Key money incentives: To take or pass?

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As developers contend for the most desirable urban real estate for their new brands, should they consider this tool?

by RAHUL PATEL

Three huge trends surging through the hospitality industry – millennials, technology and the rise of Airbnb – have spawned a plethora of responses to consumer demands. Out with the old and in with the new.

Glo, Vib, Tru, Moxy, Cambria, Radisson Blu, Ascend, Even and Centric are just a few examples of the litany of new brands that are storming into the market. They are all striving to cash in on a rapidly shifting hospitality landscape where young, hip, urban-centered travelers are driving demand.hree huge trends surging through the hospitality industry – millennials, technology and the rise of Airbnb – have spawned a plethora of responses to consumer demands. Out with the old and in with the new.

What is the demand? Technology and modern lifestyles are diverging from traditional brands offering wi-fi and continental breakfast. Consumers want their hotel to blend with their lifestyle. These new brands, with yoga mats, rooms without closets, doors opened by smartphones and so many other new features are almost unrecognizable to older travelers, who largely remain loyal to established legacy brands.

“This revolution in guest-room design is not due to costs but competition.According to industry statistics, the hotel industry has been experiencing steady growth for 84 months as new entrants in this sector are introducing innovative brands and designs that are the combined result of changing consumer trends, hospitality research and the ‘Airbnb effect,’” CNBC said in June 2017, citing Guy Langford, leader of Deloitte’s Travel, Hospitality and Leisure advisory group.

And that’s the rub for the well-known, rock-solid brands that have dominated the industry for so long. The Airbnb phenomenon, the explosion of internet connectivity and the millennial generation have rocked the playing field. The established brands must satisfy their older customers’ demands while scrambling to offer completely new kinds of experiences to keep up with younger consumers. And they know they must do so quickly or risk losing market share.

That pressure to establish a foothold with millennial travelers before the opportunity is lost is bringing about the resurgence of an old industry tool – the key money incentive.

Traditional power brands such as InterContinental, Radisson, Wyndham, Choice and Best Western are all grappling for the most desirable urban real estate for their new brands. Their fervor is prompting many to sweeten the deal by dangling key money incentives in front of hotel developers. These incentives are meant to convince developers – and assist them – to quickly launch the new brands in prime locations before a competing hipster brand beats them to it.

Key money incentives typically amount to 5 percent or less of the total project cost. On some projects, that could mean $1 million or more and could be dependent on the number of keys (or guest rooms) being delivered.

Sounds great if one of the big players is courting you as a developer. Who doesn’t like the idea of the franchise throwing in some of its own cash?

After all, the hottest urban-core properties in any city command top dollar. Total costs of land and construction can range from $15 million to $80 million on many of the new hospitality brands. A key money offer could offset some of the high upfront costs of getting a new property started on an expensive chunk of real estate.

But like with most good things, there is a catch. Although many of the umbrella brands here are proven franchisors, these newer brands are unproven. They commonly come with at least two major risk factors for the owner – pricey real estate and little to no customer loyalty.

The details are everything with key money incentives, however. Seemingly innocuous specifics can make the difference between a good or bad deal for the developer.

This is especially critical when the deal involves a new brand with no built-in customer base. The developer must scrutinize every detail about the contract – including any key money incentives – to reduce risk as much as possible.

For example, the franchise might offer an incentive tied to completion of the project by a certain date. If that date is missed, the incentive can disappear if the deal doesn’t include correct delivery flexibility. The developer loses potentially hundreds of thousands of dollars, or even more.

Keep in mind the most desirable urban locations are often among the most difficult locations for new construction. They could involve historic sites that are tightly regulated. They might be subject to strict sustainability rules. Couple that with tightening permitting rules, banking regulations and shifts in construction. High-barrier markets are dubbed that for a reason.

These and myriad other issues common in older, urban centers can wreak havoc with construction timetables. And that could make or break a key money incentive tied to a completion deadline. So, as a baseline, it is imperative to understand the milestone dates along with negotiating extensions from the onset.

A range of other forms of incentives and obligations could also be in the mix on any hotel management agreement. Often the incentive is presented as an upfront cash incentive but is really a loan/equity hybrid, where the franchise contributes certain funding as a key money incentive (with a payback burn off). However, this likely comes with an increased franchise fee (or desire to not reduce to market standards).

As such, the incentive really is more like a loan that is keyed off the hotel’s revenue, often for the life of the franchise agreement. Sometimes, depending on the expected total room revenue, that incentive money could add up to a costly loan reaching even into double digits.

The developer should also avoid assuming a key money incentive on one of the edgy, new hotel brands is just like any other key money incentive they might have seen before. Experience as a developer is extremely valuable but also dangerous if it leads to complacency about the fine details of any incentive offered.

Given that the legacy companies are almost frantic to quickly establish their new brands, those fine details could be significantly different than those seen in previous hotel management agreements.

One area you want to very closely review is your area of protection (“AOP”) to be sure that this takes into consideration legacy brands as well as the brand’s foray into new ventures.

Finally, everything is negotiable when it comes to key money incentives. The risks associated with launching an unknown brand are substantial. It’s up to the developer to negotiate aggressively to reduce those risks to the maximum extent possible and open a dialogue with the brand to address the primary concerns.

After all, this is a new venture for the franchisor, as well. And valuable input from the developer doesn’t go unnoticed.    ■

Rahul Patel is managing partner of Patel Gaines, a Texas-based law firm, and an adjunct professor of hospitality law at the University of Houston’s Conrad N. Hilton College of Hotel and Restaurant Management. He has represented more than 200 hotels and is a frequent speaker at AAHOA’s events. He also serves on AAHOA’s Government Affairs Committee.

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