Review of Hotel Casino Leases and Management Contracts

The gaming industry has seen many changes in the last few years in the way some large casinos are owned and operated. It has become difficult for a new company to both own and operate a casino. This is caused by (1) the increasing demands from institutional investors and gaming regulators requiring operational experience as a condition for financing and licensing, and (2) the expectation of considerable equity to support the debt. It is therefore unlikely that a developer will have the necessary operational experience or an operator will have the necessary equity to satisfy both conditions.

This paper will cover the two conditions whereby an owner either leases the facility or engages a management company. The first portion will cover the general economic differences followed by a comparison between a lease and a management contract using three levels of operations. The last portion will compare four proprietary management agreements using the average of two Las Vegas areas hotel casinos. There are two management agreements that are public record, Trump and Golden Nugget. However, both of these are between related parties and were not considered representative of arms length transactions.

LEASES

In general, a lease protects the owner from the "down side" risk of the investment but limits his participation in the "up side" if the business is very profitable. A lease gives the operating company more control over the property while assuming most of the financial risk. Likewise, the owner has less control and financial risk. This arrangement works best for owners that want an uninterrupted rental stream and less risk. Also, the owner does not have to be as involved either financially and managerially. And, in some instances, is not required to obtain a gaming license.

Leases tend to be for fixed periods of time ranging from 10 to 50 years or more. Most leases require that the tenant make some improvements. After the lease has expired, everything including the building and improvements, becomes the property of the landlord. This is also true if the tenant breaks the lease. Because of the reversion, a fixed period of time is needed to provide the lessee the opportunity to recover the improvement cost and, since the lessee has assumed the financial risk, an opportunity to make additional profits if the business is very successful.

It is important to evaluate costs and provisions when writing up a lease. The most important is the total amount of payments for the property, and clear language as to any rent increases for the lease term. This would include ties to revenue and profit, or cost-of-living adjustments. Another provision, is the use of the premises and what type of business the tenant may run. The tenant should resist the landlord's efforts to narrowly define what type of business will be permitted. There may be other business opportunities in the future for the tenant to exploit, but the lease may not allow this.(Davidson, 1990)

The lease should also contain who is responsible for the cost of taxes, assessments, utilities and other overhead costs. The landlord should have the tenant pay for extra taxes and assessments from improvements to the property. The tenant should exclude or limit increases in real property taxes if the property is sold during the lease. Also, the tenant should look carefully at the list of operating costs and ask for an annual statement of expenses to guard against overcharges. The landlord could start to charge excessive operating costs to the tenant. This could force the tenant into bankruptcy or make the operation unprofitable. If the landlord can increase costs while keeping the tenant captive, he may do it. The common form of this is when a landlord fires the existing service companies and starts his own, charging exaggerated prices. (Kaplin, 1992)

Further, the lease should specify who is responsible for repair and alterations of the premises. This can potentially involve large costs when repairs are made to the building's exterior and roof. The landlord should have prior review of any repairs or alterations made by the tenant. These repairs and alterations could cause liens against the property if the tenant defaults. The landlord should protect himself against this by posting a notice of non-responsibility.

 The landlord and the tenant should both carry enough casualty and liability insurance. Both parties should receive assurances that the other party has its own insurance. Other insurance risks could include business interruption and liquor consumption. Both parties typically waive rights of subrogation (to stand in each-others shoes) in the event of a loss. This agreement bars respective insurers from seeking recovery of proceeds paid for any losses of the other party. Landlords should seek agreements with tenants for them to "hold harmless" the landlord. This will insulate the landlord from risk of damages or losses caused by the tenant. This way the tenant absolves the landlord of financial responsibility and acts as his insurer. (Davidson, 1990)

Leases involve many risks and problems to both tenants and landlords. They should be negotiated so that the risks to both parties are minimized. The contract can become more important than the stipulated rent when problems occur. This is why the lease contract should be evaluated just as carefully as the rent payments.

