Hotel Management Agreements: A Guide to Key Money

This article is part of our ongoing series HMA Bites, which offers short, practical insights into key features of hotel management agreements (“HMAs”). Each instalment explores a specific clause or commercial issue that frequently arises in hotel operating arrangements.

In this edition, we take a closer look at key money — what it is, why it is used, and the issues parties should consider when negotiating key money provisions in HMAs.

What is Key Money? 

It is an upfront payment from the Operator to the Owner, often offered to induce the Owner to enter into an HMA with that Operator. Typically, it helps the Owner with a soft contribution to development costs or re-branding renovations. The amount of key money offered varies depending on the scale of the hotel development or its re-branding. It can be quite small but can also run into several million dollars. Private equity-type investors tend to favour having key money as it immediately helps with cash-flow, the balance sheet and the internal rate of return (IRR) for the project.  

So why do Operators offer Key Money?

Key money may be just the final piece that tips the scales in their favour – it helps them to stand out in the operator selection beauty parade. Traditionally in Asia, Operators only offer it for key assets or “crown jewel” properties, or where they are bringing a new brand to a particular market. However, it is becoming an increasingly common commercial consideration when persuading an Owner to reposition its asset with a re-branding exercise.

Any Strings Attached? 

Of course - like most terms in commercial negotiations, key money comes with conditions and caveats. 

1. Timing. The payment of key money is not made upfront upon the HMA being signed. Typically, it is only paid after certain works have been completed and the Hotel opens under the relevant new brand. As such, the Owner would already have funded the renovation costs or capital expenditure and naturally should not be overly reliant on the key money offered – as it is always meant as a soft contribution and offset.

2. Amortisation. The key money amount usually amortises over the life of the HMA, or at least the initial term. This means that if the HMA terminates earlier than expected, the unamortised portion will be repayable to the Operator. Importantly, this typically applies to termination in any scenario – and yes, sometimes, this is even in cases where the termination is caused by an Operator default. 

   This is a contentious point in the HMA negotiation. From the Operator’s perspective, key money is a significant investment (and risk) made in expectation of a successful partnership with the Owner and the Hotel’s performance over the long term. If the HMA is terminated early, not only do Operators lose their future management fees but they also lose the key money invested upfront. As mentioned above, this could amount to several million dollars. The Owner, on the other hand, has accepted the payment, used the funds and expected the benefit of the new brand for the full term - so why should it have to refund the unamortised portion? Thus, Operators typically insist on robust repayment provisions and Owners fight for carve-outs from repayment obligations in certain situations. 

3. What do we mean by the unamortised portion of the Key Money? As an example, say the Operator paid US$5 million in key money to the Owner for a 20-year HMA. This will then amortise on a straight-line basis at US$250,000 per year. If the HMA terminates in year 8 for any reason, the Owner will then have to repay the unamortised portion over the remaining 12 years of the term. This means that the Owner has to repay US$ 3 million to the Operator (US$250,000 x 12 years). In addition, the Owner is typically responsible for all taxes on the sums received and may also have to bear the “gross up” costs if there is any withholding tax payment on the refund payment. In other words, the Owner may be obliged to gross up the unamortised sum so that the Operator recovers the full unamortised amount on termination regardless of the tax withheld. In such instances, Owners will typically seek to avoid that burden where possible.
4. A commercial balancing act. Sophisticated and eagle-eyed Owners (or Owners’ counsel!) also tend to spot the trade-offs when Operators offer key money. Some common considerations include the following:

• Are the base fee or the incentive fees higher than the market standard?
• Are the Gross Operating Profit (GOP) thresholds for the performance test lower? Perhaps 80% to 85% of budgeted GOP instead of the standard 85% to 90%?;
• Is there a delayed performance testing period? For example, is the start of the test period pushed from year three to year 4 or 5;
• Are there expanded cure rights? For example, allowing the Operator an increased number of cure rights within a shorter time frame; or
• Are the approval rights of the Owner reduced? For example, are the approval rights only granted over a higher contractual sum for restricted contracts or a smaller number of key employees?

These concessions can significantly impact the Owner’s ability to exit an underperforming HMA or maintain control over its asset. What is important to each Owner may vary. The key is for the parties to assess how it contributes to the overall position for the Owner, its commercial objectives and the overall commercial terms.

All in all, key money can be a powerful tool and mutually commercially beneficial in competitive hotel markets – but it is far from “free money” for either party. For Owners, it can provide helpful capital at critical stages of development, but potentially at the cost of aggressive repayment obligations, reduced negotiating leverage or exit flexibility or overall higher fees. For Operators, it is a strategic investment that can secure desirable assets, but which also carries financial risk if the partnership does not endure as planned. Both parties should carefully consider the implications of having key money and how it fits within and benefits the project overall.