What is the “Third Space” and why is it important?
The COVID-19 pandemic has had a significant impact on the role of home, work and socialising as result of the containment measures employed. In some instances, the shift in roles has simply been accelerated by the onset of the pandemic, whilst in others, it has created entirely new needs. One of these being the “Third Space”; a space outside of the home and office where people can go to work, socialise and sleep. Its defining feature is its flexibility, it is multi-purpose and multi-use which allows it to fulfil work, home and social needs.
The hospitality sector has unintentionally (and fortunately) found itself in a unique position to service the demands of the “Third Space”. This is because the industry has the advantage that it already provides spaces that people want to go to. It is here that we must clarify that the “Third Space” is not simply a soulless, sterile, dedicated conference wing in a hotel, but a hub of activity and atmosphere. As obvious as it may sound, it is this desire for people to actually go to their “Third Space” that is fundamental to its success.
Over the past twelve months, given the incessant easing and restricting of measures, hospitality operators have provided this “Third Space” as either a temporary measure to increase footfall and revenue in the short-term or incorporated it as a permanent reform to their business model. For those who fall into the latter, this shift in operations has the long-term ability to help drive revenues from existing streams, such as underperforming or underutilized F&B and concessions, and also create entirely new revenue streams through membership models, which have been incredibly robust through lockdown. Additionally, establishing a “Third Space” can facilitate brand differentiation and create destination locations, whose benefits will also extend to the local community. As we know, brands like Hoxton are already capitalising on these benefits. Indeed it is highly likely that the pull of brand differentiation and Hoxton’s innovative ideas and offerings in this area was one of the main motivations for Accor’s interest in the Ennismore joint venture – which will also team Ennismore up with a number of other lifestyle brands in the Accor portfolio including Mama Shelter and their Mamaworks product.
What type of providers might this apply to most?
Given the vast number of potential clients and the diverse offering of this new phenomenon, there are a large range of hotels and others in the lodging space for whom this could be relevant. This includes: hotels with existing F&B facilities where costs of conversions would be lower; hotels with additional amenities, such as gyms, spas, salons etc. which attract both overnight guests and day visitors; and hotels whose focus is on the business-leisure (“b-leisure”) market.
It is well known that one of the hospitality sectors that has performed well through the pandemic is the drive-to resort market. Amongst these, country house hotels with large grounds and under-utilised out-buildings and country clubs with co-working and additional leisure and sporting facilities, such as Soho Farmhouse, will easily be able to successfully adapt their business models to this new norm.
Another fine performer amidst the mayhem has been the extended stay sector, as demonstrated by the recent Blackstone and Starwood Capital acquisition of Extended Stay America and the launch of new extended stay models such as Louvre’s Tulip Residences. One can easily see how customers for that type of product would also be keen on additional areas in which to work and socialise and thus would embrace the “Third space” offering.
Finally, it is clear that many business hotels will also need to adapt to an extent to the “new norm” and co-working with a difference is one important option to consider.
Legal issues involved in
Basic legal restrictions – Even with a freehold property there are title restrictions, restrictive covenants, limitations on rights over neighbouring premises and limitations on increasing usage.
Planning/Zoning – Some modifications may require a formal change of use. Unfortunately, hotel use was not included in the new planning flexibility introduced in the UK from 1 September 2020 and in a number of countries zoning restrictions vary at a municipal level.
On signing a facility agreement a borrower will probably have agreed a specific set of financial covenants based on a pre-agreed financial model of revenues and valuation. The revenues from third space would likely have a different profile.
Facility agreements will often also contain representations relating to the nature of a borrower’s business and have covenants that the borrower will not change its business or suspend a material part of its original business and so these changes could potentially trigger an event of default.
In practice, one would hope lenders would be realistic and pragmatic and see this third space expansion as a positive development for the borrower and its continuation as a viable business. Collaboration with key stakeholders here is key.
Considerations for leaseholder: Consent for the work, these will need to be obtained from landlords/superior landlords.
Permitted use – this may be very limited in your original lease so will again require permission from the landlord/superior landlord for any change. This may be particularly hard if you are a tenant of a larger building/estate and your proposed additional services may compete with other tenants in the same building/estate.
Turnover/profit rents – detailed discussions will need to be had to determine how these revenue streams will be captured. This is particularly relevant if you are also offering delivery services outside of the property.
Alienation/undertenant restrictions – Leases will also have implications as to whether or not you can run the space yourself or will need to sub-let. Also the way your customers book the space (whether by usual booking systems or memberships agreements or something else) could be restricted.
HMAs and Franchise Agreements
There are a number of legal issues and challenges that owners with managers and, to a certain extent, franchisees need to consider.
Firstly, it is highly likely that Brand approval will be required where there is any repurposing of the facilities. This will certainly be the case under most HMAs and with most franchises and so early engagement of the operators/franchisors will be important.
Many operators will claim (with a varying degree of justification) that they can run any third space offering. For example, some operators, such as CitizenM, are offering a subscription package to drive traffic. It may however be that you consider in your specific case that another entity, with specialist skills, will be better suited to operate some or all of these repurposed facilities.
If your choice is to hire a third party, this will throw up a number of other legal and contractual issues and challenges. Brand Standards, for example, are always a sensitive subject and a strict requirement for operators – the hotel operator will need to be convinced that the third party will be at a level that is consistent with the Brand Standards – or at least is not below the standards expected which might negatively impact on the hotel and its performance.
Will the third party be contracted through a lease/license or management agreement? Will this necessitate an amendment to the definition of the hotel by removing the area that the hotel operator is responsible for managing? Operators will be concerned about loss of control and of course the extent to which this will affect their compensation.
Intellectual Property is key and will of course also be relevant for owner operated properties too. Care will need to be taken to ensure appropriate and detailed co-branding terms are agreed and documented with the third party operator. It may be feasible to include these terms in the license or lease etc. or a standalone agreement may be required. These terms would include a license from the owner or brand to license use of the hotel name in return for a license from the third party such as a WeWork. Alternatively, if this arrangement is going to be rolled out across a number of properties, then a more extensive Master Co-branding/license agreement may be needed.
Care should also be taken to ensure that the registration of trademark program covers all the relevant classes. For example, you may need to obtain a registration to cover office rental or housing, as well as the sale of business related products in addition to all the typical classes required for the operation of a hotel.
Perhaps the most sensitive item for many will be the question of remuneration and compensation. How the third party will be remunerated will obviously depend upon (or perhaps dictate) the type of agreement that is entered into with the third party.
But how will the revenue and costs /profit derived from the third space be treated? Will that form part of the hotels total revenue impacting upon the management fees or will it be totally distinct? If the latter, then will changes need to be made to any operator guarantee or performance test?
Finally, thought should be given to the reservations or booking systems including to ensure that bookings for the “Third Space” are distinguished.
One must be cognisant that this is just a brief overview highlighting some of the key issues that will need to be addressed and there will no doubt be a number of others depending upon the exact form that the “Third Space” and its operation takes especially as these uses will probably only become clearer as the world starts to unlock over the next 12 months. However, in all instances careful and timely planning, implementation and documenting will be required.