Cap Ex2005 Australia

The Hotel School Intercontinental Tourism and Hospitality Industry Project
Borivoj Vokrinek 11/1/20101
Capital Expenditures
In the Australian Hotel Industry

A Pilot Study

By Borivoj Vokrinek
Autumn 2005

Tourism and Hospitality Project
Bachelor of Business in Hotel Management
The Hotel School
School of Tourism and Hospitality Management

Southern Cross University
Date:
10 November 2005

Capital Expenditures
In the Australian Hotel Industry

A Pilot Study

By Borivoj Vokrinek
Autumn 2005

Tourism and Hospitality Project
Bachelor of Business in Hotel Management
The Hotel School
School of Tourism and Hospitality Management

Southern Cross University
ACKNOWLEDGEMENT

I would like to acknowledge all participants in this study and commend them on
their willingness to share their knowledge and experience in this study.
A special note of thanks goes to Rutger Smits, ISHC, MIMC; from HVS
International – Sydney, for his encouragement and advice. Thanks to him I started
this research and had a great opportunity to discuss the CapEx issues with the
highly knowledgeable and experienced stakeholders involved in the Australian
hotel industry. Also, thank you to all the staff at Sydney office for your support
and understanding.
I also want to thank Paul Weeks, GradDipEd, MEd-Trg & Dev; from The Hotel
School Intercontinental, for enabling me to do this project and support along the
way.
Thank you.
The Author
Borivoj Vokrinek
ABSTRACT

This pilot study focuses on the issues relating to Capital Expenditures (CapEx) in
the Australian hospitality industry. High attention is paid to the thorough review
of the relevant literature with the aim of developing a solid knowledge base for
better understanding of the issues and further research. By utilizing in-dept
interviews with a variety of stakeholders, an attempt is made to identify and
explore problematic and/or important topics in an Australian context.
The study finds that the subject of CapEx is a considerable and topical issue for
the Australian hotel sector industry which would be beneficial to research further.
The CapEx are a complex matter but it seems that major issues are related to the
understanding of true CapEx needs and problems with achieving required returns
on CapEx.
No claims are made for the generalisability of findings, rather it is the intention to
raise the discussion and encourage further research.
TABLE OF CONTENTS

1 INTRODUCTION 7
1.1 BACKGROUND 7
1.2 SIGNIFICANCE 11
1.3 THE PURPOSE AND OBJECTIVES 12
2 LITERATURE REVIEW 13
2.1 CHARACTERISTICS OF HOSPITALITY INDUSTRY AND IMPORTANCE PHYSICAL
ASSETS 14
2.2 RESEARCH ON CAPEX 18
2.3 DEFINITION AND UNDERSTANDING OF CAPEX 20
2.4 CHARACTERISTICS AND FACTORS INFLUENCING CAPEX 26
2.5 PROVISIONS FOR CAPEX 37
2.6 WHY ARE CAPEX UNDERESTIMATED? 46
2.7 CAPEX PLANNING 47
2.8 EXPECTED LIFE OF THE ASSETS 51
2.9 ROLE OF ASSET MANAGER 55
2.10 OWNER/OPERATOR RELATIONSHIP AND MANAGEMENT AGREEMENTS 57
2.11 NEW TRENDS IN HOTEL OWNERSHIP AND DEVELOPMENT 62
3 RESEARCH DESIGN AND METHODS 65
4 INTERVIEW FINDINGS AND DISCUSSION 71
4.1 MAIN ISSUES IN REGARDS TO CAPEX 72
4.2 FACTORS SHAPING CAPEX 84
4.3 REPLACEMENT RESERVES AND CAPEX 92
4.4 CAPEX PLANNING 97
5 CONCLUSION AND FURTHER RESEARCH 99
6 REFERENCES 102
7 APPENDICES 110
APPENDIX 1 - THE EXECUTIVE SUMMARY OF CAPEX 2000 111
APPENDIX 2 - PWC SURVEY: RESERVE FOR REPLACEMENT OF FIXED ASSETS 117
APPENDIX 3 - EXAMPLES OF CAPEX BUDGET TABLES 118
APPENDIX 4 – DEFINITION OF RESERVES AND FF&E 120
APPENDIX 5 - ‘ABOUT THE AUTHOR’ AND ‘HVS INTERNATIONAL, SYDNEY’ 126
APPENDIX 6 – THE INTERVIEW PLAN WITH BROAD TOPICS 129
LIST OF TABLES & FIGURES

TABLES:
Table 1 – Major Expenditure Threshold to Warrant a Formalized Cost/Benefit Study 19
Table 2 - Composition of CapEx in % 28
Table 3 - Conditions influencing capital expenditures: 36
Table 4 – Useful Lives of FF&E components 39
Table 5 - USRC Hotel Investment Survey, Reserve for Replacement (US Investors) 44
Table 6 - Suggested Useful Economic Lives of Categories Tangible Fixed Assets 52
Table 7 - Effective Life of Depreciating Assets in the Accommodation Sector 53
Table 8 – Interests of Hotel Owners and Operators 58
Table 9 – List of Categories of Interviewed Stakeholders (in chronological order) 68
Table 10 – Job Titles, Associations/Membership and Expertise of Interviewees (in alphabetical order) 69
Table 11 – CapEx Categories used by interviewees 74
Table 12 – CapEx as percentage of revenues; individual averages over 10 year (6 properties, Australia) 85
Table 13 – Summary of Factors influencing CapEx spending based on the literature review 85
Table 14 – Factors shaping CapEx spending as identified by the interviewees 87
Table 15 – Performance of Hotels in Major City Markets, YTD May 2004/2005 90
Table 16 – Summary of provisions for CapEx as used by the respondents 97
FIGURES:
Figure 1 - Average CapEx by Year as a Ration to Total Revenue 27
Figure 2 - CapEx Spend over Time, as a % of Total Revenue 29
Figure 3 - Maintenance and Development CapEx – Disparity among hotels 31
Figure 4 - Accor: Manage Free Cash Flow by Reducing Renovation CapEx 35
Figure 5 - Cumulative Surplus or (deficit) of Capital Reserve vs. Actual Spending 38
Figure 6 - FF&E Reserve as a %age of Gross Revenue – Asia Pacific 40
Figure 7 - Combined CapEx spending as a % of gross revenues; 6 hotels over 10 years (Australia) 77
Figure 8 - Graph of CapEx as % of total revenues, 6 properties over 10 years Australia 84
Figure 9 - Accommodation, Cafes and Restaurants; CapEx Actual Expenditure in Current Prices 1996 – 2005 ($
Millions) 86
Figure 10 - Comparison of Hotel Revenues at International Markets; RevPAR 2004/2005 89

1 INTRODUCTION
1.1 Background
During the life of operations, almost any business must realise capital
expenditures (CapEx) to maintain competitiveness. This is especially true for the
hospitality industry where the capital expenditures have a significant impact not
only on the hotel competitiveness but also on the real-estate value of the property.
The following paragraphs provide a brief introduction to the issues of capital
expenditures in the hospitality industry.
According to the Appraisal Institute (Dictionary of Real Estate Appraisal, Third
Edition) “Capital expenditure is defined as the investment of cash or the creation
of liability to acquire or improve an asset, e.g. land, building, building additions,
site improvements, machinery, and equipment; as distinguished from cash
outflows for expense items that are normally considered part of the current
period’s operation” (Mellen, Nylen & Pastorino, 2000). McGuigan and Kretlov
(2003, p.272) highlight the long-term, positive impact of capital expenditures on a
business and define them as “a cash outlay that is expected to generate a flow of
future cash benefits lasting longer than one year”.
Unfortunately, decisions regarding CapEx are very complex due to their high
dollar values and cyclical, ambiguous and irreversible nature. For example, the
study CapEx2000 found that a full-service hotel in the US spends on average
6.1% of total revenues on capital expenditures and that the major targets of those
expenditures are ‘Rooms & Corridors’ followed by the ‘Food & Beverage’
Definition
Characteristics
of CapEx

outlets. According to Denton (1998), capital expenditures vary significantly from
year to year but in general, the expenditures are low during the early years of the
hotel life cycle with the first increase after 4-5 years for soft refurbishments.
However, the most significant CapEx requirements that hotels usually face is after
7-12 years (of operations) when the general refurbishment of the property must be
realised (Denton, 1998). Despite this predictable pattern, Beals & Denton (2004)
warn that additional unexpected expenses, such as break downs of equipment,
may frequently occur. Furthermore, Moyer, McGuingan & Kretlow (2003)
highlight the irreversible nature of CapEx. For example, once an hotelier decides
to transform a banquet area into a ‘Health & Spa’ centre with swimming pool, it is
very costly and difficult to return it to its former state. Hence, it is clear that
effective management of CapEx is necessary to cope with this complexity and to
ensure that sufficient funds are available to maintain competitiveness of a hotel
while utilising the owner’s capital in the most optimal way.
The most common provisions for CapEx are the reserves for replacement and the
practice of plans/budgets for CapEx. Many organisations employ an asset
manager/consultant whose key responsibility is CapEx management. In general,
reserves serve to accumulate funds for future capital expenditures, usually put
aside as a percentage of total revenue (Beals & Denton, 2004). According to the
‘Global Hotel Management Agreement Trends’ study (Haast, Dickson, Braham,
2005) almost every hotel management contract specifies an FF&E Reserve
(reserve for replacement of fixtures, furniture and equipment) having the fee set
as a percentage of revenues. However, Denton (1998) argues that a reserve as a
percentage of revenues might lead to an inefficient use of the capital and
unnecessary spending, and therefore he recommends to ground reserves on
expenditure schedules, plans and budgets. Such activities are usually the
responsibilities of an asset manager. The role of the Asset Manager is especially
important in the situation where the management and the ownership of a hotel are
separated (Beals & Denton, 2004). In these cases, asset managers must balance
Provisions for
CapEx

