The third way – the future of franchising

In years gone by, hotel franchising was associated almost entirely with the budget segment. Beginning in the mid-1950s with Howard Johnson motor lodges, followed by Holiday Inn, the franchise model rapidly gained traction as a way for brands to expand their business without sinking large sums of capital.

Until relatively recently, however, this was not an arrangement favoured by the mid-market and upscale tiers. For sure, franchising has many advantages – not least flexibility and serious cash-generative potential – but it does mean ceding some control. Entrust your operations to a franchise partner, and you’re letting go of what, historically, was the nub of your business.

Even once an asset-light strategy became the norm, and brands began to sell off their real estate, they typically wanted to stay in charge of their management. For higher-end brands, the dominant business model was the management contract, in which properties were sold to investors and leased back under long-term agreements. 

It is only over the past decade or so that franchising has taken off across all segments. The much discussed separation of ‘bricks and brand’ is now, to a large extent, being displaced by a three-way split – that between ‘bricks, brand and brawn’. In other words, the investor owns the real estate; the brand determines its overall look and feel; and the day-to-day operational work is carried out by a third-party franchisee.

Take IHG, which owns Holiday Inn. Committed to an asset-light strategy since 2003, it franchises the vast majority of its hotels, with most of the others operated under management contracts, and less than 1% owned and operated in their entirety. Marriott, too, owns less than 1%, and Hilton 3%, with most of the other major players similarly unencumbered.

As Aaron Greenman, executive vice-president, acquisitions and development EMEA, Interstate Hotels, explains, brands’ increasing willingness to franchise can be attributed to their changing role. Today, their key point of focus is not so much hotel management as it is marketing and distribution.

“The distribution side of the equation has become challenging for them in this era of online travel agents and other distribution channels,” he says. “So what brands have realised is that it behooves them to have strong real-estate ownership partners and management partners. They’ve realised they can’t do everything, and that it’s simply not the best business model when they try.”

Franchise model

As a leading global hotel management company, Interstate currently manages around 430 properties worldwide under franchise agreements. While many of these properties are in the budget tier (Best Western, Holiday Inn and Hilton Garden Inn, for example), many others (Autograph Collection, Renaissance or Four Points by Sheraton) are franchised under mid-market, boutique or luxury brands.

This general pattern is being replicated across the board – not just in the US, where franchising has already attained
a level of maturity, but in Europe too. According to property advisory firm CBRE, in the years up to 2020, more than 50% of all new four-star hotel deals in Europe will be under franchise.

For UK leader Redefine|BDL Hotels (RBH), the European market is one with serious growth potential. The company (which has 44 hotels in its portfolio to date and another 12 under construction) is currently working on the development of a five-star Westin hotel in central London, slated to open in mid-2017.

“Some of the hotel chains have certain brands they won’t franchise – particularly newer brand concepts at the luxury level,” says Andrew Robb, director of business development. “The reason for that is they want to make sure the brands are being rolled out correctly and in line with their strategy, and, at a luxury level, they want to do that themselves to begin with. However, as they gain more control over their brand, and the third-party management companies improve their credentials, they become more interested in franchising arrangements.”

The brands, however, are only half the story. As Robb sees it, the growth of franchising actually has more to do with the hotel owners, who are waking up to the fact that the model can bring them higher returns.

“Typically, when the brands operate directly, they focus on revenue and guest satisfaction but have been less successful at driving profit,” he says. “We achieve that through a bold and aggressive approach to revenue management and a meticulous focus on controlling costs.”

Brand-managed operations also tend to suffer from a lack of clarity in their objectives. As a rule, the brand is most interested in maximising its own business, while the owner cares about optimising local profits. This can lead to friction between the brand’s priorities and those of the individual hotel.

A third-party management company, however, is straightforwardly aligned with the owner. This makes sense for the brand (which no longer needs to worry about the owner’s returns) and for the hotel (which can unabashedly pursue its own needs).

“Ultimately, the owner of the real estate benefits by having a management company involved,” says Greenman. “Companies like Interstate are purely focused on driving the guest experience, employment satisfaction for the employees and profit for the owner.”

The third party can even go further and advocate for the owners, consolidating their feedback into a single message that makes sense to the brands.

“We can work as one voice putting the points across to the brand, rather than multiple different owners not getting the right level of recognition,” says Robb. “RBH has a strong voice within each brand, and works with them to discuss the implementation of new standards and minimise costs.”

In third place

Of course, whatever its merits, the bricks-brand-brawn split does bring certain operational challenges. Let’s say you work in food and beverage. Under an owner-operator model, you only need to get your head around the habits of a single brand. But if you’ve been recruited by Interstate or RBH, you’ll need the capacity to flit between multiple points of view.

“Our people need a kind of intellectual flexibility,” says Greenman. “When you’re working with 50 brands, it really takes an understanding of what makes the different brands unique and how you can execute that. To a certain extent, it’s like the most talented actors, who may be playing two or three roles at a time.”

Then there’s the fact that franchise arrangements are not always readily understood by hotel investors.

“It’s not only the owners that need convincing, it’s also the owners’ financing partners,” points out Greenman. “Any lender that is lending 65% of the value of a newbuild hotel will want to understand who is running it, and they may not always be the most connected to the latest trends. If it’s not the brand, they will want to know why. So this is a constant challenge and one I don’t think will ever go away.”

Ultimately, though, the strength of the model is more than a matter for conjecture – it can be determined by financial performance, which is a useful proxy for guest satisfaction. On average, hotels with a franchise brand name have higher valuations than those that are owner-operated.

For Greenman and Robb, there is little question that franchising will continue to grow, albeit with some geographic variability.

“In markets where institutional capital and private equity is more active, and hotels are regarded as a sophisticated asset class for investment, I think there is an accelerated opportunity for companies like Interstate,” says Greenman. “In markets like the Far East and Middle East, investors tend to be much longer term in their investment outlook, so third-party management will come in slower there, but the trend worldwide is the same.”

“In Asia and the Middle East, the brands are often retaining control of operations due to the lack of strong third-party management companies in the region, but, over time, as happened in US and the UK, this will develop and the trend will then continue into these regions,” adds Robb.

For the time being, the European market holds the most interest to franchisees, with Interstate looking to demonstrate its capability in the key markets of Western Europe, before moving further east. RBH, meanwhile, recently opened an office in Frankfurt, and is proactively targeting Germany and Poland.

“The brands are still very much on an upward growth curve, particularly in countries like Germany,” says Robb. “Because these markets are dominated by national brands, the global chains are seeing a lot of opportunities. And in order to capitalise on these, they need skilled on-the-ground operating companies that will allow them to get multiple projects under way at the same time.”

Most likely, the upper tier of the market will continue to lag behind the rest when it comes to franchising – after all, entrusting a luxury hotel to a third party requires a bigger leap of faith, and a greater price to pay if something goes wrong. However, as the big hotel players continue to pursue aggressive growth strategies, and the franchisees accumulate experience, it seems likely that even upscale brands will start to embrace this model.