Hotel Franchising: Advantages and Disadvantages Explored

Introduction and Background

The objective of this study is to examine the advantages and disadvantages of franchising hotel operations. To that end, this study conducts an extensive review of the literature in this area of inquiry and supplements it with interviews of two industry professionals in order to determine whether the advantages or disadvantages of hotel franchising predominate.

The first interviewee, Mr. X, is the General Manager of Radisson Blu Istanbul Asia, a well-known hotel in Istanbul, Turkey. The property is owned by a private company, Ant Yapı, and affiliated with the Radisson brand, which is owned by the Rezidor Group. The second interviewee, Mr. Y, is the Front Office Manager of Swissôtel The Bosphorus in Istanbul. That property is owned by the FIBA Group and affiliated with the Swissôtel brand, which is owned by the Raffles Group.

Literature Review: Property Lease Agreements

Chapter 19 of an HVS publication on property management reports that a property lease agreement carries both advantages and disadvantages for both parties involved. According to the literature, hotel management arrangements such as lease agreements offer the property owner several notable benefits.

Advantages for the Property Owner

First, the owner retains title to the property, which provides possession and creates residual value when the term of the lease expires. Second, 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). Third, the owner bears no operational responsibilities (Rushmore, 2002; Xiao, O'Neill, and Wang, 2008).

Disadvantages for the Property Owner

The disadvantages for the property owner are equally significant. First, 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 owners in poor physical condition and with a tarnished 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 when the lease ends.

Second, a hotel lease places the owner in a passive position. Under such an agreement, the owner has no input into hotel operations and no control over hotel management. Little can be done if the property is not operated profitably or appropriately unless the terms of the lease are formally violated.

Third, if the hotel is extremely successful, the property owner does not participate in the financial rewards to the extent that an owner-operator would. The potential for profit is therefore somewhat limited (Rushmore, 2002; Wickford, 2012).

Fourth, 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).

Advantages for the Hotel Operator

There are several advantages in a property lease agreement for the hotel operator. One of the most significant is 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). Additional advantages include the following:

First, the operator has total control of the hotel during the term of the lease, with very few approvals required from ownership. Second, 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. Third, the upside profit created by a successful hotel benefits solely the operator, who receives whatever money remains after operating expenses and lease rental have been paid (Rushmore, 2002).

Disadvantages for the Hotel Operator

The disadvantages for a hotel operator under a lease agreement are also notable. First, the operator loses possession of the property when the lease term expires, and the leasehold interest loses its value as that term approaches. Second, the financial risks of operating the hotel are borne by the hotel company; the operator must therefore have a net worth sufficient to absorb that exposure. Third, leasehold interests create contingent liabilities on corporate balance sheets that can adversely affect the value of stock in publicly traded companies. Because of the requirements for real estate investment trusts, however, hotel operating leases are sometimes a necessity (Rushmore, 2002).

Literature Review: Management Contracts

Rushmore (2002) reports that management contracts carry specific advantages and disadvantages for both the hotel company and the property owner.

Advantages for the Hotel Operator

Inexpensive, Rapid Expansion: Because management contracts typically require very little capital outlay on the part of the operator, they enable inexpensive and rapid chain expansion with a low level of investment. On occasion, hotel companies contribute working capital in the form of a loan or a small good-faith investment in order to secure a management contract.

Low Downside Risk: The typical management contract leaves the property owner responsible for all working capital, operating expenses, and debt service. The management company has no financial exposure beyond covering its operating expenses and earns a small profit from a basic management fee and a larger profit from incentive fees.

Critical Mass: The operating expenses and home office costs of providing hotel management are minimal, yet a critical mass of properties under contract is necessary to cover the cost of key operational executives, home office staff, and support personnel while still generating acceptable profits (Rushmore, 2002). First-tier management companies typically offer a computerized reservation system, which makes their fixed overhead greater than that of second-tier operations. As Rushmore (2002) notes: "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."

Quality Control: Management contracts enable hotel companies to maintain control of physical and operational quality. Hotel companies are always concerned about their public image, and a property that is physically or managerially neglected can damage a brand's reputation rapidly. A management contract provides the level of quality control the 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. In a franchise relationship, maintaining uniform quality is comparatively more difficult.

No Depreciation Expense: Management contracts are attractive to public hotel companies because cash flow realization is close to what companies would realize if they owned the property, yet the company avoids depreciation expenses, since the property owner bears that liability.

Disadvantages for the Hotel Operator

Residual Benefits of Ownership Eliminated: The owner benefits from any increase in the hotel's value generated by the management company, which accrues to the owner upon sale or refinancing rather than to the operator.

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."

Dependence on the Owner's Finances: When a hotel's cash flow is insufficient to cover operating expenses and debt service, 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).

Contract Termination: Management agreements often include provisions for cancellation — 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).

Advantages for the Property Owner

Acquisition of Operational Expertise: Management contracts provide owners with operational expertise for establishing and preserving the long-term profitability of their investment. At the same time, a management contract allows owners to retain 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.

Immediate Name Recognition: The property owner receives national or regional brand identification, which can be achieved through a second-tier management company if it is coupled with a franchise affiliation.

Quality Management: Hotel lenders and investors have become increasingly aware of the importance of 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 in the project team does not guarantee financing, it signals positive commitment on the part of the operator and can favorably influence lender decisions.

Disadvantages for the Property Owner

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 removing an incompetent operator.

Liability for All Ongoing Expenses: Under a management contract, the hotel owner is financially liable for all costs and expenses, including fixed charges and debt service. Even if the manager's neglect or incompetence caused a financial loss, the owner remains responsible for funding the negative cash flow.

Difficulty Terminating the Operator: It is difficult for owners to terminate a management agreement early or without a concurrent sale of the property.

Difficulty Selling the Property: It is more difficult to sell a property that is subject to an existing management contract.

Cost of Management: Management fees can consume a substantial portion of the cash the hotel generates. Quality hotel management is expensive. 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."

High Downside Risks: Owners of lodging facilities face significant downside risks due to the high level of fixed costs associated with hotel or motel operations. As occupancies decline, losses escalate rapidly because many fixed expenses cannot be reduced. The use of property leases shifts this downside risk from the owner to the operator, but under a management contract, any negative cash flow remains the owner's responsibility.

Operator May Favor Its Own Properties: A conflict of interest arises when a hotel company both owns properties for its own account and operates hotels for unrelated third parties. Because a hotel company generally receives greater economic benefit from sending guests to its own hotels rather than to properties it manages, the potential for unfair practices is always present. Owners should be aware of this fundamental conflict and ensure that management agreements include provisions restricting possible abuse.

Conclusion

This study's review of the literature and its primary interview data both suggest that hotel franchising offers meaningful advantages — particularly in terms of brand recognition, operational expertise, and standardized customer experience — while also presenting significant challenges related to management quality, cost, operational control, and potential conflicts of interest. The balance of advantages and disadvantages depends considerably on the terms of the specific agreement negotiated between the property owner and the franchise operator, the financial health and commitment of both parties, and the degree to which the franchise brand invests in training and property maintenance. As both interviewees emphasized, careful contract review and a commitment to quality management are essential for maximizing the benefits of a hotel franchise arrangement. Further research drawing on a larger sample of hotel managers across different markets would strengthen these findings.

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