Space as a service – the evolution of leases and management agreements

With the evolution of real estate as a service and as occupiers demand ever greater flexibility over terms, investors and operators are having to reconsider the form of their contractual arrangements.

This trend has been termed the "hotelisation of real estate", recognising that the idea of "space as a service", is expanding from the hospitality sector into other sectors. Examples can be seen in the residential context, with the growth in private rental and co-living schemes, with flexible lease lengths alongside concierge and membership services, and in the office sector, most obviously with the growth in serviced offices, as well as the trend towards managed central amenities for tenants such as communal meeting suites. Whereas the traditional approach would have been for owners to grant leases, thereby passing down the majority of the risk to the operators, we are seeing a growth in the use of management agreement structures – similar to the shift that has occurred in the hotel industry over the last 20 years.

Investors and operators, as well as other stakeholders such as lenders, and those advising them, will need to ensure they are aware of the particular features, benefits and risks inherent in such arrangements as they become more widely used in the market. Here are some key factors to consider:

1. Tenure

Firstly, a word on the legal status of these alternatives. They are sometimes used inexactly at heads of terms stages, but leases and management agreements are by their nature very different animals.

A lease is the grant of a proprietary interest involving the right to the exclusive possession of land for a determinable period of time. As such a lease is both a contractual relationship between the parties and an estate in land. Following on from that, it will be the tenant operator who will contract directly with the end users (with the owner being one level removed from the operations).

On the other hand, a management agreement is a personal contract between the signing parties. The manager will provide services to the owner, essentially selling space to occupiers (whether hotel rooms, residential apartments, or flexible office space), who will contract directly with the owner (or via the operator acting as agent). This gives the owner a more direct involvement in the operating business, although it also involves a greater administrative burden for the owner.

2. Financial modelling: rent and management fees

It is also important to appreciate that leases and management agreements have very different implications in terms of financial modelling.

It is a key element of a lease that the operator, as tenant, will pay rent to the owner. This is sometimes calculated as a percentage of turnover, protecting the operator from fluctuating occupancy levels (given it will otherwise bear all the risk of vacancies), although landlords may protect themselves with a minimum annual figure, since investors and funders generally favour long-term leases that provide steady, predictable income streams. In return, the tenant will retain the profit generated from the operating business, and may request an upfront capital contribution and a relatively long rent free period to give it breathing space to get the operations up and running and profit-making, without the burden of significant outgoings.

In contrast, in a management agreement structure, the underlying occupiers will pay rent/licence fees to the owner who will be entitled to the income, subject to the fee payable to the manager. The owner will therefore be directly exposed to the underlying occupational market, and will be analysing the deal based on projected occupancy levels, rather than a predictable rent from a single tenant as with a lease. Given the owner will be exposed to the risk of vacancies, the management fees are often performance-linked. Fees are often comprised of two components: a guaranteed base amount (calculated as a percentage of revenue from the operating business), and an incentive element (to be earned by the operator only if gross operating profit (calculated by deducting costs from revenues) exceeds an agreed threshold). Owners will want to ensure transparency in the way in which revenue and costs are calculated and particularly in the way that central costs (e.g. reservation or membership services) are allocated to a property. As such, the key performance indicators, and profit and revenue definitions, which set out what can be taken into account when calculating the costs payable by the owner and the fees due to the manager, are often the subject of detailed negotiation.

On the face of it, a lease provides greater security as it is the operator, rather than the owner, who has to deal with vacancies. However, it is not uncommon to see operators taking leases in ring-fenced SPVs with owners accepting limited recourse and capped guarantees – effectively meaning that even in lease structures, owners are often underwriting the success of the underlying operating business (based on their assessment of the underlying fundamentals – location, quality, demand – that will drive high occupancy rates), rather than the covenant strength of the operator itself.

3. Control and costs

Where an operator has a lease, it will generally have control to run the business as it sees fit, subject to specific requirements negotiated in the lease (e.g. an owner receiving a turnover rent may wish to require the operator to seek to maximise turnover). It will contract with and be directly liable to the end users who occupy the premises. In terms of costs, a tenant will typically be responsible for maintaining, repairing and insuring the property (or for paying the cost in relation to common parts), and for picking up other outgoings such as utilities and rates. Since granting a lease involves an interest in land, an operator taking a lease would also expect to pay SDLT, which may add significantly to the operator's costs.

A management agreement arguably gives less overall control to the operator, although it will usually be responsible for the day-to-day running of the business, including hiring employees, providing facilities, marketing and promoting. The agreement will set out how much or little input the owner will have in the business operation, and how the owner's residual liability should be addressed; if the operator acts as agent for the owner, the owner will want to be protected in the situation where the operator exceeds its authority or otherwise incurs liability for the owner without justification.