interests of both owners and operators; however the primary responsibility is to
the owner (Beals & Denton, 2004).
According to Denton (1998), there is a growing trend towards a management and
ownership separation in the hospitality industry with investors who are less
knowledgeable about the specifics of hotels’ operations. This is especially true
for investors who are institutionalised or fragmented (Denton, 1998). For
example, there are a growing number of strata management hotels and resorts in
Australia where each unit is owned by an individual investor (in NIF study, No
Author, 2003). These investors are often ‘mums & dads’ who do not have any
experience with a hotel’s operation. However, also institutionalised investors lack
understanding (Anon., 2003). According to the NIF study, the hotel investment is
frequently just small part of large investment portfolio in funds that are not
particularly focused on the hospitality sector, such as superannuation funds (No
Author, 2003). Thus, the ultimate owner is very distant from the day-to-day
operations. However, the separation and remoteness of the owners from the
operations combined with lack of understanding might raise problems with
CapEx. Many authors argue that there is a clash of interests between owners and
operators in regard to CapEx. According to Higley (2005), operators may tend to
spend on capital expenditures more than is necessary because CapEx are fully
paid from the owners’ funds. Highley (2005) argues, that due to a management
fee structure which is predominantly based on revenues and operating profit,
operators have no incentives to be responsible with spending on CapEx. On the
other hand, the investors/owners’ interest is to maximise return on investments,
hence they may prefer to invest funds into other projects with higher returns.
Especially those owners who have short-term investment horizons might be
reluctant to provide funds for CapEx. For example, some investors interviewed in
the NIF study suggest that “the ultimate investment term for hotels should be 3-5
years so that investor avoids making any capital expenditure” (No Author, 2003,
p.54). Beals & Denton (2004) inform that operators may be frustrated since some
owners fail to provide funding for necessary renovations. Hence, the different
Issues with
CapEx

interests of owners and operators make management of CapEx difficult and may
lead to frustration on both sides; the owners might feel that the operators do not
manage property in their best interests and the operators might be frustrated due
to the lack of resources and the low standard of the property. This problem is
accelerated by the vague definitions of the CapEx.
It is surprising that despite the significance of CapEx, there is a lack of uniform
standards for defining what is and is not a capital expenditure (Beals & Denton,
2004). This creates room for further disagreements between owners and
operators/managers. According to Denton (1998) operators tend to capitalise
expenditures as much as possible since this way it does not reduce their fees that
are usually based on operating profits and revenues. On the other hand, owners
prefer to recognise expenditures as a ‘revenue expense’ since it reduces the tax
obligation and fees paid to the operators. Hence, it is not surprising that CapEx
are subject to many discussions and studies. However, the majority of the
literature is from the USA and there is a little that can be found in Australia. It is
the intend of this study, to establish an initial platform for further research of
CapEx in the Australian hotel market.

1.2 Significance
Australia is competing with other countries on the international tourism market
and Australian hotels must be in good condition to satisfy the high requirements
of international and domestic travellers. Furthermore, investments in the
Australian hospitality industry are necessary to maintain long-term
competitiveness and stimulate further development. It is clear that the issues
involved with CapEx influence both, number of investments into the industry and
the satisfaction of the hotel guests. The Australian accommodation industry
generated more than 8.2 billion of total revenues in 2001 (ABS, 2002). This
combined with the already discussed finding of the US study ‘CapEx2000’ that a
full-service hotel in USA spends in average 6.1% of total revenues on capital
expenditures, allows to calculate that the broad dollar value of the CapEx issue in
Australia is approximately half a billion dollars a year. Even though this is a very
rough and simplified estimate, it helps to realise the significance of the subject for
the Australian hotel sector. Hence, it is clear that it is important to strive for a
good understanding of the CapEx and that a study exploring this issue in an
Australian context might be valuable for all stakeholders; investors, owners,
lenders, operators, customers and consequently, for the whole society.

1.3 The Purpose and Objectives
Using a pilot study sample, this study analyse provisions for Capital Expenditures
in the Australian hotel industry.
The objectives of this research are:
 To explore current practices and problems related to the provisions for
Capital Expenditures in Australia
 To examine views of the different stakeholders – owners, operators and
asset managers
o Is there any disagreement among the stakeholders regarding
CapEx?
o Are the provisions for CapEx able to ensure that sufficient funds
are available to maintain hotels’ standards and competitiveness?
o Is the owner’s capital used in the most optimal way?
 To increase knowledge regarding the Capital Expenditures in the
Australian hospitality industry and establish a base for further
quantitative research
Purpose
Objectives

2 LITERATURE REVIEW
The literature review section is a critical part of this pilot study. There are two
reasons;
First, it is necessary to analyse related literature to get sufficient knowledge about
possible issues, hence to ensure the quality of the primary data collection; the
interviews. In other words, the review of current literature revolving around the
CapEx helped to raise appropriate questions as well as it enhanced understanding
of participants answers during the interviews.
Second, the body of the literature review partially fulfils the purpose of this pilot
study; to explore current practices and problems related to CapEx, to examine the
view of stakeholders and to establish a base for further research.
The review starts with the nature of hospitality industry and the importance of
physical assets for this type of business. Then the paper focuses on CapEx, its
characteristics, definitions and on suggested provisions for management of these
expenditures, such as ‘Replacement Reserve”. Finally, the literature evolving
around owner/operator relationship and CapEx is examined including a brief
introduction to new trends in the ownership structure, such as strata titled hotels.

2.1 Characteristics of Hospitality Industry and
importance physical assets
There are no doubts that the hospitality industry is a service industry. However, it
seems that the majority of the literature emphasises ‘intangible’, human part of
the service (for example: Ingram, 1995; Brotherton, 1999; Skapinker (2003),
Hartline, Woolridge & Jones, 2003). Hence it needs to be reminded that the
overall service delivery is dependant not only on soft assets such as people but
also on hard physical assets (No Author, 2005). In effect, according to the World
Travel and Tourism Organization (WTTO) all tourism industries depend on
physical assets such as buildings and infrastructure (WTTO, 1999). This is
particularly true for the hospitality industry.
Losekoot, Wezel & Wood (2001) point out the uniqueness of hotel industry given
by its capital intensive nature and strong interface between facility management
and provision of commercial hospitality. According to the authors, the
satisfaction of customers is strongly affected by physical features of a hotel
facility. Losekoot et al (2001) argue that in terms of customer’s satisfaction, hotel
managers underemphasize the importance of “hard’ facility related factors (i.e.
condition of physical assets) in favour to almost exclusive focus on “soft”
interpersonal factors such as personal service (2001). The authors agree that
customer service is an essential element of hospitality; however, they argue that
“no amount of front-line worker concern for the welfare and experience of the
customer can compensate for flawed product” (Losekoot et al, 2001:298).
Losekoot et al (2001) conducted a research that provides evidence about growing
guests’ emphasis on the quality of the product rather than the quality of service.
The research analysed customer complaints in two hotels and found that every
third or fourth guest complaint is related to facility factors such as room
Physical Assets
and Customer
Satisfaction

temperature, restaurant capacity, room amenities, décor and carpets. Similarly,
according to LRA Worldwide (a global provider of specialized brand assurance,
brand performance and quality assurance consulting services), the physical
attributes are important factors influencing customer satisfaction in hotels. For
example, the LRA Satisfaction Survey highlights that “satisfaction with the
guestroom is, by far, the most important element in determining a guest’s overall
satisfaction with a particular hotel or hotel brand” (LRA Worldwide, 1999:3).
This is confirmed by Hassanien & Baum (2002) who note that a study conducted
by Dube et al (2000) found physical aspects and room design to be the third and
fourth determinants in the customers’ purchase decisions, after hotels location and
brand name but, interestingly, before service attributes. Libert & Cline (1996)
believe that hospitality enterprises require two types of infrastructure to do
business and fully meet customer needs - real estate and technology.
According to Johnstone & Duni (in Pagliari, 1995), hotels differ from other real
estate. In contrast to other property types, hotels combine the real estate leasing
component with other business activities such as running restaurants, equipment
rentals and business services (Johnstone & Duni in Pagliari, 1995). Thus, hotels
are true operating businesses. This consequently increases requirements on
capital. For example, Johnstone & Duni in Pagliari (1995:490) emphasize that;
“The excessive wear and tear on hotel real estate due to the public nature of the
facilities requires annual expenditures for property renovation and improvements
that other real estate types do not require”. Ransley & Ingram (2000) also stress
that hospitality properties are capital-intensive assets, and argue that those high-
value assets require concentrated management in order to generate adequate
returns on the capital employed (Ransley & Ingram, 2000).
Hassanien & Baum (2002) point out that hospitality industry is characterized by a
“dogmatic need for repositioning”. The authors believe that the repositioning is
inevitable within the life of any hotel due to continuous changes in the
Need for
renovation
Hotels as a
capital
intensive Real
Estate

