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Hotel Lawyer with more advice on Hotel Management Agreements, focusing on critical budget provisions.

HMA Budget Provisions: Why they are so important, and 5 Key elements for a good budget provision

by Robert E. Braun | Hotel Lawyer

Introduction

We have emphasized in previous articles how a good hotel management agreement can add significant value to a hotel property, and how a bad one can detract just as significantly - a swing of as much as fifty percent in value.

Good agreements create a balance between the rights and needs of managers to have the authority to operate a hotel in a consistent and predictable manner, while creating accountability and responsiveness to the Owner. One of the ways of achieving this balance is through the budget process detailed in a well-drafted hotel management agreement or HMA.

Importance of Budgets

It is difficult to overstate the importance of a meaningful budgeting process for a hotel. Ultimately, the budget represents the implementation of the Owner and Operator's vision for the Hotel. It is the means by which the Owner and Operator achieve the qualitative goals we associate with the brand or style of the hotel, and the quantitative goals of achieving a well-run, efficient and profitable business. Moreover, it is often the means by which we judge the performance of the Operator.

The approved budget is also key to many other provisions in the agreement. Often, the inclusion of a line item expense in a budget will constitute the Owner's approval of that expense without further inquiry. For this reason, Owners consider the budget process seriously and recognize that it will have far-reaching impact on the success of the property. Properly drafted, the budget process created by the HMA provisions can provide the Owner its most significant ability to affect the operations, profitability and success of the Hotel.

Challenges

Owners face a significant challenge in the budgeting process. Simply stated, the Operator has the upper hand for a variety of reasons. Unlike Owners, Operators create budgets all the time. Operators have entire departments of staff dedicated to budgets and have much greater experience than do Owners. This experience and capacity gap increases each year. Operators almost always dictate the form of the budget, giving them a benefit in presentation (and knowing in which 3 line items an expense is buried). Moreover, Operators have access to much more information than do Owners, both as to the property at issue and all of the Operators' other properties. For these and other reasons, Operators almost always have a big "home field advantage" when it comes to creating and evaluating budgets.

Owners face another challenge in that while Operators spend many months preparing a proposed budget - some Operators have told us that budgeting is, in fact, a year-round process - Owners have only a short window of time at the end of the year in which to evaluate and critique budgets. Given the reality of Thanksgiving, Christmas and the New Year's holidays, Owners have only four to five weeks to evaluate and respond to the budget that Operators have been preparing for months.

5 Key elements to a successful budget provision

Given these facts, there are five key pieces to crafting a good budget provision in an HMA that can add great value to the hotel and save a lot of grief when times get tough.

1. Time

The proposed budget must be delivered in time for the Owner and its advisors to evaluate it carefully and thoughtfully respond - at least sixty days before the beginning of the fiscal year, typically November 1. Doing so will allow for the necessary review, comments, redrafting and review that makes the budget process meaningful. If possible, the operator should provide preliminary budgets even earlier.

2. Scope of review

Some operators will attempt to limit the scope of the Owner's review by stating that certain estimates, such as anticipated room rates or expenses necessary to meet brand standards, are not subject to Owner's objection. This is wrong! The Owner should have the ability to question everything in the budget. It doesn't mean the Owner will always prevail, but the Owner should have a say.

3. Owner's Approval and Resolution of Budget Dispute

Meaningful approval rights. Owner's approval rights of the budget must be similarly meaningful. It is not adequate to provide that the Operator shall consider Owner's comments in good faith, and then shall be entitled to make the final decision in its sole discretion or words to that effect.

Use of an independent expert. If a dispute cannot be resolved between the parties, it should be handed to an independent expert who reviews the issues from not only the operator's side but also from the Owner's side. We also like to provide a standard (other than just "brand standards") that governs how the expert will decide the dispute.

Baseball arbitration. Often, it makes sense to be explicit and consider "baseball" arbitration as an alternative to "traditional" arbitration. In baseball arbitration, the arbitrator must adopt the position of either party, but cannot custom design his own random solution. Baseball arbitration tends to force each of the parties to be more reasonable (i.e. to narrow the gap) so that they don't lose everything they want. And it means that at least one party's vision will be implemented, instead of a cut-and-pasted collage of two different approaches.

CapEx should be sole approval of Owner. There is one exception to an arbitrated resolution of budget disputes - capital expenditures. Capital expenditures beyond its regular, agreed-upon contributions to an FF&E reserve should be within Owner's sole control.

What happens if no agreed budget? Hand-in-hand with approval is a means of operating the hotel pending resolution of a budget dispute. Most agreements provide that when the parties cannot agree on the budget (or any parts of it) the Operator will operate in accordance with the part of the budget that are agreed upon, and for the other parts in dispute, will operate under the prior year's budget with some kind of adjustments. While this is generally workable, adjustments should be considered where a prior year included one or more unusual transactions or events.

4. Budget Format

While it should go without saying, budgets must be provided in adequate format and detail to provide real information about the Operator's plans. Budgets should be detailed enough to include not only the line items, but clear narrative explanations of the assumptions underlying those assumptions. It is also essential that the budget process be integrated, so that operating, capital and marketing be presented as a unified whole.

Budgets should also be zero-based, rather than an increase (or decrease) of the prior year. The underlying assumptions and rationales of the budget need to be rethought and reanalyzed, so that Owners are not presented with the repetition of prior years' mistakes and do not miss changes in markets or technologies that move so quickly.

5. Variances and Amendments

Most operators argue that budgets are a planning device but cannot be relied upon, and they should be authorized to stray from the budget. This results in a meaningless budget. We believe that the Operator should be contractually required to adhere to the budget except for permitted variances which are carefully defined in the budget provision of the HMA.

Consequently, while minor variances can be tolerated, some basic guidelines should be followed:

What goes up also goes down - Operators often provide that expenses can increase when occupancy increases. That may be true, but operators should be held to the opposite as well. when occupancy drops, operators should work effectively to reduce expenses and maintain profit margins.

Budgets line items are not fungible - Operators sometimes argue that savings in one part of a budget should allow for overruns in others. This merely makes the budget process ineffective. each part of the budget should stand on its own.

Back to the Future - Changes to the budget should not be imposed by the Operator alone. if circumstances change, the operator should submit a new budget for review and approval on the same basis as the original budget.

Don't be a stranger - The budget should be considered with each monthly reporting period, and the operator should be required to report regularly on its budget compliance, the causes of variations, and how they are being addressed.

Conclusion

Hotel owners who fully participate in the budgeting process can positively affect the operations and profitability of the hotel. The budgeting process can be time-consuming. But isn't it worth taking the time once a year, however inconvenient, to protect your investment? The budgeting process can also be contentious. But isn't it worth it to work through disagreements to find ways -- one line at a time -- to leverage your investment into greater profitability? And wouldn't it be great if you and your operator understood and respected each others' needs and were aligned in your commitment to owning and operating a great hotel?

This is Jim Butler, author of www.HotelLawBlog.com and hotel lawyer, signing off. We've done more than $60 billion of hotel transactions and have developed innovative solutions to help investors be successful in bidding for hotel acquisitions, and helping investors and lenders to unlock value from troubled hotel transactions. Who's your hotel lawyer?