While owners hire managers to operate properties because of their expertise, resources and reputation, and serious interference with the operator's business decisions is likely to be resisted, the owner may wish to introduce approval rights over budgeting, expenditure and key operating decisions, given that the cost of maintenance, repair and other outgoings will fall to the owner. There can be a tension here, as the operator will want to be able to incur a level of expenditure to enable it to keep the premises in a high state of repair and decoration and reflective of its brand standards, whereas the owner will want to control what is spent and to have discretion over large sums. (This may be less stark where an owner appoints a manager to provide a "white label" (i.e. unbranded) operation on its behalf.) Given the link with the calculation of management fees, the management agreement should enable the owner to restrict the operator's ability to incur certain types of expenditure that may result in increased revenues, and therefore a higher base fee, but which may not correspond to increased profits – for example, sales promotions. Best practice leans towards the agreement of an operating budget with projected profits which the owner is able to review from time to time.

A question which arises is who employs the employees involved in the provision of the operations. In a lease structure, the employees would be employed by the operator. With a management agreement there is greater scope to discuss which employees sit within the manager, and which are more appropriately viewed as attached to the building and hence could be employed by the owner, albeit managed day to day by the operator. Where this is the case, an owner will nevertheless wish to be indemnified against employment liabilities which may arise.

Owners may also seek to include non-compete restrictions to prevent managers operating at competing locations within a defined radius. This will ensure the manager is not incentivised (for example by more favourable financial arrangements) to attract occupiers or potential occupiers to another building within the same catchment area, which could dilute the profitability of the owner's building. The extent to which this will be accepted will depend on the parties' respective negotiating strengths.

4. Assignment

It is typical for a tenant under a lease to be able to assign or underlet the premises (usually subject to the landlord's consent not to be unreasonably withheld), and in so doing pass the benefit and burden on to a successor. Similarly, if the owner was to sell the property, the purchaser would acquire subject to and with the benefit of the operating lease, which would continue to bind the successor owner.

In contrast, given the personal nature of a management agreement, it would be unusual to permit a manager to transfer the rights and obligations under a management agreement to a third party successor. And whilst a management agreement should not prevent an owner from selling the property (or a property-owning SPV), the agreement will need to be clear about what the parties intend to happen on a property sale, given it will not automatically run with the land. This is often overlooked by sellers and purchasers (particularly where the management agreement relates to an amenity area within a multi-let building and so may appear on a tenancy schedule for convenience), who incorrectly assume the arrangements will transfer across with the property on an asset sale (whereas the benefit of the management agreement would transfer across with the owner SPV on a corporate sale). This can also be an issue on financing, since a lender may be keen to ensure it has the ability to keep the management agreement on foot if it enforces its security, and similarly managers will often want to ensure they are able to continue notwithstanding a loan default by the owner – direct agreements can usually be negotiated to address these concerns.

5. Remedies/Termination

Where a tenant is in breach of covenant under a lease, a landlord will be able to invoke its statutory remedies under the Landlord and Tenant Acts, including forfeiture (subject to the tenant's equitable right to seek relief from forfeiture). A tenant would not normally have a right to terminate for landlord breach or insolvency. If greater flexibility is desired, the landlord could seek a fixed or rolling break right, subject to payment of a break premium, but given the lease will run with the land, this may not be considered necessary.

In the case of management agreements, the contract will specify the circumstances in which the owner or manager will be able to terminate or otherwise seek redress for breach of contract. The owner should have the right to terminate if the operator defaults under the agreement. This is often extended to failure to meet defined performance measures, or if the operator is the subject of a change of control or breaches a non- compete restriction. The manager may also be granted a right to terminate for owner default, subject to lender cure rights. As with a lease, an owner may reserve the right to terminate without cause (e.g. in the event of sale in circumstances where the purchaser does not wish to take on the manager), but should expect the operator to require payment of a termination fee in that circumstance.

A word of warning: to ensure there are no issues obtaining possession on termination, the owner should be careful not to accidentally create a tenancy under which the operator will enjoy security of tenure as a business tenant, by ensuring that the management agreement (both in its drafting and its operation) does not provide the operator with exclusive possession of the premises or otherwise have the hallmarks of a lease.

In either structure, business continuity on termination is critical, and the management agreement or lease should provide for a smooth transition on termination or expiry. That will include dealing with the question of who owns the intellectual property rights in the business' processes, computer systems and branded materials, access to occupier data, continuation of arrangements with key occupiers, and retention of key employees.

6. Conclusion

This is a dynamic and rapidly evolving area of the market, which has already seen structural change that is expected to accelerate. Owners, operators, funders and their advisers will need to be innovative, flexible and commercial to take advantage of the opportunities and successfully navigate the changes on the horizon.