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SHA614: Achieving Hotel Asset Management Objectives

School of Hotel Administration, Cornell University

Project: Tactical Renegotiation for the Tucson Turnadot Hotel

Instructions:

First, read the Case Description and review Exhibits A and B on page 5 of this document. You should also review Exhibits C, D, and E, which you can download. When you have read the description of the case and reviewed the supporting materials, answer the five questions on page 4 of this document.

To submit this assignment, please refer to the instructions in the course.

Case Description

The Tucson Turnadot Hotel is a 400-room four-star suburban hotel; it is widely considered to be a well-run hotel that achieves a slight RevPAR premium compared to its competitors. Like many hotels built in the late 20th century, the hotel opened with two restaurants, but demand for the specialty restaurant dwindled and the space has been vacant for over a year. The owner (“Owner”) and manager had discussed a conversion of the space to meeting rooms but acknowledged that additional meeting space was not in demand at the hotel. The Owner of the Tucson Turnadot Hotel (“Hotel”) proposed to the manager that the Hotel enter into a lease with Sophie’s Restaurant in 6,600 square feet of vacant space (the former fine-dining restaurant) adjacent to the Hotel lobby. (See Exhibit A for an abstract of the proposed lease.)

Sophie’s is a well-known and well-respected steakhouse restaurant in Tucson. As part of the lease agreement, the Owner would invest $1,025,000 of the $3,025,000 investment needed to convert the vacant space into an operating Sophie’s Restaurant, with Sophie’s contributing the remaining $2,000,000. The new restaurant is expected to open at the beginning of Year 1. Both the Owner and the manager, Turnadot Operations (“Turnadot”), agree that the proposed steakhouse restaurant would make a positive addition to the Hotel. On the other hand, the manager made it clear (and the Owner reluctantly agreed) that the management contract gives Turnadot the right to reject any such change in the operation for two major reasons. First, the change would affect brand standards, as indicated below, and second, the management contract gives Turnadot (not the Owner) the right to control every aspect of the Hotel’s operation. Thus, to implement the change, the management contract would have to be amended to allow the leased restaurant.

The Hotel currently has one operating restaurant, the Grazer’s Grill, a classic three-meal hotel restaurant operated by Turnadot. The Owner’s original proposal was to close the Grazer’s Grill and convert the space into meeting rooms as soon as Sophie’s Restaurant opened. The tenant of Sophie’s Restaurant indicated that they are willing to work with Turnadot to operate all food and beverage at the Hotel according to Turnadot brand standards, including breakfast and dinner from Sophie’s and room service and catering from the banquet kitchen. However, Turnadot brand standards require Turnadot to operate at least one restaurant in the Hotel because prior experience indicates that leased restaurants do not provide acceptable breakfast service, room service, and catering services, which are important to overall guest satisfaction. The Owner reluctantly agreed to Turnadot’s position over the short term, even though the profitability of Grazer’s Grill will be reduced as hotel customers use Sophie’s Restaurant for lunch and dinner. All three parties (Owner, Turnadot, and Sophie’s) have agreed to revisit the relationship after two years of operation by Sophie’s; this will allow the new restaurant to open and stabilize, and it preserves the option to integrate the F&B operations into Sophie’s at a future date.

The Owner and Turnadot jointly prepared a financial analysis of changes in the hotel; this analysis is attached as Exhibit C. Both the Owner and Turnadot have confidence in the Exhibit C analysis.

Treatment of Restaurant Investment under the Management Agreement

Under the terms of the Management Agreement, the Owner’s $1,025,000 investment in the restaurant could be treated in two ways.

1. FF&E loan—The Owner could make an FF&E loan to the Hotel to finance the investment; any FF&E loans carry an interest rate of 8.0%. The loan will be repaid in five equal payments of $300,000. The loan is treated as a deduction when calculating the incentive fee for Turnadot. Thus, FF&E loans have the effect of lowering Turnadot’s incentive fee. This treatment lowers the taxable income of the hotel due to the treatment of the loan’s interest as an expense.

2. Additional capital investment—The Owner’s priority will be increased by 10.75% of the additional Owner investment of $1,025,000. This will also lower Turnadot’s incentive fee. This treatment has no impact on the taxable income of the Hotel.

Impact on Turnadot Management Fees

The terms of Turnadot’s management fees are presented in Exhibit B. Turnadot earns a base fee based on Hotel revenues and an incentive fee if Hotel profit exceeds the Owner’s priority. Turnadot has not earned any incentive fees because the Hotel’s profit has not exceeded the Owner’s priority. Due to improvements in the Tucson market, the Hotel is projected to exceed the Owner’s priority in the next few years.

Turnadot prepared an analysis of the impact of the restaurant lease on Turnadot’s management fees, which is presented as Exhibit D. The analysis compares Turnadot’s management fees assuming the investment is treated as an FF&E Loan with the management fees that would be incurred if the investment were instead treated as an additional capital investment. The 8% discount rate is Turnadot’s after-tax risk-adjusted WACC. Turnadot has not shared the Exhibit D information with the Owner.

Financial Analysis for the Owner

The Owner prepared a financial analysis of the impact of the proposed restaurant lease on the value of the hotel, which is presented in Exhibit E. The analysis compares the Owner’s before-tax NPV assuming the investment is treated as an FF&E Loan with the NPV of treating the investment as an additional capital investment. The 12% discount rate is the Owner’s risk-adjusted before-tax required return. The Owner has not shared the Exhibit E information with Turnadot.

Questions

1. Acting as an asset manager representing the interests of hotel ownership and considering only the financial analysis, would you recommend that the investment be treated as an FF&E loan or additional capital investment? Why?

2. Acting for Turnadot and considering only the financial analysis, would you recommend that the investment be treated as an FF&E loan or additional capital investment? Why?

3. Now expand your analysis to consider more than just the finances. List two qualitative factors that the Owner should consider and two qualitative factors that Turnadot should consider. How would they alter your analysis for either side?

4. Should Turnadot waive its brand standard and close the hotel restaurant? Why or why not?

5. How might the Owner and Turnadot deal with the impact of the new restaurant on Turnadot’s management fees?

EXHIBIT A

Proposed Sophie’s Lease Terms

Term: 10 years plus four five-year renewal options.

Rent: The rent is the sum of the Minimum Rent and the Percentage Rent.

Minimum Rent: Year 1 $150,000

Years 2–10 $200,000

Years 11–15 $220,000

Years 16–20 $242,000

Years 21–25 $266,200

Years 26–30 $292,820

Percentage Rent: 5% of restaurant revenues above $3,000,000

Tenant Improvements: $3,025,000 total investment—$2,000,000 to be paid by tenant and $1,025,000 to be paid by the Owner.

Utilities: Sophie’s is to pay for all utilities in the leased space, estimated at $25,000 in the first year of the lease.

EXHIBIT B

Turnadot Management Fees and Term

Contract Term: 20 years with two 10-year extensions. The contract has 11 years remaining in the initial term.

Base Fee: 3% of revenues

Incentive Fee: 25% of Incentive Fee Cash Flow (defined as net House Profit less the Owner’s Priority)

Owner’s Priority: $4,898,341. This sum is 10.75% of $45,565,963, the cumulative amount of the Owner’s investment in the Hotel before any investment in Sophie’s Restaurant. If the investment in Sophie’s Restaurant is made, the Owner’s priority increases to $5,008,529.

Exhibit C

Exhibit D

Exhibit E

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