environment. Hassanien & Baum (2002) inform that repositioning is usually a
costly process and almost always inseparable from renovation of physical assets.
Interestingly, Hassanien & Baum understand renovation as “the process of
retaining or improving the hotel image by modifying the tangible product, due to
a variety of reasons, through any changes in the hotel layout (e.g. property
structure-new extension) and/or any addition or replacement of materials and
Furniture, Fixtures & Equipment” (2002:148). Thus, according to the authors,
renovation includes not only repair and replacement activities within the existing
building but also new product developments such as room extensions or building
of new conference facilities attached to the hotel. This basically covers all
possible areas that require CapEx.
Also McDaniel (2003) emphasises that hotels are capital intensive businesses due
to inevitable replacement cycle. The author points out the conflict between brand
standards and financial return objectives given by the growing brand standard
requirements that are pushed by the competitive pressures created by oversupply
and diminished demand (McDaniel, 2003).
Ransley & Ingram (2000) refer to the integrated nature of hospitality products.
According to authors, hospitality industry is similar to car industry which is
facing ultimate conflict between design and production costs. Similarly, in the
hospitality industry “there are properties that are difficult to manage or operate,
but sumptuous in style“(Ransley & Ingram, 2000:239). Thus, Ransley & Ingram
highlight that specialist and stakeholders involved in development and
management of hospitality products need to understand its integrated nature. In
other words, all major actors have to learn how to work “in unison and with
mutual understanding of their individual disciplines/roles” otherwise there will be
inefficiencies in capital development expenditures and consequently lower
operational profitability of the facilities in hospitality industry (Ransley &
Ingram, 2000:239). In addition, Ransley & Ingram believe that these working
Integrated
Nature of
hospitality
products

inefficiencies restrain innovation and the ability of industry to react to the
changing needs of markets within national and international contexts.
Consequently, as Ransley & Ingram (2000) argue, this situation causes lower
attractiveness of the industry for institutional investment and, is not consistent
with environment that would create opportunities for future growth.
According to Ransley & Ingram (2000), there are three main trends in hospitality
industry that are related to physical assets. These are:
 Traditional ‘owner = operator’ framework is superseded by a structure in
which the ownership of the asset is vested in one entity and while the day-to-
day management of the hospitality business is carried out by a third party
 The hospitality properties are becoming larger and more complex structures
requiring greater amounts of capital and being much more substantial
businesses requiring integration of property operations.
 Increasing emphasis on financial aspects of hospitality operations. Entry of
large financial institutions into hospitality ownership partially initiated shift
of focus to financial returns away from traditional hospitality as the measure
of success
Hospitality
trends and
physical assets

2.2 Research on CapEx
According to Berg & Skinner (1995) CapEx is vital for organizations in
hospitality industry. The authors remind that failure to adequately plan for CapEx
was one of the major reasons for many bankruptcies and operating losses the hotel
industry experienced in the early 1990s in USA. Perhaps this is the reason why
most of the research regarding CapEx has been conducted in the USA. Although
the majority of this research has been focusing on CapEx appraisal techniques
there is also a limited number of studies that has been focusing on
definition/understanding of CapEx or actual CapEx spending.
There are numerous studies focusing on capital budgeting in hospitality (i.e.
(Eyster & Geller, 1981; Berg & French, 1995). However, despite the fact that it is
important to understand investment assessment techniques, it would be above the
scope of this paper to discuss them here. Fortunately, these techniques are well
covered in most financial analysis books. In general, it can be simplified that all
these techniques involve some form of comparison of required investment to
expected cash flow within specified time. Ransley & Ingram (2000) inform that
all the traditional techniques for investment appraisal are used in hospitality
industry with NPV (Net Present Value) and IRR (Internal Rate of Return) as the
most popular methods. However, the authors point out that the sophistication of
analyses varies according to the type of the expenditure; refurbishment is usually
assessed locally and without formal analysis whereas expenditures in the
development, that usually require a significant amounts of investments, are
usually subject of feasibility studies and evaluated by several investment appraisal
techniques.
DeFranco & Schmidgall (2003) recently conducted more comprehensive research
among 600 hotel professionals and once again reviewed the utilization of
traditional capital budgeting criteria, such as Payback, NPV and IRR. The study
Assessment of
CapEx

found that almost 75% of respondents agreed that they had undertaken a
formalized cost/benefit study prior to acquiring property and equipment.
However, 46% of them admitted that this was done only for "major" acquisitions.
The table below provides more details about what respondents considered as a
major project:
Table 1 – Major Expenditure Threshold to Warrant a Formalized Cost/Benefit Study
Expenditure Levels Frequency (%)
over $1,000 12.6
over $10,000 37.8
over $50,000 21.9
over $100,000 10.1
over $250,000 0.8
over $500,000 2.5
Other 14.3
Source: Capital Budgeting and its uses in the Lodging Industry DeFranco & Schmidgall (2003)
Interestingly, the study found that in the case of small hotel operations, the
majority of managers/owners do not conduct formalized studies. In addition,
DeFranco & Schmidgall (2003) identified 6 main categories of CapEx as
identified by hotel managers:
 Replacements to improve revenues;
 replacements to reduce costs;
 replacements for maintenance;
 expansion of existing concepts;
 expansion into new concepts and
 safety and environmental projects.
As can be seen, the range of cash outflows that may be considered as CapEx is
relatively wide. This brings to the light the discussion regarding the unclear
definition of CapEx.

2.3 Definition and understanding of CapEx
In regards to understanding of CapEx, the main issue is what item should be
expensed and what should be capitalized. For example, Schimdgall & Damito
(1997) found that about 62% of hoteliers are often or sometimes unsure about
whether expense or capitalize an item and, that more than 72% of respondents
would appreciate better guidance. In their next study, Schimdgall et al (1998)
focused on criteria used by hoteliers for decision making regarding capitalization
of expenses and find that the most frequently used criteria are as follows:
A. In case of Equipment Purchase – the item is commonly capitalized when
expenditure exceeds defined dollar amount or/and when expenditure is
part of hotel renovation.
B. In case of Repair & Renovation – the expense is commonly capitalized
when improvement prolongs the useful life of the property or/and when
the improvements are over a certain dollar value
However, the study also finds that there are several “grey” areas that are difficult
to classify (Schimdgall et al, 1998). For example, 49% of the respondents
believed that parking lots should be capitalized only when repaving consists
minimum of 2.5 inches of bituminous asphalt whereas the rest of respondents
either disagreed (31%) or was uncertain. Large disagreement was also in regards
to pool motors; only 52% of the respondents believed that this expense should be
capitalized. Other grey areas identified in the study were as follows:
 Reupholstering (59% of respondents would expense and 41%
capitalize)
 Repairs and major overhauls of existing equipment (55% of
respondents would expense and 45% capitalize)
 Boiler re-tubing (54% of respondents would expense and 46%
capitalize)
(Schimdgall et al, 1998:30)

These empirical findings indicate that the definition of CapEx is unclear. The
following section will thus examine the clarity of CapEx definitions in well
recognized standards and accounting guides.
Uniform System of Accounts for the Lodging Industry (USALI, 1996) is the
accounting standard specifically developed for hospitality industry. However,
CapEx is not explicitly discussed in this standard since it is not an item of the
balance sheet. Despite that USALI comprise a CapEx related provision in the
‘Section 4 (Statement of Cash Flow; Cash Flows form Investing Activities)’ and
also in the section “Expense Dictionary” (USALI, 1996).
According to the Section 4, Capital Expenditures, as a cash flow item, “represent
payments to purchase property, buildings, equipment, and other productive assets.
These payments include interests payments capitalized as part of the cost of those
assets (USALI, 1996:26)” This section of USALI also suggests to disclosure
separately the portion of the capital expenditures that is required to maintain
operating capacity from the portion that results in an increase in the revenue
generating capacity of the property. This should help to determine whether there
is/was adequate investment in the maintenance of operating property or not
(USALI, 1996). Logically, it will also help to determine what portion of CapEx
was actually invested into new capacities and products. This is an interesting
advice since it helps to define two major types of CapEx:
A. Capital Expenditures that are required to maintain operating (existing)
capacity of the property
B. Capital Expenditures that represent an increase in revenue-generating
capacity of the property
It is worth noting that Phillips (2003) builds on this definition and research
spending on “Maintenance CapEx” and “Development CapEx” among hotel
chains in the UK. The Phillips’ findings will be discussed later in this paper.
USALI -
Uniform
System of
Accounts for
the Lodging
Industry

In addition to the provision in the Section 4, the Expense Dictionary section of
USALI (1996) indirectly defines CapEx by denoting that not all property
expenditures should be recorded as an expense. It states that; “an expenditure
made to purchase an item with a useful life of more than one year will typically be
capitalised. That is, the amount will be included as an asset on the balance sheet
and expensed through depreciation or amortization over the item’s useful life
(USALI, 1996:205)”. However, two main exceptions are identified to this general
rule:
1) Minor expenditure – “Immaterial expenditures, where the benefit of
capitalising the item may not outweigh the cost of setting up and
maintaining the depreciation records”. This expenditure might be
expensed. However, the USALI do not provide concrete dollar amount
that would determine when the expenditure can be expensed. It is a
question of judgement but once the amount is defined, it should be
followed consistently as a part of the property or company policy (USALI,
1996).
2) Repair expenditure – “Expenditure that only restores the value or
expected life of the asset to its condition prior to the repair.” - In other
words, any expenditure that extends the life of the asset or increases value
of the asset should be capitalised (USALI, 1996).
The second exception seems to open the door to discussions about which expense
restores the condition of an asset and which extends its life or increases its value.
The section provides some guidance about expenditures that are usually expensed,
such as interest costs or software development costs; however, if those
expenditures occur as a part of the acquisition of the asset, it should be included in
the total amount that is capitalised (USALI, 1996).
According to new Australian Accounting Standards (Kemp & Knapp, 2005), that
are aligned with International Accounting Standards, a hotel is considered as
Property, Plant and Equipment. Hence, the main section of AASB relevant CapEx
in hotels is AASB 116; ‘Property, Plant and Equipment’. According to the
AASB –
Australian
Accounting
Standards