MANAGEMENT CONTRACTS

Management contracts allow an owner to have another company come in and manage the property. The relationship follows three key principles. (1) The managing company has sole and exclusive rights to manage the property. (2) The owner is financially responsible for property expenses and risk. (3) The owner turns over complete operating control and responsibility to the manager. The manager in turn uses its expertise to create value by generating operational cash flow. Negotiations for the contract usually center on the sharing of financial risk and operation's decision making. The owner designs incentives to produce bottom line performance from the management company, while the management company tries to limit the participation of the owner in operation's decisions.

Some owners look for management companies that will take a share in the projects financial risk. This makes them equity partners, both having a stake in equity and cash flows. The operator can make an equity contribution providing cash, equipment or technical services. Some of the items frequently funded by management companies are working capital, operating inventories, gaming equipment and pre-opening expenses. Currently about 40% of existing contracts provide for operator contributions. (Eyster, 1990)

The contract should include what the manager's system expenses (corporate overhead) the owner must reimburse the management company. These costs may include marketing, advertising, sales, accounting and procurement. They may also include room and board expenses of the managers corporate staff. These reimbursable expenses can amount to 2-4% of gross revenues (Eyster, 1989). Managers should not make system reimbursable expenses subject to negotiations, since this would create inequities among properties in their system. On the other hand, an owner must protect his property from corporate charges that are abusive such as private airplanes, executive retirement, expensive corporate offices and support staff that may not be directly needed for his property.

Over the years, the length of contracts have become shorter to give owners more options. Some owners believe that shorter contracts give more of an incentive for manager performance. Also, the short term allows the owner to remove a bad manager and reduce termination payments to buy out a manager (Eyster, 1990). The problem with short term contracts is that the manager has no long-term commitment to the project. To overcome this problem, some contracts have tied manager performance to contract renewal.

A significant change in recent contracts, gives the owner the ability to terminate the contract if performance provisions are not achieved by the manager. The manager performance should be based on annual income before fixed charges. It must also include an exclusion period if the business is a start-up because of the unpredictable cash flow. Further, a shortfall allowance should be given if the performance is not achieved. This is usually between 8 and 15%. (Eyster,1990)

Management contracts for hotel casinos differ from the industry standards for hotels without casinos. In most hotel contracts the management company receives a percent of the total sales, usually 3 to 5 percent, and sometimes a participation in the cash flow as an incentive bonus. However, with a hotel casino the casino in most cases will produce more income than the total of the other revenue departments, and presents a big financial risk because of its twenty four hour operation and high variable costs. Therefore, the percent of revenues in hotel casino contracts is generally less and more emphasis is placed on participation in the "house profit".

 House profit is usually defined as net income before capital costs such as depreciation, interest, amortization, insurance, taxes and extraordinary cost such as defending law suits. The logic behind this definition centers on these costs being the costs associated with owning the property. However, since house profit is a defined term, it may consist of the above and then reduced by certain items such as debt service, both principal and interest. A more recent term for house profit is EBITDA (earnings before interest, income taxes, depreciation and amortization). Which ever term is used, the need for a for a clear definition is important. Neither of these terms are defined by generally accepted accounting principles.

Most contracts provide for a percent of gross revenue as part of the management fee, but this is best limited to casino revenues. The unique aspects of hotel casinos where complimentaries, group discounts and junkets are a major cost results in problems defining, or agreeing to, gross sales. The casino revenue is the only revenue capable of a clear definition as to gross. Most casinos are regulated, audited and taxed on gaming revenue as defined by the state. Therefore, less disagreements arise if the gaming revenue is used exclusively.

COMPARISON OF LEASE AND MANAGEMENT CONTRACTS

Most lease contracts require a fixed payment, usually on a monthly basis. The payment may be computed as a rate of return based upon the cost or the fair market value of the property. For example, the lease payment may represent an annual return equal to 12%, or 1% per month of the fair value.

Long Term leases may call for an inflation adjustment. Usually this is computed every five years based upon the increase in the areas consumer price index. This inflationary factor is added to the monthly payment.  Another technique is a combination of a fixed payment related to equity and an other payment equal to debt service. This approach has become common with the introduction of variable rate interest charges.

