When growth of an expense item exceeds the overall average, owners become concerned. However, since management fees are designed to reward operators for positive performance, excessive growth in management fees is not necessarily unwelcome.
Most management contracts include two components for compensation – a base fee and an incentive fee. The base fee is typically charged as a percentage of total revenue. Incentive fees, on the other hand, are paid to the management company once a certain profit threshold is reached. Incentive fees are designed to make management more conscious of the bottom line since owners achieve their return-on-investment from profits, not revenue. For the purpose of this analysis, profits are defined as net operating income before deductions for capital reserve, rent, interest, income taxes depreciation, and amortization.
U.S. hotels have achieved double-digit gains in profits each year since climbing out from the depths of the industry recession in 2009. Therefore, it is not surprising that the number of properties reporting an incentive fee payment has risen each year as well. While the increase in the occurrence of incentive fee payments is reflective of the industry recovery, further analysis reveals that profits have yet to reach the levels required for a number of management companies to earn their incentive fees.
The Influence of Real Profits
Based on the September 2013 edition of Hotel Horizons®, PKF-HR is forecasting nominal unit-level profits to return to pre-recession levels in 2014. However, when adjusting for inflation, real profits are not projected to reach pre-recession levels until 2015. This lag in real profits has influenced the incidence of incentive fee payments
In 2012, 10.5 percent of the properties in the Trends® sample that reported paying a base management fee also paid an incentive fee. While this is the greatest percentage reported since 2009, it is still significantly less than the 18.2 percent figure posted in 2007.
Effectiveness of the Incentive
In an effort to evaluate the effectiveness of the incentive clauses within the management contracts, we analyzed data from a same-store sample of properties that reported a management fee payments in both 2011 and 2012. This analysis revealed mixed results.
Properties that paid an incentive fee in 2012 saw their profits rise by 10.9 percent during the year. Concurrently, for owners that did not pay an incentive fee, profits at their properties rose by 11.4 percent. On the surface, because profits increased to a greater degree at hotels that did not pay an incentive fee, it does not appear that owners benefitted from their incentive payments in 2012. However, it might also mean that some management companies generated greater growth in profits, but have yet to achieve other incentive requirements such as a minimum dollar value or debt-coverage ratio.
When we restrict our analysis to just those properties that paid an incentive in either 2011 or 2012 (but not both), we do see that the intended influence of the incentive fee. Within this sample, properties that paid an incentive fee in 2012, but not in 2011, saw their profits increase by 19.5 percent. Conversely, for properties that paid an incentive fee in 2011 but not in 2012, profits increased by just 2.9 percent. Therefore, those management companies achieving the profit growth from 2011 to 2012 were justly rewarded with incentive fees.
For the properties that paid an incentive fee in 2012, total management fees averaged 4.6 percent of total revenue. This compares to an overall Trends® sample average of 3.0 percent.
Looking at the individual components, base management fees equaled 2.9 percent of total revenue, while the incentive fees averaged 1.7 percent. Measured as a percent of profit, base management fees averaged 10.5 percent and the incentive component was 6.4 percent, for a total management fee ratio of 16.9 percent of net operating income.
PKF-HR is forecasting unit-level profit growth in excess of 10 percent each year through 2015. Accordingly, we believe the number of properties reporting an incentive fee payment will continue to rise.
More importantly, real profit levels are beginning to return to pre-recession levels. When this occurs, management companies will begin to surpass the performance hurdles in their contracts that heretofore have suppressed their ability to earn incentive fees.
Robert Mandelbaum and Viet Vo work in the Atlanta office of PKF Hospitality Research, LLC (PKF-HR). To purchase a copy of Trends® in the Hotel Industry, please visit www.pkfc.com/store. This article was published in the December 2013 edition of Lodging.
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