Recognition Rule of this standard (Kemp & Knapp, 2005:522) “the cost of an
item of property, plant and equipment shall be recognised as an asset if, and only
if:
(a) it is probable that future economic benefits associated with the item will
flow to the entity; and
(b) the cost of the item can be measured reliably”
The standard is quite specific but for the purpose of this paper the important is
that under this recognition principle the cost of an item of property, plant or
equipment includes not only initial costs but also “cost incurred subsequently to
add to, replace part of or service it (Kemp & Knapp, 2005:522, paragraph 10)”.
In regards to initial costs incurred in acquisition of the asset, the standard
highlights that even though some initial expenditures to acquire property, plant or
equipment do not lead directly to a growth of the future economic benefits, the
item should be recognised as an asset (thus expenditure should be capitalised) if
the item is necessary for the entity to obtain the future economic benefits form the
other assets (Kemp & Knapp, 2005). In other words, if the expenditures enable
the entity to derive future economic benefits from other assets in excess of what
could be derived had the item not been acquired, it should be capitalised (Kemp &
Knapp, 2005). The standard gives as an example of the expenditures necessary to
comply with safety regulations or environmental requirements.
However, for the purpose of this paper the most relevant are the paragraphs
related to subsequent costs. According to the standard, the entity should not
capitalise the costs of the day-to-day servicing of the property, plant or equipment
(Kemp & Knapp, 2005). These costs should be recognised in profit and loss as
they incur.
The standard defines the cost of the day-to-day servicing as the expenditures with
the purpose of repairs and maintenance of the item of property, plant and
equipment which are primarily the costs of labour and consumables but it also
might include costs of small parts (Kemp & Knapp, 2005:522:12). Unfortunately,

the definition of what is meant by ‘small part’ is not provided. However, the
standard provides specific guidance how to capitalise replacement of parts of
items of property, plant and equipment or replacement of whole items that are
necessary on regular or irregular basis, given to the nature of some assets. As an
example of such a ‘replacing part’ expenditure that should be capitalised, the
standard gives the seats in an aircraft or interior walls of the buildings.
Noteworthy, the standard does not specifically require the replacing part or the
whole new item to increase the inflow of future economic benefits derived from
the item, to be eligible for capitalization.
Hence, someone may interpret the standard that it is sufficient if it is probable that
future economic benefits associated with the item which is replaced or part of
which is replaced ‘will flow’ to the entity and the costs are measurable. (Notice
the difference between ‘increase of economic benefits’ as commonly used
criterion in regards to capitalization and ‘will flow’ as applied in the recognition
principle of the AASB standard). In this case, the cost of replacing parts would be
capitalised, added to carrying amount of the asset.
However, very important is that the carrying amount of the parts of the item or
items that are replaced should be, according to the AASB standard derecognised
(Kemp & Knapp, 2005). The gain or losses arising from the derecognition of an
item of property, plant and equipment should be included in profit or loss when
the item is derecognised and “regardless of whether the replaced part had been
depreciated separately” (2005:523). The standard provides detailed guidance of
how to determine the carrying amount of replaced items or replaced parts of the
items.
Hence, the standard can be understood that if the hotel management decides to
replace the walls in the building, the costs should be capitalised, even though it
does not increase the expected life of the building or the increase economic
benefits generated from the building. It is sufficient that the replacement of the

walls will enable the hotel (building) to maintain its economic-benefit generating
capacity. The logic behind this is that, when the expected life of the whole
building was initially determined, it was assumed that some parts, such as walls,
will need to be replaced on some standard/regular basis.
The Chartered Institute of Management Accountants (CIMA 1996) defines capital
expenditure as ‘the cost of acquiring, producing or enhancing fixed asset’
(Ransley & Ingram, 2000:75). A fixed asset is “any asset, tangible or intangible,
acquired for the retention by entity for the purpose of providing a service to the
business, and not held for release in the normal course of trading” (Ransley &
Ingram, 2000:75). Expressed more simply capital spent is “the expenditure
relating to the purchase and enhancement of long term fixed assets such as land,
buildings, furnishing, equipment, motor vehicles and machinery“ (Ransley &
Ingram, 2000:75). According to CIMA, ‘spend on fixed asset’ is easily
recognised as a capital expenditure due to its well determined characteristics
which are:
 the expenditure is usually substantial in nature
 the precise benefits arising from the use of the expenditure may be difficult
to determine and will be based on estimate but,
 these benefits may be spread over more than one year
 the expenditure will be related to furthering the objectives of the business
(Ransley & Ingram, 2000:75)
However, Ransley & Ingram (2000:75) also admits that some spends might be
difficult to classify as capital expenditure. Whether it is an issue in Australia or
not, will be determined through the interviews with industry stakeholders which
will be the next step after this literature review.
Based on their JLLH study (2005) Jones Lang LaSalle Hotels define CapEx as
expenditures that “relates to structural changes of the property, major
remodelling, replacement of existing assets etc. in order to maintain the hotel
and/or improve the profitability of extend the live of the asset” (JLLH study,
2005:18). Interestingly, also this definition does not consider only expenditures
that increase economic benefits or extend economic life of the asset as CapEx.
CIMA - The
Chartered
Institute of
Management
Accountants
Jones
Lang
LaSalle
Hotels

2.4 Characteristics and factors influencing CapEx
It is clear that characteristics of CapEx and factors that influence CapEx are
mutually interconnected. In other words, CapEx in hospitality have specific
characteristics due to factors specific to this industry. Some of these CapEx
characteristics and factors were already identified in the background section to
this paper. These are:
 Decisions regarding CapEx are very complex due to their high dollar values
and cyclical, ambiguous and irreversible nature (McGuingan & Kretlow,
2003)
 Capital expenditures vary significantly from year to year but in general, the
expenditures are low during the early years of the hotel life cycle and the
first increase usually occurs after 4-5 years, for soft refurbishments.
However, hotels usually face the most significant CapEx requirements after
7-12 years of operations, when the general refurbishment of the property
must be realised (Denton, 1998).
One of the most comprehensive studies regarding CapEx in hospitality industry
that gives very good picture about characteristics of CapEx as well as it helps to
identify some of the main factors that influence capital spending in hotels, has
been the research conducted and published by ISHC on a regular basis. The last
study was published in 2000 (the executive summary can be found in Appendix
1.). This study analyses historical data of 350 hotels across the USA as well as
estimates future spending based on expert analysis of expected costs and useful
lives of items. The study finds that CapEx vary significantly within the life cycle
of the hotel, depend on the ultimate age of the property and differ by hotel type. In
addition, the study also found some correlation between ownership type and
CapEx.

The pictures below clearly illustrates that the magnitude of CapEx varies
significantly within the life cycle of a hotel.

Source: ISHC study CapEx2000, Mellen et al. (2000)
Figure 1 – Average CapEx by Year as a Ration to Total Revenue
According to Berg & Skinner (1995) CapEx are below 3% of revenues only
during the first 5 years of the property life and than the expenditures go up and
usually do not fall below 3% again. In other words, a new hotel has limited or no
needs for CapEx, while ageing properties will usually demand more attention.
The graph provided above illustrates that initial increase in CapEx requirements
should be expected in the sixth or seventh year of a hotel’s life due to the need
for replacement of soft goods. However, the first real CapEx escalation will
likely occur around year 9 to 11 when rooms and corridors will need renovation
(Mellen et al., 2000). As for the following years, according to Berg & Skinner
(1995), CapEx regularly increase every 7th
to 9th
year as an average hotel must
undergo major renovations within this interval, to maintain competitiveness. The
table below provides a broad picture of the typical composition of CapEx (based
on ISHC study).
Life cycle
of the
property

Table 2 ‐ Composition of CapEx in %
Component Full-Service Hotel Limited-Service Hotel
Room & Corridors 33% 29%
Building 14% 24%
Other Public Space 16% 13%
Food & Beverage 11% 10%
Technology 8% 8%
ADA / Life Safety 3% 5%
Other 15% 11%
Interestingly, the data from ISHC study indicate that over time, as properties
age, the CapEx tend to vary more significantly among individual properties. This
is clearly reflected in the Figure 1, where the maximum and minimum of CapEx
spending as a percentage of revenues widens within the years (Mellen et al.,
2000). This suggests that in case of an older property CapEx estimates might be
more difficult. However, Berg & Skinner (1995) point out that in comparison to
modern properties, older properties were found to require generally more CapEx
per room as well as a percentage of revenue.
Ultimate
age of the
property

Figure 2 below illustrates the difference in average CapEx in Full-Service hotels
and Limited-Service hotels.

