Advantages and disadvantages of franchising in hotel operations

Franchising of Hotels: Advantages vs. Disadvantages

The objective of this study is to examine the advantages and disadvantages of franchising hotel operations. Toward this end, this study will conduct an extensive review of literature in this area of inquiry as well as interview two individuals, Mr. X, and Mr. Y in order to determine whether there are more advantages or disadvantages.

Mr. X is the General Manager of a well-known hotel in Istanbul Turkey, specifically Radisson Blue Istanblue Asia. The property is owned by a private company 'Ant Yapi' but the hotel is affiliated with brand Radisson, owned by the Rezidor Group. Mr. Y is the front office manager of another hotel in Istabul, specifically Swiss Otel Bosphorus, the property being owned by FIBA group and the hotel affiliated with Swiss Hotel brand with the brand being owned by Raffles Group.

Literature Review

Chapter 19 entitled Property Management of an HVS publication reports that a property lease agreement is inclusive of both advantages and disadvantages to both parties. The advantages to the property owner are those stated as follows:

(1) The owner retains title to the property, which provides possession and creates residual value when the term of the lease expires.

(2) The financial risk to the owner is minimized, particularly if the hotel company is creditworthy and has guaranteed a minimum rent (Elgin, 2010; Yu, 1999).

(3) The owner has no operational responsibilities. (Rushmore, 2002; Xiao, O'Neill, and Wang, 2008)

The disadvantages of the property owner are inclusive of the following stated disadvantages:

(1) The operator has little incentive to maintain the property in top condition as the lease term nears its expiration date. For this reason, many hotels are returned to the owners in poor physical condition, as well as with a tainted reputation. Furthermore, because much of the existing business is often diverted to other hotels managed by the operator, few reservations are on the books for the owner or new tenant.

(2) A hotel lease places the owner in a passive position. Under such an agreement, the owner has no input in the operations of the hotel or control over the hotel management. Little can be done if the property is not operated in a profitable and appropriate manner unless the terms of the lease are violated.

(3) If the hotel is extremely successful, the property owner does not participate in the financial rewards to the extent of an owner/operator. Thus, the potential for profit is somewhat limited. (Rushmore, 2002; Wickford, 2012;

(4) Leases are difficult to terminate. Unlike a management contract, which is an agency agreement, a lease creates an encumbrance on the real estate that gives the tenant specific rights of possession. (Rushmore, 2002)

There are several advantages in a property lease agreement for the hotel operator and one of these is reported to include that a higher chance of success exists "since a proven business formula is in place. The products, services and business operations have already been established. (Business Mart, 2012) In addition, there are other advantages including those stated as follows:

(1) The operator has total control of the hotel during the term of the lease with very few approvals required from ownership.

(2) A profitable hotel creates a leasehold value that can sometimes be mortgaged by the operator. If the terms of the lease permit a transfer, the leasehold value can also be realized through a sale.

(3) The upside profit created by a successful hotel will solely benefit the operator, who receives whatever money remains after operating expenses and lease rental have been paid. (Rushmore, 2002)

The disadvantages for a hotel operator are as follows:

(1) The hotel operator loses possession of the property when the lease term expires.

(2) The leasehold loses its value as the term of the lease expires.

(3) The financial risks of operating the hotel are borne by the hotel company, so the operator must have a net worth great enough to be able to incur the exposure.

(4) Leasehold interests create contingent liabilities on corporate balance sheets that can adversely affect the value of stock in publicly traded companies. Of course, because of the requirements for real estate investment trusts, hotel operating leases are a necessity. (Rushmore, 2002)

Rushmore (2002) reports that management contracts have specific advantages and disadvantages to the hotel company and the property owner alike. Advantages for the hotel operator are reported to include the following stated advantages:

(1) Inexpensive, Rapid Expansion: Because management contracts typically require very little in the way of capital outlay on the part of the operator, their use can make possible inexpensive and rapid chain expansion with a low level of investment. In fact, on occasion, in order to secure a management contract, hotel companies contribute working capital in the form of a loan or some other small good-faith investment.

(2 Low Downside Risk: The typical management contract leaves the owner of the hotel responsible for all "working capital, operating expenses and debt service' and the management company is reported to have "not financial exposure" basically cover its operating expenses and making a small profit from a basic management fee and a larger profit from incentive fees.

(3) Critical Mass: The operating expenses and home office cost of providing hotel management is minimal yet a "critical mass of properties under contract is necessary in order to cover the cost of key operational executives and home office and support staff and still generate acceptable profits." (Rushmore, 2002) it is reported that first-tier management companies offer a computerized reservation system most of the time making the fixed overhead greater than that of a second-tier operation. Rushmore (2002) states: "The size of the critical mass varies depending on the class and types of hotels operated, along with the nature of the services offered by the management company. The typical range of critical mass for a first-tier company is forty to fifty hotels under contract; for second-tier companies, the range is usually ten to fifteen hotels. Luxury hotels require a greater critical mass than budget operations because home office support must be more extensive. Similarly, convention-oriented chains with extensive group marketing needs require a larger critical mass than chains catering primarily to commercial travelers."

(4) Quality Control: The management contracts enable hotel companies to maintain control of physical and operational quality. Hotel companies, are always concerned about a favorable public image. It is easy to ruin a good reputation fast if a property is physically and managerially neglected. A management contract provides the level of quality control the hotel operator needs. When an unrestricted management policy and a funded reserve for replacement exist, the management company has near total control of quality and image of the property. In a franchise relationship, it is more difficult to maintain uniform quality.

