No Place for Amateurs

In a real estate world awash with equity and debt, hotel investment sales are hitting record volumes. Last year, according to Jones Lang LaSalle, some $21 billion worth of hotels traded hands in the United States alone. Many of those deals were huge portfolio transactions, but some $11.4 billion represented one-off deals.

Although some properties went to experienced buyers, novice buyers are getting into the hotel game as well — investors who, when it comes to hotel franchising, often don't know what they're getting into. “In a lot of cases, some pure amateurs are buying hotel properties,” says Morris Lasky, president and CEO of Chicago-based Lodging Unlimited Inc., a hotel management company.

Franchising represents an enormous chunk of the hospitality industry. According to the American Hotel & Lodging Association, in 2004 (the latest year for which totals are available) the top 10 franchisers in the United States alone had their flags on about 2.36 million rooms, or more than half the domestic room total of about 4.41 million.

Being inexperienced in a large industry doesn't mean that newcomers can't succeed as hotel franchisees. But it does mean that they have to proceed carefully. Investors should be on guard for five major pitfalls to avoid.

  1. Franchise or else

    Avoid picking the wrong franchise — The owner's first decision about the hotel is probably the most important for the success or failure of the property: whether to affiliate with a franchise, and if so, which one?

    In the strictest sense, hotel franchising isn't mandatory. An investor who puts up the required cash can buy a hotel and call it anything he likes. But if he wants to borrow money to buy the property, that's another story.

    “Affiliating with a franchise is usually a condition of a loan,” says Michael Leven, president and CEO of Atlanta-based U.S. Franchise Systems Inc., which franchises the Microtel Inns & Suites, Hawthorn Suites, America's Best Inns & Suites and AmeriSuites brands. “It's a kind of insurance policy for the lender, who sees the brands in terms of their business generation potential.”

    Stephen Rushmore, president and CEO of the New York-based hotel consultancy HVS International, says that new owners need to make smart decisions about which brand best suits their needs.

    “Each franchise has a market position and an image, trying to differentiate itself,” he notes. Buyers need to look at the location of the hotel, the direct competition, and ask what the franchise is going to do for them.

    A Hilton, Hyatt or Marriott, for example, would be appropriate if the property is in position to attract meetings and groups, but that kind of business would be far less if the property were a Days Inn or Holiday Inn. “Find an affiliation that will serve your market with the right image and the right pricing point,” he advises.

  2. Contract oversights

    Don't overlook negotiable items — Because the franchising of any business is regulated by the federal government, hotel franchising deals are among the most tightly structured agreements in real estate.

    Though there are some variations, basic franchise fees (combined with marketing, reservation and other fees) might add up to as much as 10% to 12% of gross room revenue in the more established chains. For emerging chains, the fees might be as little as 4% to 6%.

    “Hotel franchisers usually know their markets, and they know what a flag can get at a particular location,” says Peter Dumon, president of Lombard, Ill.-based Harp Group, a hotel franchisee with experience in owning Holiday Inn, Marriott and Starwood brands, among others. “So they aren't going to budge on fees.”

    There are minor exceptions to the steadfastness of franchisee fee structures that shouldn't be overlooked. In some cases, according to Dumon, fees are “ramped up” by the franchiser — they begin at a certain level early in the agreement, and are increased every year for a few years until the final annual fee is reached. “Emerging chains sometimes do that,” he says.

    Fees might be inflexible, but there are other parts of a franchise deal that might be negotiable. “A strong brand will have all the leverage,” says Rick Swig, president of RSBA & Associates, a San Francisco-based hospitality industry consultant. But in the case of new or weaker brands, a new owner might have leverage, he adds.

    Sometimes a franchiser can be persuaded to help an owner pay the costs of a brand conversion or capital improvements to a property. These kinds of expenses might be covered by a property improvement plan (PIP), which spells out what the owner is responsible for in terms of making modifications to the property.

    A good many franchisers are pushing to get new product out to the marketplace and are in fact willing to haggle on such matters. “PIPs are definitely negotiable,” says Lasky. “The problem is that people sign the agreement offered by the franchiser without looking at it line-by-line, and don't bother to negotiate.”

    For example, one franchiser might ask the owner to change the roofline to conform to a brand standard, but if the owner questions that, the franchiser might modify the request or even pay for part of it. The takeaway? If an owner isn't smart enough to ask for a deal, chances are he won't get one.

  3. The overconfidence trap

    Don't overestimate the importance of the brand — Affiliation with a brand doesn't guarantee success, however well-known it is. According to Lasky, new owners are often overconfident that a flag will ensure success.

    “Branding is only part of the story, because you have to market the hotel yourself,” he says, estimating that even under optimal operating conditions, a national reservation system might only account for 16% or 17% of any hotel's business.