Figure 2 CapEx Spend over Time, as a % of Total Revenue
It is clear that CapEx vary by hotel type quite significantly. For example; when
combining last two ISHC studies, CapEx2000 and CapEx1995, it can be found
that limited-service hotels spend in average on CapEx somewhere about 3.7% of
gross revenues over 25 years whereas full-service properties required 6.9% over
the same period of time (Mellen el al. 2000).
Hotel
Type

The results from ISHC study CapEx2000 suggests that the spending for hotels
owned by public hotel companies will exceed that spend on hotel owned
privately. In particular, private-held hotels spend 52% less on CapEx (in
average) than hotels owned by public companies.
There are two issues that need to be kept in mind in regards to ISHC study. First,
the authors warn about applying the averages for estimating CapEx for individual
hotels, since CapEx in each facility may also vary based on hotel’s specific
circumstances such as:
 Construction
 occupancy;
 competition;
 geographical location;
 brand;
 difference in local costs factors and
 other factors
High variance of CapEx within properties in time is confirmed by Phillips (2003)
who researched Maintenance and Development CapEx among UK hotel chains.
Figure 3 below shows evident disparity in the maximum and minimum levels of
both Maintenance and Development CapEx spending as a percentage of hotel
turnovers within the surveyed hotel chains. For example, during 2002, one hotel
chain spent more than 20% of its turnover on CapEx, while the least amount spent
by other hotel chain was 3.1% (Phillips, 2003). Interestingly, Phillips also point
out that the 4% rule of thumb measure for ‘Maintenance CapEx’ does not reflect
current hotel chains practice, since the CapEx were almost always above 4%
(Phillips, 2003). Even higher disparity in CapEx was observed in regards to
Development where one hotel chain spent 51% of hotel turnover in 2000 whereas
other hotel chain invested only 1% of turnover towards development of new
revenue generating capacities.
Ownership
Structure
Other
Factors


Source: Phillips, (2003)
Figure 3 ‐ Maintenance and Development CapEx – Disparity among hotels
If we ignore the conflict of ‘Maintenance CapEx’ with the accounting definitions
of CapEx, the differentiation between spending on two types of CapEx,
Maintenance and Development, leads to a second issue that needs to be kept in
mind when assessing results of ISHC study CapEx 2000. It is that the study
investigated ‘all capital improvement costs’ of owning hotels over an asset’s life
span. In other words, ISHC CapEx includes not only cost to replace ‘short lived
items’ or ‘furniture, fixture and equipment’ but also:
 Updating design and décor;
 curing functional and economic obsolescence, thereby
extending both the physical and economical life of the
asset;
 complying with franchisor’s brand requirements;
 technological improvements;
 product change to meet market demands;
 adhering to government regulatory requirements; and
 replacing all short and long-lived building
components due to wear and tear
Clearly, the list above includes CapEx that are not only necessary to maintain
current generating capacity of the facility, such as replacing components due to
wear and tear, but it may also includes CapEx that may result in increased

revenue generating capacity of the lodging property, such as ‘product change’ or
‘technological improvements’.
The two lists above can be also seen as the lists of factors that may drive CapEx
spending. Other authors confirm some of these factors.
For example, Losekoot et al (2001) believe that CapEx are predominantly driven
by the enhancements in the guest technologies, such as integral bathrooms,
communication and entertainment technologies, mini-bars, trousers press and so
on.
Watkins (1996) adds that hoteliers should engage in CapEx such as refurbishment
not only to replace outdated items but also for strategic purposes. The author
understands renovation as replacement and refurbishment of existing
items/facilities but also as the development of new facilities within the existing
hotel. In particular, Watkins (1996) stresses 4 frequent reasons to renovate:
 To prepare for special events (i.e. Olympic Games)
 To increase profitability (i.e. new bar)
 To attract convention business (i.e. development of conference
facilities)
 To satisfy repeat business
According to the University of Sydney (Planning Research Centre, 2005), the
hotel construction and development (including refurbishment activities) are, in
Australian context, pushed primarily by the events. This confirms one of Watkins’
arguments. However, the most interesting point raised by this author is in regards
to renovation for satisfaction of repeat business. Watkins (1996) argues that there
is more pressure to renovate more often if the hotel relies/focuses on repeat
business. Hence, the segmentation strategy can actually influence CapEx
spending. This brings to light possible interrelations between CapEx and the
customers’ satisfaction.

It was already discussed that for many customers the physical appearance and
functional aspects of the accommodation facilities is important. Gunter (2005)
adds that customers require unique experience not only from a service delivery
perspective, but also from an aesthetic perspective, especially in terms of luxury
and upper-upscale hotels. According to the author, the customers require bigger
rooms and bigger bathrooms with highly designed elements. Also according to
Angela Denney, director in the hospitality and restaurant studio at FRCH Design,
"People are a lot more educated about design and [furniture, fixtures and
equipment]” and “People are exposed to a lot more ideas, so people tend to
expect more out of guestrooms now" (in Gunter, 2005:60). Growing popularity of
design and boutique hotels supports this argument. However, the question is
whether the customers are ready to pay for ‘It’.
Unfortunately, the author of this paper did not find any quantitative study that
attempted to quantify the link between CapEx and customers’ satisfaction.
Furthermore, no quantitative study was found that would link CapEx and profits,
either through increased revenues or reduced costs.
In effect, Phillips (2003) finds that even hotel financial executives have, in many
cases, difficulties to perform post investment appraisal of CapEx since the returns
could be affected by too many factors beyond the control of management and it is
difficult to link cause and effect. Especially in the case of replacement and
multiphase CapEx projects, managers see disaggregation of investment and
returns very difficult. According to authors, CapEx are frequently seen as an
‘enabler’ rather than the ‘driver’ of business (Phillips, 2003). Despite lack of
research it is clear that not always are customers willing to pay extra money for
improvements. For example, internet access in rooms is now-a-days more and
more expected as a fee-free standard. This might accelerate concerns among
hotels owners in regards to the effectiveness of CapEx spending.

Higley (2005) provides insights from the recent annual meeting of the presidents
of American hotel owning companies and according to his reportage, the main
factors that owners consider when approving Cap-Ex is, not surprisingly, the
return on investment (ROI). In particular, the owners prefer the Cap-Ex which
will enable the hotel to raise the average daily rates (Higley, 2005). In effect, the
hotel owners admit that the price increases became more product-driven and less
market driven (Higley, 2005). ‘Product-driven’ means that rates are actually
raised up to cover for high Cap-Ex in contrast to ‘market-driven’ increases where
the price changes are based on demand (Higley, 2005).
In addition, according Chipkin (2005) CapEx might be affected by ownership
structure, in particular the demands of operators. However, the author informs
that many operators understand owners’ concerns about investment returns.
According to the author, some operators consider owner’s willingness to pay
when introducing initiatives that will require CapEx, such as up-grading the
brand standards. Chipkin (2005) gives following resent examples:
 Intercontinental Hotels Group's Holiday Inn brand have opted for a
new hotel prototype that is designed to be less expensive to build
and maintain
 Even though Hilton Hotels brand standard require a new television
that costs twice as much as the previous one, the new standard
does not require the armoire to even out the final costs. In addition,
the standard requires new type of beds but the increase of this
CapEx will be balanced by reduction of expenditures in other areas
such as elimination of the need for two phones and two phone lines
and reduced dining room costs.
 Choice Hotels pursue approach "franchisee-first" and claim to
propose to the owners only those changes that will increase
revenues.
 Starwood hotels & Resorts Worldwide's Sheraton tests positive
revenue impact of new CapEx initiatives, such as Sweet Sleeper
(bed), in own properties first before introducing it to franchisees
Source: ‘Brands consider costs, consumers when reimaging’ Chipkin (2005)
Ownership
Structure

Phillips (2003) looks at CapEx from operators/management point of view and
finds that managers see the best time to realise CapEx in the bottom of the
economic cycle as hotel companies have a stronger negotiating position with all
parties involved in the hotel development process. However, Phillips warns that
when there is a slowdown in earnings growth, owners will become less willing to
spend. Phillips advises that management have to find a balance in income
distribution (owners/shareholders vs. CapEx) since failure to ascertain the
appropriate balance in distribution could affect the share price (2003). Phillips
gives Accor as a good example of how to achieve desired free cash flow from
operations by decreasing renovation CapEx (2003).

Source: Accor 2002 Full-Year Results: Presentation to Financial Analysts,
http://www.accor.com/gb/upload/pdf/gb_Resultats_2002_web_gb.pdf
Figure 4 – Accor: Manage Free Cash Flow by Reducing Renovation CapEx
The picture clearly illustrates that Accor, in market down-turns, is ready to
scarify some of renovation CapEx in order to maintain steady Cash Flow.
However, Crandell warns that this might lead to the acceleration of CapEx
requirements in the future. However, it needs to be stated that Accor seems to
take this in consideration by setting the minimum for Maintenance CapEx
spending at 4%. In addition (Phillips, 2003) finds that incremental CapEx
spending might be less respectful of customers’ convenience than “big bang
approach”.

However, according to the Lodging Industry Investment Council (LIIC, 2005)
expensive Product Improvement Plans (PIPs) are still a threat to investment
yields, since hotel brands are expected to be very strict with lodging owners in
terms of requiring huge expenditures to maintain ever increasingly stringent
product standards.
Also Crandell (2002) discusses the influence of operators and franchisors on
CapEx in hotels. However, the author adds that lenders should also be
considered. According to Crandell “lenders, who control the ‘purse strings’, want
to clearly understand capital expenditure plans and, as a result, may require that
certain projects be done, even if they aren’t necessary at the time” (2002:1).
Lawson (1995) also provides brief overview of macroeconomic factors that can
have impact on CapEx in hotels. These are as follows:
Table 3 ‐ Conditions influencing capital expenditures:
Changes Conditions
Economic Low rates of interests charges on loans and the availability of
capital for investment
Business Progressive increase in hotel prices and property values
compared with other sector (price and cost indicies)
Demand Expansion of demand arising from growth in tourism or/and
investment in the attractions of the area
Incentives Government-regulated incentives for new investment and
conversion/refurbishment schemes
Source: Lawson (1995:p 34)
Now, it is clear that CapEx may involve and be affected by many factors and all
stakeholders such as owners/investors, customers, authorities and operators.
Hence the effective provisions for management of CapEx are important. The
following section will review the literature in regards to provisions applied to
manage CapEx in hotels.
Macro-
economic
Factors