(5) No Depreciation Expense: Management contracts are desirable to public hotel companies since the cash flow realization is close to what they would realize if they owned the property however, the company avoids the depreciation expenses since the property owner is liable.

Disadvantages for Operators include the following stated disadvantages:

(1) Residual Benefits of Ownership Eliminated: The owner benefits from any increase in the value of the hotel generated by the management company. This benefits the owner when selling or refinancing the property.

(2) Minimal input in Ownership Decisions: According to Rushmore (2002), "Most management agreements apply minimal restrictions on the owner's ability to transfer ownership to another party. An undercapitalized owner, for example, can restrict cash needed to cover shortfalls and adversely affect the operation and quality of the property. Also, as with any relationship, a management contract requires cooperation from both parties; a difficult owner can make life miserable for a management company by imposing any number of unreasonable demands."

(3) Dependence on Finances of Owner: When the cash flow a hotel generates is not enough to cover operating expenses and debt services it is reported that the hotel operator "…is totally dependent on the owner for providing necessary funds. No matter how thoroughly a management company investigates the creditworthiness of a hotel owner prior to entering into an agreement, adverse circumstances can quickly deplete anyone's financial resources. The risk to a hotel management company goes beyond the inconvenience of insufficient operating capital or a deferral of needed furniture replacement; it could ultimately result in the loss of a management contract as a result of bankruptcy or foreclosure. Beside the negative effect on a management company's income and reputation, such a cancellation (on the part of a bankruptcy court or foreclosing lender) seldom involves payment of a cancellation fee to the management company." (Rushmore, 2002; Adrian, 2010)

(4) Contract Termination: There are often provisions for cancellations and it is reported "…typically upon a sale, that allow owners to terminate the agreement upon payment of a stipulated cancellation fee. The disruption in management deployment and public identity, however, can be damaging especially to a first-tier operator." (Rushmore, 2002)

The advantages for the owners include the following stated advantages:

(1) Acquisition of Operational Expertise: hotel contracts make the provision to owners with operational expertise for establishment and preservation of the long-term profitability of their investment. Simultaneously, a management contract enables owners to keep ownership benefits in the form of cash flow, depreciation deductions, tax benefits, value enhancement, refinancing opportunities, and possession of the property after the contract expires.

(2) Immediate Name Recognition: the owner of the property receives national or regional identification achieved only through a second-tier management company if coupled with a franchise affiliation.

(3) Quality Management: Hotel lends and investors have recently become more aware of the industry and this has resulted in an emphasis on quality management. If the operator is a second-tier company, it generally must have a franchise affiliation in order to attract the necessary financing. While including a nationally known hotel company as part of the project team does not guarantee financing, it does show positive interest on the part of the operator that can favorably influence the investment decisions of the lender.

Disadvantages for the owner include the following stated disadvantages:

(1) Loss of Operational Control: a management contract results in the operator gaining total operational control of the property. If the property is not managed correctly, the owner will have great difficulty in removing the incompetent operator.

(2) Liability for All Ongoing Expenses: the hotel manager under a management contract is financially liable for all costs and expenses including fixed charges and debt service meaning that even though the manager's neglect or incompetence resulted in the financial loss, the owner is still responsible for funding the negative cash flow.

(3) Termination of Operator: it is difficult for owners to terminate management agreement early or without a sale.

(4) Sale of Property: It is more difficult to sell a property that is subject to an existing management contract.

(5) Cost of Management: The management cost can use a great portion of the cash the hotel generates. Quality hotel management is reported as expensive. The cost of management can absorb a substantial portion of the cash generated by a hotel. According to Rushmore (2002 "If the occupancy level is low, as in the case of a newly opened hotel, the total management fee could exceed the cash flow after debt service, meaning the owner would have to contribute additional capital to the venture. To assist owners during start-up periods and provide lenders with an additional debt service cushion, most hotel management companies will subordinate their incentive fee to debt service. This means that if the income before debt service is insufficient to cover the mortgage payment, the management company would either forgo or defer their incentive management fee."

(6) High Downside Risks

Owners of lodging facilities face downside risks that are due to the high amount of fixed costs associated with the operation of a hotel or motel. As occupancies drop, losses escalate rapidly because many of the fixed hotel expenses cannot be cut back. The use of property leases shifts this downside risk from the owner to the operator, but under a management contract, any negative cash flow is the responsibility of the owner.

(7) Operator May Favor Own Property

A conflict of interest always exists when a hotel company both owns and operates properties for its own account and operates hotels for nonrelated third parties. Because a hotel company generally receives a greater economic benefit from sending guests to its owned hotels rather than to properties it manages, the possibility for unfair practices is always present. Owners should be aware of this basic conflict and be sure that management agreements include provisions restricting possible abuse.

Interview I -- Mr. X

What are the advantages that you perceive from the franchise of a hotel as compared to an independent hotel?

The franchise hotels are more standardized in terms of their service provided and the experience of the customer when they visit the hotel.

2. Do you believe that the franchised hotels are more profitable than the independent hotels?

Most of the time, yes I believe that they are.

3. Why?

Because the franchises draw return customers who have not actually visited the destination of the hotel but are return customers because they have stayed at the franchise hotel in other locations and enjoyed their stay.