    Leven agrees that unwarranted optimism on the part of hotel buyers can easily be a trap, even if they think they've studied the numbers. He explains that franchisees sometimes anticipate making at least the chain's average production at their property, without realizing that some properties won't make the average, possibly their own.

    The tools to project occupancies and revenue per available room (RevPar) for a property, based mainly on computer models, are certainly more sophisticated than they used to be. “But feasibility studies are still just a guesstimate, not a science,” says Leven.

  4. Not defending turf

    Avoid competition from your own franchiser — A novice hotel buyer might assume that a franchiser has the owner's best interest in mind, and would ensure that another francishee from the same chain be kept at a safe distance. But that's not necessarily the case.

    “You need to know what's your protection against the intrusion of other franchises from the franchiser,” says Leven, positing that two hotels at 60% occupancy in the same trade area would provide more royalties to the franchiser than one at 80%. Competent franchisers, however, don't pit same-brand hotels against each other.

    There are two ways to deal with the potential of another property in the brand locating nearby. One solution is pre-emptive, giving the existing franchisee an exclusive area for the brand.

    “You need to fight for as much exclusivity as you can,” says Dumon. “That's entirely negotiable. A five-mile radius around the property has been a good rule of thumb for us during negotiations.”

    The other option is to conduct an impact study, usually undertaken for the existing franchisee by a third party, which purports to detail the impact of a new franchise on the market area. It's a guide to how much business the new franchise might take from the existing one, but it doesn't do anything to prevent that impact.

    Moreover, Rushmore with HVS International insists that impact studies are not perfect when it comes to investment decisions. “An impact study is the most unreliable kind of study I know, because how can you really measure the business impact of a hotel that doesn't exist yet?” he asserts. “It's a shot in the dark, a guess, a gut feeling. I refuse to do them anymore.”

  5. Lack of an exit strategy

    Avoid expensive termination provisions — Another potential sticking point between franchiser and franchisee is the terms of the termination of the franchise.

Typically early termination of a franchise requires the payment of “liquidated damages” to the franchiser, which sometimes amount to as much as three years' worth of all fees, based on the hotel's performance in the previous 12 months and paid as a lump sum.

A large termination fee may well be worth it to an owner who wants to sell the property, but not in other cases. “Termination has always been, and will be, a bone of contention, especially in non-performing hotels,” says Leven.

Owners might feel let down by their current brand, and want what they perceive to be a better flag. “In those cases, franchisees sometimes refuse to pay when they want to change flags,” says Leven. “Negotiations follow, sometimes involving a third party, and the payment usually ends up at about half the damage number.”

Like other negotiable parts of a franchise agreement, termination provisions should be carefully scrutinized by a franchisee, even if he or she has no intention of exiting the business. A hotel investor needs to know exactly what's contained in a termination clause, says Dumon. “The possibility always remains that the franchisee will need to get out.”

Dees Stribling is a Chicago-based writer.

A breakdown of hotel franchising costs

The fees involved in hotel franchising are so consistent that they're often published on franchisers' or other web sites. HVS International, a New York-based hotel consultancy, has gone so far as to create a franchise fee calculator that, given a brand name and certain other parameters, will calculate franchise fees.

For example, in the economy lodging sector, a Super 8 with 100 rooms and an average room rate of $50, at 75% occupancy in years three through 10 of the agreement, will cost the franchisee about $1.56 million over the life of the deal, or 10.2% of gross room revenue.

Moving up the hotel hierarchy, a 300-room Crowne Plaza with an average room rate of $110 at 75% occupancy in the same time period will cost the franchisee $10.4 million, or 10.4% of gross room revenue.

But those are estimates. A more detailed breakdown of the fees is offered by franchisers in uniform franchise offering circulars, which are documents first mandated by the federal government in the early 1970s to stem a rash of fraudulent franchise schemes at the time.

A good example of the franchise costs for a limited-service hospitality property — the kind that first-time investors usually buy into — can be found at Microtel, which is franchised by U.S. Franchise Systems. Currently, the chain has about 18,900 rooms in 262 properties, with another 1,337 rooms in 19 properties under construction.

Microtel's initial franchise fee is $35,000, with a royalty fee of 4% of gross room revenues in the first year of the franchise, 5% in the second year, and 6% each year after that for the 20-year life of the franchise.

An advertising fee, which includes reservation fees, comes to 3% in the first year, and then slides downward: 2.5% in the second year and 2% each year after that.

In the case of building a new property, the construction costs for a franchisee will run $35,000 to $36,000 per room, not including land.

Exclusive territories are “available,” according to U.S. Franchise Systems, meaning that savvy franchisees who understand the business can negotiate for territory from the franchiser.
Dees Stribling

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