2.5 Provisions for CapEx
There are two main tools that are employed to manage CapEx; FF&E reserve and
CapEx plans/budgets. However, to manage these tools effectively the literature
suggests employing an Asset manager whose main responsibility is management
of CapEx on behalf of the owner (Beals & Denton, 2003).
Johnstone & Duni (in Pagliari, 1995) believe that establishing a reserve for
replacement that is funded from cash flow on an ongoing basis is the best way to
ensure a sufficient renovation capital that is critical for the long-term success of
hotel properties. The authors suggest putting funds aside in low risk insured
account on regular basis so that resources are available for the major renovations
that will occur every 5-7 years (Johnstone & Duni in Pagliari, 1995). However,
Denton (1998) argues that reserve for replacement is, in effect, a “rudimentary
step” in management of CapEx due to following reasons;
 It does not provide sufficient funds for capital projects anyway
 It leads to inefficient use of capital
Denton explains that since the CapEx are not correlated to revenues the reserve
for replacement can be over funded for long period of time; usually the initial
period in hotel life cycle (see the picture below) whilst significant amounts of
funds may be lacking when major renovation need to be undertaken (1998).
Denton particularly warns against using constant percentage of revenues as a
determinant for contributions to the replacement reserve. As can be seen from
Denton’s example of CapEx in full-service hotel with 200 rooms (Figure 5
below), the reserve funded by steady contribution of 4% from gross revenues
almost never fit with the actual CapEx requirements.
RESERVES FOR
REPLACEMENT


Based on a steady contribution to the reserve based on a arbitrary percentage of hotel revenue.
Source: Managing Capital Expenditure (Denton, 1998)
Figure 5 ‐ Cumulative Surplus or (deficit) of Capital Reserve vs. Actual Spending
Denton (1998) reminds that major CapEx occur within 10-12 years hence
relatively high amounts of money can be tied up on the reserve account without
efficient use for this period of time. As a consequence of such inefficiency,
investors suffer high opportunity costs since the funds could be generating much
higher returns elsewhere and, the hotel is not properly maintained in later years
due to shortages of funds in the reserve. On the other hand, Rushmore (2002)
warns that even though FF&E assets have an average useful life of 8-10 years,
there are many items with much shorter life. Thus, the contribution to the FF&E
reserve should start with the first year of operations (Rushmore, 2002). To support
his arguments, Rushmore (2002) provides following table of typical useful lives
of various FF&E components.

Table 4 – Useful Lives of FF&E components
Source: Hotel Investment Handbook, Ch.20, Rushmore (2002:63)
As can be seen, a new hotel may need funds from the FF&E reserve already in the
second year as some items should be replaced within this time frame (Rushmore,
2002). The issue of useful lives of items will be discussed further in the next
section of this literature review.
Despite many pitfalls and discussion in regards to replacement reserve, it is
widely used across the industry. There are two reasons for it: requirements of
operators and lenders.
It is clear that operators need to undertake replacements and renovations to
maintain competitiveness of the managed hotel. However, in most cases, it is up
to owners to provide necessary funds (Denton, 1998). To ensure that some level
of funds will be available, operators usually require in management agreements
with owners to establishment a replacement reserve, since worn-out facility
negatively affects profitability as well as the image and reputation of the operator
(Rushmore, 2002). Most of management agreements usually define an FF&E
reserve. FF&E reserve can be specified as reserve “solely for capital
improvements and replacements of and additions to furniture, fixtures, and

equipment so as to maintain the hotel in first-class condition“(Rushmore,
2002:73). According to recent John LaSalle Hotels study (Haast et al. 2005)
FF&E reserve was found to be the standard provision in management agreements
across all major markets; USA, Europe and Asia Pacific which includes Australia.
It was also found that some agreements allow for an escalating structure of
reserve that ramps up to the stabilised percentage; from small or nil percentage in
the initial years to a fixed percentage (stabilised fee) going forward from year
three or five onwards. Interestingly, agreements in the Asia Pacific were found to
specify a stabilised fee of about 3.1% of gross revenues which is about 20% less
than typical agreements in Europe (3.9%) and more than 29% less than in USA
where owners are required to put aside in average 4.4% of gross revenues.

Source: Jones Lang LaSalle Hotels; Baker & McKenzie (2005)
Figure 6 FF&E Reserve as a %age of Gross Revenue – Asia Pacific

The “ramp up” approach to replacement reserve discussed above is designed to
respect lower CapEx requirements in the early years of hotel life and the
owners/investors concerns about inefficiently tied up money on the reserve
accounts. In addition, Denton (1998) advices those owners/investors that have
multiple properties under management by the same operator to apply the portfolio
approach to replacement reserves. The author suggests concentrating
contributions from all hotels to single fund/reserve and applying these common
funds for replacements across whole portfolio of properties, thus dispersing the
volatility of the capital outlays, assuming the properties are in different stages of
the lifecycle (Denton, 1998). This is in line with suggestions of the Property
Council of Australia that recommends the investors to solve issues with
fluctuations in CapEx funding requirements by building a well-balanced portfolio
of properties with different timing for CapEx and using cumulated funds
“wherever and whenever most necessary” (JLLH, 2003:67)
However, the JLLH Management Agreement study (Haast et al., 2005) found that
there is another trend in regards to the FF&E reserve. The FF&E reserve is
becoming an accounting entry in the owners’ books rather than an actual cash
fund, particularly in Australia. This is an interesting finding since it contradicts
the ultimate purpose of the reserve; to ensure funds. However, the study also
found that most agreements impose a legal obligation upon owners to provide
sufficient fund for CapEx to maintain hotel at its specified standard, particularly
in relation to 5-star hotels (Haast et al. 2005). It needs to be understood that this
obligation is related not only to regular replacement of FF&E but it covers other
hotel assets. This brings to light definitions of Replacement Reserve.
According to literature it seems that there is confusion between Replacement
Reserve and FF&E reserve. These two terms are used interchangeably however; it
seems that these terms are not understood and/or used in a same way by all
stakeholders. Beals & Denton (2003) emphasize that FF&E reserve should not be
understood as a fund for replacement of major building components, such as
Portfolio
Approach
to
Reserves
Reserve as
accounting
entry
Confusion
with
Reserves

roofs, elevators, and chillers. Despite this, Phillips (2003) found that many hotel
general managers frequently use the FF&E reserve to fund the replacement of
major building components, instead of keeping funds strictly for periodic
replacement of FF&E. According to the Dictionary of Real Estate Appraisal,
Reserve for Replacement is defined as “The funds put aside for the periodic
replacement of furniture, fixtures and equipment [FF&E]” (US Appraisal
Institute). However, according to the PricewaterhouseCoopers LLP Investors
Survey (Korpacz, 1999) Reserve for Replacement is understood as “a dollar
amount allocated for periodic replacement of building components during a
property’s economic life”. In Addition, the PWC dictionary specifies ‘Reserve for
Replacement of Fixed Assets in Hotel Valuations’ and define it as: “An allowance
that provides for the periodic replacement of building components, and furniture,
fixtures, and equipment, which deteriorate and must be replaced during the
building’s economic life”. Hence, there is a significant difference in definitions,
since some of definitions include only FF&E and other definitions cover all fixed
assets. However, replacement of FF&E is only part of all CapEx that are
necessary to be realised in hotels to maintain competitiveness. For example,
according to the latest ‘Development Costs Study’ by HVS International, FF&E
creates only 16% of development cost for the average full-service hotel in USA
(Sahlins, 2005).
Stephen Rushmore, President and Founder of HVS International, also highlights
that the FF&E reserve cannot cover all replacements and, furthermore, that the
needs for replacement/renovation are increasing (2003). According to Rushmore,
40 years ago a hotel needed about 2% of revenues for replacement of FF&E;
however, now-a-days hotels are facing intensifying functional obsolescence of
assets especially in hotel rooms. This combined with the high competition pushes
the FF&E replacement needs up to 4-5% (Rushmore, 2003). However, Rushmore
also predicts that tomorrow’s hotel rooms will contain highly sophisticated and
expensive technology that will require another 2-3% of total revenues for
replacement. In addition, Rushmore points out that at some time any hotel will

need to replace/renovate permanent components such as plumbing, electrical
systems, heating and air conditioning, exterior façade and structural components
(Rushmore, 2003). According to Rushmore, these items are not covered by FF&E
reserve and usually will require an additional 1-3% of total revenues. When all
these needs are compounded together, it can be calculated that an average hotel
needs to put aside between 7-11% of total revenues to protect its assets from
functional obsolescence and physical deterioration (Rushmore, 2003). Even
though Rushmore does not suggest establishing a specific reserve for all these
inevitable expenditures he highlights that investors need to realise that FF&E
reserve is just a part of the whole picture in regards to CapEx needed.
Surprisingly, Stephen Brener, a president of another hotel valuation and
consultancy company, had very similar opinion already in 1992. Brener (1992)
forecasted that by the late 90s full service hotels will require to set aside 5-7% of
gross revenues for FF&E replacement and another 1-2% for capital
improvements. In addition, the Brenner believed that after year 2000 a five year
hotel will need to put aside approximately 10% of revenues to remain
competitive. Interestingly, Brener (1992) believed that those reserves will be
required by long-term investors and not operators.
In relation to the Replacement Reserve, it is important to realise that some
investors factor-in the replacement reserves when appraising hotels. For example
PWC Study (Korpacz, 1999) found that 46.3% of investors use direct
capitalization methods of income that deduct the Replacement Reserve. Hence,
the perceived standard for escrow level of Replacement Reserve may have a
significant impact on investment to hotels. According to 2004 USRC Survey,
hotel investors used in their estimates an average of 4.2% of gross revenues for
Replacement Reserve, however, some investors applied up to 6%. The following
table provides a summary of USRC Survey findings in regards to the
Replacement Reserve.

