Negotiating Hotel Operating Agreements for Mixed-Use Developments

By: Robert (Bob) H. Voelker
June 2007

The high cost of construction and a desire to create broader “lifestyle destinations” has given rise to the placement of luxury hotels in larger mixed-use developments with retail, condominium or office components, and additional restaurant or entertainment venues are becoming commonplace. In negotiating the operating or management agreements for hotels in these mixed-use developments, hotel operators are legitimately concerned about maintaining quality and consistency of the brand image not only in hotel design and operations but also in the larger context of the total development, while wanting to capture the “up-charge” in either value or rental rates that the brand lends to the remaining parts of the mixed-use project. However, the owner/developer and other parties associated with the mixed-use development (co-developers, tenants, operators of third party venues) have competing concerns.

Among the issues that need to be addressed in hotel operating agreements for mixed-use developments are:

Joint Ventures between Owner/Developer and Third Party Operators

The owner/developer of the mixed-use development may enter into joint ventures for the operation of the restaurant, nightclub or other third party venues, and may contribute capital for tenant finish-out and start-up costs. Unless separately accounted for, the income from these third party areas may become part of the gross operating revenue (GOR) of the hotel, subject to the hotel operator’s fees. However, this revenue is not merely attributable to the hotel, but is also dependent on the third party operator’s “brand” (e.g., trendy restaurant or nightclub affiliation) and the equity put at risk by the operator or the owner/developer. In determining the “fair share” of the third party revenue subject to the hotel operator’s fee, a balance must be struck between the draw of the hotel brand versus the contributions (third party operator brand and equity) that are not attributable to the hotel brand. Should the gross or net income from these venues be the base for determining the hotel operator’s fee? Should the income from third party areas be carved out and treated separately from the standard hotel income?

Competing Venues in Hotel versus Third Party Areas

In a large mixed-use development, the hotel will have amenities that will compete with retail, restaurant, bar and other facilities in the larger development. Examples include hotel spa vs. health club, hotel coffee bar vs. local or national coffeehouses, hotel bar vs. local restaurant and bar, hotel sundries store vs. drug or grocery store, etc. The hotel operator should and will be protective of its revenue stream and want to maintain a high level of economic activity and foot traffic through the hotel, and the hotel operator will want approval rights over competing operations. The owner/developer of the mixed-use development will want to maintain maximum flexibility to attract the largest, most-diverse tenant base into its retail space.

Approval of Third Party Venue Operators and Plans and Specifications

Major hotel operators are rightfully very protective of their brand image, and have extensive rules, regulations and procedures designed to maintain quality that drill down to small details, including approval of the background, experience and reputation of third party operators of major components of the mixed-use development and of the compatibility of the plans and specifications for these venues. The owner/developer will be required to submit the plans and specifications for the entire mixed-use development to the hotel operator and inquiries may also extend to other parts of the development that are controlled by parties beyond the control of the developer – other developers of portions of the mixed-use master planned community and even owners of out-parcels to the extent that their activities raise concerns for the brand image.

Food Services

If the restaurant is third party operated, and not controlled by the hotel operator, arrangements will need to be made to have room service and catering provided by the third party restaurant operator. Room service may also be provided to the residential components (condominiums or apartments) of the development. To create economies of scale, the restaurant kitchen and banquet/catering kitchens may be combined. Banquet/catering and hotel room service revenue are intrinsically tied to the hotel operations and should be subject to the hotel operator’s fees; however, residential room service and food service provided to other venues (nightclub, bars, etc.) are less tied to the hotel and the income arising from these sales could be subjected to reduced hotel operator fees. The kitchen expense side of the equation becomes even more complicated and careful accounting will be required to keep banquet/catering staff costs separate from third party kitchen staff costs. Room service menu pricing and the up-charge for delivery will also be source of discussion between the hotel operator and the restaurant operator.

Approval of Other Elements of Development

Complex mixed-use developments have intertwined service components that serve the hotel, retail, residential, office and other components of the development, including motor courts, parking and valet services, loading docks, trash facilities, utility connections, elevator usage, back-of-house operations, etc. The hotel operator will be intimately concerned that the use of these common facilities by other components of the mixed-use development will create obstacles to providing superior service to hotel guests and will want approval rights and/or control over parking arrangements, loading dockmaster rules and other common area facility usage, including future rules that can only be determined as operations commence. Co-developers and even tenants will be equally concerned that the hotel operator will take precedence and impact upon their operations.

In dense urban mixed-use developments the issues cited above are exacerbated by the proximity of competing uses both horizontally and vertically. Visually, the tract map or site plan for the development becomes interlocking three-dimensional jigsaw puzzle pieces, and the various component pieces become co-dependent and must peacefully co-exist as one living, adaptable organism. The competing concerns of hotel operator, owner/developer, co-developers, residential unit owners, tenants (both retail and residential) and other users of the mixed-use development must all be balanced and flexibility should be built into all of the operational documents, including the hotel management agreement.