The global health crisis has shown the limits of the commercial real estate lease model, prompting landlords and tenants to turn to more flexible systems, such as hotel management or franchise agreements.
The hotel industry is particularly vulnerable to the major, unforeseen events that keep rocking today’s highly unstable business environment. From the 2015 terrorist attacks in Paris and Nice to the Covid-19 pandemic and its slew of movement and trade restrictions, not to mention the war in Ukraine, which has caused a massive spike in the cost of raw materials and energy, a series of unprecedented adverse events have plunged the hospitality industry into its worst crisis to date, challenging its reliance on the traditional commercial real estate lease model.
The limits of hotel leases
The Covid-19 crisis has exposed the shortcomings of commercial lease arrangements, which, while they have the merit of protecting the tenant by entitling it to a renewal option and, therefore, to compensation for eviction, they also leave it to bear the bulk of the operational risk, as has been established by legislation, case law and contractual practice.
In its three rulings of June 30, 2022, the Court of Cassation (France’s highest court) held that the tenant alone bore the risks posed by the pandemic, favoring a strictly materialistic interpretation of the landlord’s obligation to deliver possession, reducing it to the mere obligation to make the leased property available to the tenant—without regard to the fact that government restrictions on service to the public had made it impossible for the tenant to use the premises in accordance with their intended purpose—, and denying the tenant the benefit of “force majeure“.
Tenants under hotel leases have therefore been forced to deal with rent payments and pandemic-related risks on their own, unlike hotel operators who run hotels under management contracts.
The import of these rulings has been underestimated, when the court’s position effectively amounts to burdening the tenant with the risk of force majeure and government action, so long as there is no material damage to the leased property .
Tenants’ extreme exposure to real estate and business risks is exacerbated by the length of commercial lease terms, whether fixed by law—which, for instance, requires registered apartment hotel leases to have a minimum initial term of 9 years—, or by the contractual practice of institutional landlords in the traditional hotel industry, which also impose lengthy minimum terms.
While the Court of Cassation has recently ruled that renewed leases must provide for a 3-year break option , the fact remains that the initial 9-year commitment transfers most of the real estate and business risk to the tenant alone.
Cost-sharing provisions are particularly detrimental to the tenant—who, under most institutional leases, is responsible for adapting the property to changing regulations—, given that, while the French Commercial Code prohibits any transfer of the burden of “major repairs”, the narrow definition of that term under Article 606 of the French Civil Code does not, in principle, include the replacement of large equipment, which can therefore be transferred to the tenant.
The new challenge that both parties have to face is that of sustainable development and corporate social responsibility (CSR). It should be recalled that the commercial real estate provisions of Article 175 of France’s 2018 housing law (“loi ÉLAN”) , which apply to commercial buildings greater than 1,000 sq. ft.—e.g., hotels—, impose a three-stage reduced energy consumption goal: -40% by 2030, -50% by 2040 and -60% by 2050. Noncompliant businesses face a fine up to 7,500 euros, as well as the publication of their name on a government website (a sanction known as “Name & Shame”). Since the 2018 housing law does not apportion responsibility between landlord and tenant, the respective obligations of the parties, including as regards repairs, energy consumption management, and liability for any “Name & Shame” or other sanctions imposed on either party, must be clearly established in the lease. The further deterioration of the economic and regulatory
environment, the heightened risk of war and disease outbreaks, and, on a more positive note, the development of multi-use assets (the hotel market boasts an increasingly diverse and complex offering that ranges from tourist accommodation to co-living, co-working or dining options, all of which may be combined into a single asset) require adjusting the leases or asset-light contractual arrangements that are used to share value between hotel operators and investors.
Asset-light model now the preferred route for operating a hotel
While hotel management already was the preferred model before the Covid-19 crisis, it is now used ubiquitously as a way to keep operators from bearing the financial risk of running the hotel, as they do under commercial leases which provide for variable lease payments and guaranteed minimum payments to be made to the landlord, irrespective of the revenue generated by the hotel.
Compared to a commercial lease, hotel management is a much more flexible operating model whereby the owner of the business (which may also be the owner of the property) hires a professional manager to run the hotel in its name and on its behalf. The manager uses its own brand and its own distribution channels, if it is part of a hotel chain, or acts as a franchisee, if it is a “white label operator” that wishes to run the hotel under another name and rely on the expertise and network of another brand.
For the manager, this model has the undeniable advantage of transferring all operating and financial risks to the hotel owner. As a type of agency arrangement under Article 1984 of the French Civil Code, it is more flexible than the business lease model, in particular as regards its term and the compensation to be paid to the manager, which consists of a fee based on the revenue generated by the hotel and a “performance fee” calculated as a percentage of the gross operating profit. However, as a way to keep control over the operation of the business, the hotel owner may establish a “performance test” whereby it will be able to terminate the agreement for free if, after a designated period of time—for example, two consecutive operating years—, the gross operating profit fails to reach the required level and falls below the revenue per available room (RevPAR) of a selection of competitors (the “competitive set” or “compset”).
In contrast to a lease, where the landlord is not the tenant’s business partner, a management contract establishes a real financial partnership between the hotel owner, which has a vested interest in the profitability of the hotel—not just that of the building—, and the manager.
