that decision lightly. Careful analysis, planning and implementation is key to ensuring a smooth process, and with any luck, maximising the value of your hotel asset.

If you are considering any of the above structures or processes, please feel free to get in touch with us to discuss in more detail.