In hotel management agreements, the alignment of interests between hotel owners and operators is often more theoretical than practical. Operators typically earn a base management fee tied to a percentage of gross revenue and an incentive management fee tied to profitability, most often a percentage of gross operating profit (GOP) or adjusted net operating income. While this incentive fee is meant to motivate the operator to maximize the hotel’s bottom line, it does not always ensure the owner receives a fair return on their investment, especially during periods of underperformance.

To address this imbalance, every hotel owner should negotiate a provision known as the “Owner’s Priority.” This powerful clause defers payment of the operator’s incentive fee until the owner receives a minimum return, typically defined as a fixed dollar amount or a percentage return on invested capital. Only after this threshold is met does the operator begin to collect an incentive management fee.

How the Owner’s Priority Works

At its core, the Owner’s Priority is a hurdle or waterfall provision that protects the owner’s financial interest by establishing a preferred return on investment before any incentive management fee is paid to the operator. The typical structure works like this:

• Gross operating profit (GOP) is calculated as usual.
• From the GOP, expenses such as FF&E reserve contributions and property-level obligations are accounted for.
• Then, the Owner’s Priority is paid to the owner—this could be a fixed annual return (e.g., $2 million) or a percentage return on the owner’s invested equity (e.g., 8%).
• Only after the Owner’s Priority is fully satisfied, will the operator receive an incentive management fee from the remaining cash flow.

This structure is similar to a preferred return in private equity and real estate partnerships, where the sponsor (in this case, the operator) doesn’t receive a performance fee until investors (the owner) receive a specified return.

Benefits to the Owner

The Owner’s Priority provision has several key advantages:

• Ensures a Minimum Return: The owner is guaranteed to receive a minimum annual return before the operator receives an incentive management fee.
• Shifts Risk to the Operator: The operator must generate strong financial performance to earn its full incentive fee.
• Incentivizes Performance: It aligns the operator’s goals with those of the owner, encouraging a focus on profitability rather than brand-mandated spending or systemic priorities.
• Discourages Over-Investment: Since the operator’s incentive is subordinated to the Owner’s Priority, they are less likely to push for capital projects that dilute owner returns.

Negotiating the Owner’s Priority

Operators will often resist this provision or seek to lower the priority amount, especially in soft markets or for new hotels. Owners should be prepared to justify the level of return they seek, typically based on a reasonable return on equity or financing benchmarks, and be willing to adjust the incentive fee percentage accordingly.

Additionally, owners must ensure that the contract language is clear about how the Owner’s Priority is calculated and whether shortfalls in one year are carried forward (a cumulative shortfall) or reset each year (non-cumulative). The more owner-friendly version is cumulative, holding the operator accountable for underperformance over time.

Final Thoughts

The Owner’s Priority provision is a critical tool for hotel owners seeking to protect their returns and realign incentives with their operating partners. It ensures that the operator doesn’t profit when the owner does not. When properly structured and negotiated, it transforms the management agreement from a one-sided, brand-driven contract into a true partnership where both parties succeed only when the hotel performs effectively.

For More Information on Selecting a Hotel Operator and Negotiating a Management Contract Click Here

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