Table 5 ‐ USRC Hotel Investment Survey, Reserve for Replacement (US Investors)
Winter 2003 Winter 2003 Winter 2004 Winter 2004
Reserve for
Replacement
Limited
Service
Full -
Service
Limited
Service
Full -
Service
Average 4% 4.2% 4.1% 4.2%
Range 3.0% - 5.0% 3.0% - 5.0% 3.0% - 6.0% 3.0% - 6.0%
Source: USRC Hotel Investment Survey, US Realty Consultants, Inc.
Also PWC Survey among investors asked the participants about rates they use in
regards to reserves, in particular the Replacements Reserves of Fixed Assets. The
results from the study ranges between 2-8% of the total revenues (Korpacz, 1999).
This relatively wide range of constants for the reserve is interesting, however it
needs to be clarified that most of the investors in the survey quoted to use 3-5% of
the total revenues as a constant for the Reserve for Replacement of Fixed Assets
(More details can be seen in Appendix 2). However, Pagliari (1995) argues, that
too low constants for replacement reserve, used by valuers/investors, is a
drawback in many hotel appraisals. According to Pagliari, when calculating net
operating income (NOI), appraisers need to deduct more than 3% of total
revenues to account for future CapEx. In addition, Pagliari (1995) warns that
many appraisers do not account for the position of the hotel in its life cycle.
Pagliari gives the example of a 20 year-old property that will require major
refurbishment within a few years which may approximate 10-30% of the market
value of the property which is much more than 3-4% of gross revenues (1995).
Another important stakeholder that usually require the establishment of a
replacement reserve in hotels are lenders such as banks. The intention of lenders
is to ensure that the loan security (usually the hotel facility itself) will be well
maintained (Denton, 1998). For example, Wilder (2004) informs that most
lenders in the USA require a monthly replacement reserve often approximating 4
percent of gross sales. Wilder (2004) gives some advices on how to negotiate
with lenders but admits that some lenders, especially those providing commercial
mortgage backed securities, are less flexible in negotiating escrow levels for
Lenders and
Replacement
Reserves

replacement reserve because their strong reliance on ability to resell the loans to
end-buyers. According to the author, the ability to resell to end-buyers is
influenced by debt rating from a credit-rating agency, such as Moody's or
Standard & Poor's, and these agencies usually impose tight requirements that
inhibit the loan originator's ability to negotiate terms (Wilder, 2004).
It seems that CapEx are officially underestimated despite the data in available
research.

2.6 Why Are CapEx Underestimated?
According to Berg & Skinner (1995) CapEx include not only the replacement of
worn-out furniture, finishes and soft goods, but also all wear and tear in general
and replacements and renovations of building components and heavy equipment
due to obsolescence, regulatory requirements such as OH&S, changing
technology, franchise product demands and market demand for product change.
The authors argue that these expenditures have been “long assumed to be covered
with replacement reserves” (Berg & Skinner, 1995) This creates unrealistic
expectation since as was already mentioned, ISHC study indicates that in reality,
these expenses will probably be much higher than 3% which is the standard
contribution to the FF&E reserve. Berg & Skinner (1995) provides a list of
reasons why the industry continues to formally underestimate CapEx, despite the
actual experience within the industry. These factors are:
 Some owners (usually private owners) try to expense (as opposite to
capitalise) as many items as possible.
 Recognising the true CapEx level reduces the value of existing hotels, and
as a result, CapEx are often hidden
 Recognising the true costs of CapEx raises the feasibility threshold for
new hotel development, making financing and developing hotels more
difficult
 Appraisers fear the loss of clients if they report a lower hotel value by
recognising the cost of CapEx
 In many cases, there is a poor planning and record keeping in regards to
CapEx
Also the authors of ISHC study recognise fear of some stakeholders that their
findings will lead to the increase of funds required by lenders or/and operators to
be set aside (in the form of reserves) thus consequently affecting investor’s return
on investment.

2.7 CapEx planning
According to Denton (1998) proper plans are the most effective tools to manage
CapEx. “Without an effective system of defining, budgeting for, and monitoring
capital expenditures, one can almost be certain that projects will be undertaken at
the wrong time in the investment cycle, that too much money will be spent, and
that the owner will be unpleasantly surprised by shortfalls in the capital
expenditure reserve” says Denton (1984:2). This is reflected in most management
agreements where operators are usually required to provide the owner with a
CapEx plan, which should be updated on an annual basis (Beals & Denton,
2004). According to the JLLH Study, 85.7% of management agreements in Asia
Pacific contain a requirement for budget approval by owners (Haast et al. 2005).
According to Beals & Denton (2004), the plan is typically developed using a
“ground up” approach, whereby the manager looks at the property’s physical
condition and assesses guest satisfaction, brand compliance and the property’s
competitiveness in the market place.
Beals & Denton (2004) suggest developing 3-5 years plans based on this review.
Crandell (2002) suggests developing 10 years capital programs, since this period
reflects the renovation cycle of hotels. According to the author, a 10-year CapEx
plan gives better flexibility in the CapEx timing. It also enables to set priorities so
that limited funds are not spent on the early-year or “like to do” projects that
might be less important than CapEx requirements in the following years
(Crandell, 2002). Denton (1998) goes even further and develops a 30-years plan
to provide thorough picture about long term CapEx needs including replacements
that will be necessary within 20-24 years, such as elevators (cable) or roof.

To be relevant, long term plans should be updated on an annual basis and the
expected cumulation of funds in Replacement Reserve should be compared to
planned CapEx requirements (Crandell, 2002). Beals & Denton (2004) also
advice to compare proposed CapEx against the projected funds in property’s
Reserve for Replacement. In the case where the funds are determined to be
inadequate to cover requested CapEx, Beals & Denton give two options to the
owners:
 defer or eliminate non-essential items to conserve funds; or
 infuse additional capital into the property to complete all the
requested projects
(Beals & Denton, 2004)
To enhance the decision making process, items in the CapEx plan should be
ranked according to their importance for the survival of the building and the
business. Crandell (2002) suggests three categories:
 Have-to-do CapEx (i.e. fix the roof when it leaks)
 Nice-to-do CapEx (i.e. replace carpeting and other soft goods)
 Smart-to-do CapEx (those items that require additional investment
to generate higher revenues, such as the makeover of a restaurant
or upgrading meeting facilities)
Ransley & Ingram (2000) suggest to plan for CapEx already during the design
stage of hotel development and recommend applying ‘life-cycle costing’.
According to the authors, ‘life-cycle costing’ is a technique used to examine the
capital, operating and maintenance costs and revenues of an asset. Ransley &
Ingram argue that this method enables to realise that greater initial investment
might provide higher return since it can reduce replacement and repair costs over
the life of the building. It is especially true for hotels where the asset value is
based on the profitability of the operations rather than bricks and mortar, and
where current expenditure on running expenses will, over time, exceed the initial
capital expenditure by many times (Ransley & Ingram, 2000).

The benefits of life cycle costing are as follows:
 It enables understanding of long-term consequences of the design and
capital expenditure decisions and,
 the relation between capital expenditure, design and operating costs
 It considers design and CapEx in accordance with the clients own
investment criteria (Ransley & Ingram, 2000)
Denton (1998) suggests detailed long-term CapEx plan. According to the author,
each functional component of the hotel, such as guestrooms, bathrooms,
corridors, exteriors, building systems should be itemized and replacement costs
with anticipated life expectancy should be assigned to each item. This should be
transformed into CapEx plan with a synoptic table, thus helping to manage
appropriate funding (Denton, 1998). Examples of CapEx budget tables can be
found in Appendix 3. In addition, the detailed list of required CapEx should be
accompanied by the full description of the expenditure, a concise reasoning for
expenditure including the identification of the aspect of the facility it will
improve and the determination of funding (Rushmore, 2002). Denton (1998)
summarises the benefits of such as detailed long-range capital planning model as
follows:
 The model provide an effective financial planning tool that allows
owners to anticipate future requirements and not to be caught
unprepared for major renovations
 Concerned lenders can track the level of escrowed funds and adjust
their contribution requirements accordingly
 If the contribution to replacement reserve is not set as constant
from revenues and is adjusted according to estimated CapEx needs,
the model eliminates gaps of undefended reserves or underused
capital
 It allows owners of multiple properties to coordinate capital
requirements and thus maximise use of capital and reduce
fluctuation of Cash Flow
 Having long range capital planning model facilitates annual budget
reviews and approvals, since once there is an agreement among

parties on general assumptions of the model, there will be less
discussion regarding timing and payments of CapEx
 Having specific annual spending targets for capital expenditures,
determined life expectancies and replacement costs of the items
will enable owners to hold management accountable for
maintaining assets and allows monitoring of the effectiveness of
preventive maintenance and purchasing programs
 Applying the model to acquisition analysis for existing hotels can
provide a potential purchaser with a reasonably clear picture of
future capital requirements, thereby helping the owner make an
appropriately priced purchase offer
However, Beals & Denton (2004) warn that many plans tend to be developed
around available funds rather than through thorough assessment of the property’s
true capital. In addition, there are several potential pitfalls that might occur when
the plans are developed by operators. These are as follows:
• The CapEx plan provides no incentive and actually is a disincentive for
Operators to be thorough in their analysis of capital needs or to address the
replacement of expensive mechanical items or major repairs. By drawing
attention to a major expenditure that the Owner would otherwise not be
aware of, the Operator reduces the funds available for other items or risks
throwing the reserve" into the red.” Thus, items like carpet replacement and
restaurant refurbishment are always included in Operator-generated plans,
but less visible yet equally essential items like replacing a chillier, roof
repairs, or plumbing and electrical updates are often excluded, leaving the
Owner to fund those items on an unbudgeted basis when the repairs are
needed.
• The system requires the Operator to be adept at cost estimating for their
requested expenditures, placing a burden on managers who may not have
adequate experience or corporate resources to develop accurate estimates
and creating an opportunity for human error to render the five-year plan
dangerously misleading. For this reason, a formal Asset Register is often
developed, through the services of a specialist cost consultant.
• If the Operator is given discretion over the timing of items within the five-
year period of the plan, the opportunity exists for the Operator to accelerate"
pet projects" and defer projects that may be more important for the overall
wellbeing of the property.
• When Operators have to "fit" Capital Expenditure needs to the availability of
funds, this often leads to partial solutions, such as renovating a portion of a
property's guestrooms in one year and deferring the remainder until more
funds are available. Although acceptable on a limited basis, this tactic can
ultimately result in a property that has dramatically inconsistent quality
levels, thereby diluting the overall impact on the guests. This approach often
also results in more money being spent in total because economies of scale
are compromised when work is accomplished piecemeal or over a protracted
period of time.
Pitfalls in
the CapEx
planning
process:

