If one starts with the basic premise that hotel managers should be paid for managing, the incentive management fee structures that are prevalent today largely miss the mark. They actually compensate managers based primarily on overall market performance, rather than their individual merits as managers.

HVS;
Hotel managers are typically paid a base fee equal to 2.0%-to-3.0% of total revenue—3.0% being the most common—plus an incentive. Incentive fee structures vary, but over the last decade or so, they have coalesced around a formula that pays managers 10% to 20% of cash flows that exceed a certain performance threshold. This threshold is generally reached when the net operating income exceeds a return on the owner’s investment of between 8.0% and 10%. 

The concept behind incentivizing managers based on free cash flows available to owners is to align the interests of management companies with those of owners. Unfortunately, an even more basic concept is often forgotten─ that managers should be compensated based on how well they manage. The structure of incentive fee thresholds compensates managers primarily based on the performance of the market, rather than the results achieved by management—exclusive of market performance. As a case in point, during the go-go years between 2004 and 2007 scarcely a manager went without incentive fee compensation, while in the down years of 2009 and 2010 the opposite was true. A better system would compensate high-performing managers for better-than-average performance in years good and bad. 

Management’s effectiveness is evidenced by two primary results: the ability to generate an appropriate share of top line revenue within the relevant competitive market (in other words, to produce the highest possible level of revenue per available room—RevPAR—penetration1); and to convert that revenue into as much sustainable cash flow available to the owner (net operating income, or NOI) as possible. Thus, the best way to truly align the objectives of management with those of ownership would be to base management compensation on RevPAR and Gross Operating Profit (GOP) margin penetrations2. Using GOP margins instead of NOI margins makes sense because expenses that are deducted from GOP to derive NOI, like insurance and real estate taxes, are mostly outside of management’s control. Managers should be compensated for executing well on things that are under their control; they should not be rewarded—or penalized—for things that are not. Below is a quick reference list of things that can be primarily controlled by management, and those that are primarily controlled by ownership as they relate to RevPAR and GOP margin penetration. 

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