If the property owner is a good negotiator, or in those instances where related parties are involved, the lease may call for participation in the operation. As mentioned earlier, the lease may call for a fixed rent computed as a percent of the cost or value. This rent becomes a base rent. The participation may be a percent of gaming revenue in excess of a fixed amount. For example, if both parties agree that $25,000,000 in gaming revenue would be the amount needed for a successful operation, the lease would call for an additional rent equal to 5 percent of the gaming revenue in excess of $25,000,000.

Some hotel casino leases call for one rent on the land value, another equal to total debt service for the improvements and still a third related to participation in gaming revenue or net income. When net income is used problems generally occur. These problems usually relate to an operators overhead costs where services are shared between other operating entities by a parent company.

To demonstrate a simple lease arrangement, a compilation of the average of the 13 resorts on the Las Vegas Strip with revenues above $75 million and an average of the 10 properties on the Boulder City Strip. This range is used to note the difference between large and small hotel casino operations.  The following schedule shows the complete income, expense and net profit.

Comparative Financial Statements

To show how management contracts differ from leases, a simple management contract may contain the following:

1. Gross gaming revenues shall be the amount recorded in the books as "gaming win" as reported to the Nevada Gaming Control Board.

2. House profit will be computed by deduction from gross revenues every expense arising from the existence of the premises and operations, except the following:

a. Payments of principal and interest on any sums borrowed.

b. Depreciation expense incurred with respect to improvements and personal property.

c. Amortization of any kind relating to deferred costs.

d. Lease payments with respect to real or personal property.

e. Insurance costs for fire or extended coverage.

f. Property taxes.

g. Outside Accounting or attorney fees.

3. There shall be paid to manager a fee for services rendered in managing the business, a sum equal to 5% of the gross gaming revenues as base management fee, and sum equal to 10% of the house profit as management incentive fee.

The follow schedule shows the computation for house profit.  Again, this is simplified by just using the depreciation and interest for the averages of the Las Vegas prepares.

The two parties to the contract would each participate as shown in the following schedules.

The reader must be aware that these schedules do not include all the detail of a management contract.  In real life, all things being equal, some of the expenses shown in the operating statement would have been absorbed by the Manager making the owners net income higher than shown.

* Assume a principle payment of $10,000,000.

The above comparison emphasizes both the risk and benefits associated with management contracts. The owner takes a beating if the operation is not successful.  However, if the operation is more than successful, the owner reaps a bigger benefit.  We have seen this with some of the early riverboats.

To further demonstrate the difference between leases and management contracts, the following is a computation of the same financial information using the simple lease.

Simple Lease

Owner Lessor

ANALYSIS OF VARIOUS MANAGEMENT CONTRACTS

This following analyses compares the same two averaged hotel casinos areas from Las Vegas. Four different proprietary management contracts are used to demonstrate the management fees that would be generated given the above averages. Each management contract discussed will have an analysis for both a large and small operation.

The following demonstrate the wide range of fees and varied approaches to management contracts. It is also important to note how the fees will vary depending upon the total revenue mix and profitability of the hotel casino.  The following examples will use the next schedule.

 The fourth contract gives the manager 2 1/2% of gross revenues before complimentaries. Also, the manager receives 10% of house profit before depreciation, but after interest expense. The analysis for a large hotel/casino is in the table below. This analysis shows that the operator receives 35% of net income. The analysis for a small hotel/ medium casino is in the table after. This analysis shows that the operator receives 37% of net income.

CONCLUSION

The four contracts are based mostly on a percentage of house profit, but they use different percentages. The best contract for a manager would be the third one, since this gives the manager the highest percentage of net income. For the owner, the first contract would give the manager the lowest percentage of net income.

The following table compares net income of the various management contracts to the example of a 12 percent rental lease.

This analysis compares the owner and operator/manager's incomes for both lease and management contracts. The difference is related to the amount of risk the owner is willing to take. The owner must decide if he is willing to take on more risk in a management contract. If the risk is too high, a lease would be a better course of action.

The best analysis an owner can make would be to compare the above assumptions to a hypothetical operation. We averaged enough hotel casinos for the two groups that we feel comfortable with the percentages as a starting guide.  This would also include a hotel casino with projected operations at the low, medium and high range for risk evaluation. The owner would then develop the comparable numbers of net income and evaluate the possible operating risks and benefits.

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