Beals & Denton (2004)
Another problem with CapEx planning is the difficulty of determining the time
when the asset will need to be replaced.
2.8 Expected life of the Assets
Accurate assessment of assets replacement needs in the future of a property is the
core element of CapEx plan (Denton, 1998). In regards to assets’ life, Rushmore
(2002) talks about the ‘useful life’ of the asset which is affected by uses to which
these assets are subjected, amount of guest traffic, quality and durability of its
construction. Australian Accounting Standards (AASB) handbook (Kemp &
Knapp, 2005) defines useful life as:
(a) the period over which an asset is expected to be
available for use by an entity; or
(b) the number of production or similar units expected
to be obtained from the asset by entity
(Kemp & Knapp, 2005:521)
The AASB standards also inform that following factors need to be considered in
determining the useful life of an asset:
(a) Expected usage of the asset. Usage is assessed by reference to the asset’s
expected capacity or physical output
(b) Expected physical wear and tear, which depends on operational factors
such as number of shifts for which assets are to be used and the repair and
maintenance programme, and the care and maintenance of the asset while
idle.
(c) Technical and commercial obsolescence arising from changes or
improvements in production, or from a change in the market demand for
the product or service output of the asset
(d) legal or similar limits on the use of the asset, such as the expiry dates of
related leases
(Kemp & Knapp, 2005:521)
It is clear that some factors, especially commercial obsolescence and legal
changes may be difficult to predict for 5-30 years ahead. The British Association
of Hospitality Accountant (BAHA, 2000) provides a guide for hotel valuers and

accountant and defines the following useful lives of tangible fixed assets that
reflect refurbishment cycles for a typical hotel.
Table 6 ‐ Suggested Useful Economic Lives of Categories Tangible Fixed Assets
Category Range of Useful Economic Life
Land - Freehold Infinite
- Leasehold Life of lease.
Building Core - Freehold Determined by
directors.
- Leasehold Life of lease
Building Surface Finishes and Services 20 to 30 years
Plant and Machinery 15 to 20 years
Furniture and Equipment 5 to 10 years
Soft Furnishings 5 to 7 years
Computers – PMS/PC hardware and software 3 to 5 years
- Major systems installations Up to 10 years
Motor vehicles Up to 5 years
Source: British Association of Hospitality Accountants (BAHA, 2000)
Even though CapEx replacement plans are not developed for tax purposes, the
guidance given by the Australian Taxation Office (ATO, 2005) might be useful
for the determination of expected life of assets. ATO uses the term ‘effective life’
of depreciating an asset and describes it in broad terms as follows.
“Effective life of a depreciating asset is how long it can be used by any entity for
a taxable purpose or for the purpose of producing exempt income, having regard
to the wear and tear you reasonably expect from your expected circumstances of
use and assuming reasonable levels of maintenance”.
(ATO, 2003:8)
In general, ATO gives two options for businesses to determine the effective life
of the assets. First, organizations may determine the effective life by themselves
and ATO provides guidance for this option plus suggests using the following
information:
• manufacturer's specifications
• independent engineering information
• your own past experience with similar assets

• the past experience of other users of similar assets
• the level of repairs and maintenance commonly adopted by users of the
asset
• retention periods
• scrapping or abandonment practices
• the physical life of the asset
ATO has also its own estimates of the effective lives of depreciating assets which
are reflected in determinations by ATO commissioners. ATO recently issued a
revised table for the effective life of depreciating assets including assets specific
to the Accommodation Sector (Schedule 1, Table A). Excerpts of this table are
presented below.
Table 7 ‐ Effective Life of Depreciating Assets in the Accommodation Sector
Item Effective Life
Audio-visual entertainment assets including 5 years
(amplifiers, speakers, televisions and projection equipment)
Carpets, mattresses and guestroom furniture 7 years
Window blinds and curtains 6 years
Bed spreads, blankets and quilts 5 years
Bedding (including mattress protectors, pillows and sheets) 2 years
Crockery and cutlery 4 years
Glassware 2 years
Hot water systems (excluding commercial boilers and piping) 10 years
Source: ATO Determination, 3 June 2005
It is necessary to realize that items are not replaced according to the initial
schedule (or tax office requirements) but according to when they actually fail,
become damaged or worn, or when competitive conditions dictate (Beals &
Denton, 2004). Hence monitoring of assets’ condition and regular up-dates of
CapEx plans are necessary (Beals & Denton, 2004). In addition, the effective life
of the assets is closely linked to the quality of maintenance. If an asset is well
maintained, its effective age may be less than its actual age and, if an asset is not
maintained properly its effective age may be less than initially estimated (Beals &
Denton, 2004).

It is clear that the management of CapEx is a very complex process that requires a
good knowledge of relevant issues and expertise. Swing suggests owners to
employ an Asset Manager (1994).

2.9 Role of Asset Manager
According to Swing (1994) the hotel sector is rapidly evolving due to technology
enhancements, legal statute refinement, and new competitive requirements and
many owners do not have the professional hotel expertise to handle the broad
scope of demands associated with hotel assets. However, Swing highlights that
investors and owners cannot rely on operators to protect their assets and suggests
employing an asset manager; either internally or through an outside firm that
provides specialty asset management services (1994). According to Bridge &
Haast in Ransley & Ingram (2004) there are three areas where asset managers
play a major role:
 Product Definition – Ensure a consensus between owner and operator about
hotel positioning and the volume of CapEx to maintain that position, plus the
assessment of new opportunities. Achieving a balance between the needs of
current and future guests, the standards of the operator and the volume of
investment required to be made by the owner
 Service and operating standards – Ensuring maximising of sustainable Cash
Flow while at the same time maintaining the quality and character of the
hotel. To challenge and support the operator to ensure that the most
appropriate service and operating standards are set to support the value and of
the hotel and its operating performance.
 Financial Supervision – Monitoring of performance and ensuring that budgets
are challenging but also achievable
(Bridge & Haast in Ransley & Ingram, 2004:255-262)
According to Ransley & Ingram hotel properties are typically high-value; capital-
intensive assets that require concentrated management in order to generate
adequate returns on the capital employed, (2000:38). “Asset management is “the
process by which a property with money value is effectively controlled and
managed as a business” (Ransley & Ingram, 2000:38). Ransley & Ingram,
(2000:39) define the roles of asset managers and provide three main factors that
contribute to the increasing role of asset managers in hospitality industry, it is:

- The increasing value of the property asset brought about by hospitality
properties becoming larger and more complex structures requiring greater
amounts of capital and being much more substantial businesses requiring
integrated on-property operations
- The increasing trend, begun in the USA in the late 1960, for the traditional
owner/operator framework to be superseded by a structure in which the
ownership of the asset is vested in one entity and while the day-to-day
management of the hospitality business is carried out by third party
- Increasing emphasis on financial aspects of hospitality operations and how
ownership brought about by shift of focus to financial returns and away from
traditional hospitality as the measure of success (and in part brought by the
entry of large financial institution into hospitality ownership)
Ransley & Ingram, (2000:39)
According to (Beals & Denton, 2003) the CapEx process should ideally be
governed through four critical activities, typically carried out by the owner or an
Asset Manager acting on behalf of the owner. These activities are:
 Monitoring and directing property maintenance to maintain or extend the
useful life of the assets;
 exercising oversight over capital budgeting and expenditures to ensure that
the owner’s funds are expended judiciously;
 creating an effective system (the Capital Expenditure plan) for monitoring
and anticipating Capital Expenditures, enabling the owner to plan for future
expenditures and thus allocate financial resources appropriately; and
 strategic decision-making regarding upcoming Capital Expenditures, whether
required or discretionary
Source: (Beals & Denton, 2003)
Ransley & Ingram (2004) suggest recognising the importance of the asset
manager’s role in management agreement, especially in the case of investors who
do not have direct experience in hotels. Thus, a management agreement should
provide rights for an asset manger to receive budgets, reports, attend meetings and
generally act as the owner’s representative (Ransley & Ingram, 2004). It is subject

to negotiation whether the fees and expenses of the asset manger will be
recognised as operating expense or not (Ransley & Ingram 2004).
This brings to light the relationship between owners and operators and
management agreements.
2.10 Owner/Operator Relationship and
Management Agreements
The relationship between owner and operator is formally represented in the
conditions of a management agreement. The final conditions in management
agreement are the result of negotiations between owner and potential operator
(Ransley & Ingram, 2000). The relative positions of the parties are given by the
number and level of interest of operators in a property which is determined by the
nature of the property and its location (Ransley & Ingram, 2000). In addition, the
competition among operators and conditions in the particular market place has a
significant impact on bargaining positions of the parties. Ransley & Ingram hold
that the owner’s position is improving as the capital is in shorter supply and there
are more operators than new management opportunities, especially in the
locations where development opportunities are constrained by the scarcity of sites
and the restrictive and complex planning legislation (2000). Eyster (1997) agrees
and adds that the owners’ position is improving also due to the experience of
hired third party or in-house asset managers and other experts, which is even
enhanced by the active exchange and sharing of experience though associations
and forums of owners and industry professionals. According to author, the only
factor that offsets the bargaining power of the owners is the consolidation
movement in the hospitality management sector (Eyster, 1997). The following

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