Challenges facing the boutique hotel sector

With boutique hotels often having smaller teams and being reliant on online travel agencies (OTAs), the sector faces a raft of challenges as issues continue to arise with data privacy and cybersecurity, employment, IP and brand protection, and increasing OTA fees.

As well as this, the October 2024 Budget adds to these challenges with a 7% minimum wage increase, higher taxes (employers’ NIC rates rising from 13.8% to 15%, with the NIC threshold dropping from £9,100 to £5,000), and reduced reliefs (business rates discounts decreasing from 75% to 40% in April 2025).

The increasing frequency and severity of climate disasters is causing tourism revenue losses and property damage. Insurers are raising premiums, increasing deductibles, and reducing coverage in high-risk areas prone to climate risk. This creates challenges for hotels to secure insurance meeting lender requirements, with some areas nearing un-insurability (e.g. hotels located close to cliffs where landslides or slumps have been reported).

In this article, hospitality sector partner Nadia Milligan outlines some of the challenges boutique hotels will need to overcome.

Lease options available to hoteliers

Hoteliers can better safeguard profitability through their leases, for example:

1. Turnover leases: A turnover lease is where the rent payable to the landlord is based on the revenue generated. The definitions used to calculate ‘revenue’ are significantly important. For example, operators should seek to exclude as much as possible from the definition of ‘revenue’ (including service charge and tips). Landlords may suggest ‘grossing up’ any discounts given to staff or family so, for example, a guest room sold on 50% staff discount is grossed up, for the purposes of the calculation of ‘revenue’ to 100% of what the room would have otherwise sold for.
2. Understanding repairing obligations in leases: The importance of this cannot be understated. It is crucial for operators to undertake a building survey prior to entering any commitment to enter a lease to ensure that any defects in the property are identified and a decision is proactively made as to which party is responsible for the repair of the defect(s) and ongoing repair obligations. Responsibility for the repair and maintenance of the various elements of a hotel can have a significant impact on the profitability of a hotel. Operators should understand whether they are entering into:

   a. Full Repairing and Insurance Lease (known as an ‘FRI lease’) where the operator will be responsible for all costs related to the repair (both interior and exterior, structural parts, FF&E, and even inherent defects), maintenance and insurance of the property. The landlord will have no repairing liability but will often procure buildings insurance and charge the cost back to the operator. An FRI lease might be more appropriate for an operator for a new-build property, where it is given the benefit of guarantees and can obtain collateral warranties from the contractor and the professional team who built the hotel.

   b. An Internal Repairing and Insuring Lease (known as an ‘IRI lease’) where the operator will be solely responsible to repair and maintain the internal parts of the hotel, whilst the landlord is responsible for repair and maintenance of the exterior and structural elements. An IRI lease is more appropriate for older properties or those with high maintenance requirements.

3. ‘Lease hacks’: Whilst the key features of FRI and IRI leases are summarised above, there are some workarounds which can benefit operators, for example:

   a. Being in control of HVAC and boilers whilst passing the cost to the landlord: as HVAC and the supply of hot water to the hotel is of crucial importance to operations, an operator may not be at ease with the landlord being responsible for this. Operators could negotiate terms specifying that responsibility for HVAC and boilers rests with the landlord but that the operator will carry out general repairs and maintenance up to an agreed cap, and the cost will be deducted from future instalments of rent.

   b. Unfortunately, the successive Covid lockdowns resulted in the closure of many hotels throughout the UK. An operator should consider inclusion of a right to break the lease in the event of any Government-enforced hotel closure(s).

4. Hotel management agreements (HMAs):
   Where a hotel is managed under a HMA, hotel owners have numerous commercial options at their disposal to better safeguard profitability, for example:

   a. Fees: Most HMAs require a hotel owner to pay a ‘Base Fee’ which is based on total revenue (i.e. before any deduction is made for any operating expenses – known as ‘top line revenue’) and an ‘Incentive Fee’ which is based on adjusted gross operating profit (there is no industry standard but typically deductions include contributions to the FF&E Reserve and property insurance – also known as ‘bottom line revenue’). Agreeing to pay a higher level of base fee and a lower incentive fee does not align the operator with the owner’s financial goals.
   Hotel owners can also negotiate tiered incentive fee structures, e.g. an ‘Owner’s Priority Return’ where the owner must achieve a minimum return (a ‘priority’) before the operator receives any Incentive Fees, coupled with increasing percentages of Incentive Fees where certain thresholds are met, depending on the profitability of a hotel.
   Fees should be negotiated as early as possible during negotiations, ideally with a lower base fee and a stepped incentive fee.

   b. Working capital and CapEx: HMAs should contain robust clauses requiring the owner to sign off on annual operating and capital expenditure budgets, which are agreed with the operator in advance of each new financial year. However, ultimately, if an operator overshoots either budget and overspends (whether on operating expenses or capital expenditure), the owner will ultimately be required to pay additional working capital to the hotel’s operating account and/or pay for unforeseen capital expenditure. Owners should ensure that they have clear visibility over the operator’s spend to ensure that the budgets are adhered to throughout each financial year.

Artificial intelligence

Artificial intelligence (AI) advancements enable cost reductions and operational efficiencies – linking sustainability to growth and enhanced guest experiences. While investments in hardware, software, networking, and cloud computing are necessary, the benefits are immense.

AI helps manage resources efficiently and can result in immediate cost savings as well as lowering a hotel’s environmental footprint. For example, climate control and lighting, local sourcing of food waste reduction, automated maintenance checks, and staff allocation can all be powered by AI.

Sustainability credentials

Hotels with certifications from the likes of BREEAM, GRESB and Green Globe attract environmentally conscious travellers and corporate travellers (some of whom will only stay in properties that have eco-friendly credentials).

As more guests now prioritise eco-friendly solutions, developers must meet ESG standards. Businesses who fall under the Corporate Sustainability Reporting Directive (CSRD) are required to make their first CSRD disclosures in their 2025 management report using 2024 data. This includes reporting on their environmental impact (including the impact of corporate travel). Eco-friendly guests are also increasingly requesting an ‘ESG receipt’ with details about their carbon footprint regarding their stay.

Hotels should embrace sustainability in design and refurbishment, incorporating energy-efficient systems, circularity, and eco-friendly construction, aligning with consumer and investor priorities.

With regulators pushing for greater transparency in sustainability reporting, hotel owners should set clear ESG strategies, including benchmarking sustainability KPIs, allowing owners to identify areas for improvement for each hotel.

If you have questions or concerns about any of the issues raised in this article, please contact hospitality sector lawyer Nadia Milligan.

For more information on the trends in the hospitality sector, click here.