Global Hospitality Advisor: The Condo Hotel Boom

What Does it Mean for the Industry?

Smith Travel Research reports that there are 227 condo hotel projects in the development pipeline, representing more than 93,000 units— close to the average annual supply of traditional hotel rooms in a “normal” year. That is a boom!

This meteoric rise in condo hotel development has caused some to wonder about the product’s long term viability, but industry experts say that it is the fundamentals of the project that will determine its success—or failure.

“The greatest challenge to the ultimate success of a condo hotel for all participants—unit owner, developer, lender, manager and hotel guest—is to create a physical asset and an operational model that functions as closely as possible to a traditional hotel,” says Robert Haiman, senior vice president of Remington Hotel Corporation. “This includes all facets of location, market demographics, design, construction, amenities and operations. If these fundamentals are sound, the condo hotel should generate occupancy, rate and RevPAR commensurate with a traditional hotel property.”

Not everyone’s an “expert” but properly aligning all these factors can be tricky and requires the counsel of advisers who have experience gained over many transactions, not those who jumped on the bandwagon recently.

“Lack of experience with an understanding of the condo hotel product is one of the biggest problems I see in the condo hotel arena,” says Tom Engel, president of T.R. ENGEL Group, LLC. “Most people are just not quite familiar yet with the many sides and complexities of a condo hotel deal. We all know of developers who see condo hotels as potential cash cows and who quickly become involved in projects—far too involved in many cases—without fully understanding these complexities. Our recommendation: Get guidance on the front end, and spend some time educating yourself about condo hotels. This will save developers a lot of headaches and money in the long run.”

Jim Butler, chairman of JMBM’s Global Hospitality Group concurs, adding that there is a desperate shortage of talent with experience in condo hotels with what Butler calls the “Third Dimension”—the unique complexities, opportunities and problems that are created by the intersection of condominiums and hotels, but do not exist in either of the condo or hotel dimensions by themselves. “To illustrate the problem, traditional residential condo documents are worthless for a condo hotel,” Butler says. “A surprising number of developers have asked us at the last minute for a ‘second opinion’ on their condo docs prepared by traditional residential condo experts. It’s a good thing they did! They were unworkable for a condo hotel. We literally couldn’t ‘fix’ them. We had to tear them up and start from scratch.”

Not all condo hotels are alike People refer to many types of projects as “condo hotels” and this creates a lot of confusion. The term is used for a variety of very different product ranging from a traditional hotel with residential condominiums next door, or on the top few floors, to properties where some or all of the hotel rooms have been turned into condominiums and are sold off to individual investors. Some condo hotels may have as many as four or five different types of residential components. All these regimes may offer different advantages and issues, but the first step is to be clear about the type of project involved. According to Butler, the current furor is about the type of project where some or all of the hotel rooms are condominiums sold to individual investors. Many of these projects are ground-up, new construction, and others are conversions of existing projects. Both can work, and both can be tricky.

“Many condo hotel units are being sold to either foreign purchasers who are not necessarily versed in the customs and practices of the United States or less sophisticated investors who are persuaded by the sizzle of a marketing campaign—they genuinely believe that they are making a traditional real estate investment that will realize significant appreciation over time,” says Jonathan Roth of Canyon Capital Realty Advisors. “In a rising market, a lot of missteps and false projections get masked.”

Justin Schuman of 3Wall Development agrees, adding that some buyers are going to be surprised and very disappointed if the market drops and the units sell for less than their original purchase price. And that disappointment may come on top of big assessments that get levied on condo hotel unit owners to maintain hotel brand standards for the units as the years go on. “When that happens,” Schuman says, “I expect to see many condo hotels being bought up and converted back to either straight hotels or straight condominiums. But I do believe that condo hotels will survive and thrive, probably those where only a small portion of the units—10 to 20 percent—are designated as condos.”

Another condo hotel lawyer at JMBM, Catherine DeBono Holmes, says that one important key in dealing with these issues is to carefully manage and satisfy the expectations of all parties—the developer, the operator, the lender, the hotel guest and the condo unit buyer. Meeting these expectations is not just a matter of marketing, but includes good regime structure, fair allocations of income and expense, full disclosure, and a conservative approach to the "operational bridge” between condominiums and hotel operations. “It is critical that all these issues are dealt with properly before they get ‘baked in’ to condo docs and related agreements such as the CC&Rs, HOA agreements, Unit maintenance agreement, HOA management agreement, Hotel management agreement, and some extremely important definitions of ‘shared facilities,’ ‘common facilities,’ and ‘commercial facilities,’” says Holmes.

Mapping the path to success

Another important part of this structure is setting up an attractive and viable rental program for the hotel condo units— one that ensures that enough unit owners will put their units into the hotel rental program to provide an adequate inventory of rooms for a viable hotel operation. “With the right structure and incentives, condo hotels should get a substantial majority of the condo unit buyers to participate in the developer-sponsored rental program,” says Haiman. He adds that experienced condo hotel lawyers help develop the necessary provisions for the condo regime documents to provide the operator with the necessary control over hotel operations and maintenance of the property’s consistency and quality.

“My view is that in order to effectively operate a condo hotel, the manager must be a ‘benevolent dictator.’ By that I mean that the condominium documents must provide the manager with total control over all operations, maintenance, repair and improvement of the property,” Haiman says. “In turn, the manager must wield this power in a fair and rational manner and cannot simply use the condo owner’s association as a means to defray the hotel’s fixed expenses.”

The specific geographic market is another very important factor in determining the success of a condo hotel. Randy
Smith of Smith Travel Research noted that Nevada and Florida, followed by California and Illinois, are presently the
top markets for condo hotels. Smith says that the top four states account for 76 percent of condo hotel product
nationwide.

Beyond location, there are several critical factors that define the likelihood of success for a condo hotel development: access to capital, development/construction experience, condo sales and marketing, and hotel operations. Haiman says that the key most often missing from developments is professional hotel management. “Professional management is critical and something that needs to be locked down in the overall condo hotel design, or you are going to experience major problems down the road,” Haiman adds.

Avoiding Liability

But condo hotels are not a panacea, nor are they right for every situation. They must be implemented correctly or they
will create a disaster, says Butler. A survey of the delegates attending JMBM’s sold out Condo Hotel Conference in March 2005 revealed that the issue of greatest concern is “liability” and liability prevention—liability from homeowner lawsuits, construction defect claims and securities claims. Butler and Haiman agree that the best approach to avoid liability is to carefully develop a viable condo hotel regime, and then to do whatever it takes to make it work. “Happy people don’t sue,” says Haiman.

Running afoul of the securities laws, which are enforced by the Securities and Exchange Commission at the federal level and by various state securities commissions or agencies at the state level, is another serious threat that must be managed from the outset. “The first step is to understand that the sale of condo hotel units will be a ‘security’ unless a few technical—but very important—rules are meticulously followed,” says JMBM’s Catherine DeBono Holmes. She adds that developers are also well-advised to have securities lawyers with condo hotel experience review marketing materials, assist in sales force training, and develop appropriate documentation for sales people and condo buyers, such as certifications and representations of specific compliance requirements. The bottom line? “There are plenty of unique challenges. This is an evolving process that will continue to advance,” says Butler. Although the explosion of condo hotel projects has created more demand than the current supply of experienced advisers, he recommends that developers take their time to assemble the right team. "Experience is worth its weight in gold if you want to avoid ‘on the job training’ which is both costly and dangerous,” he says.

Looking ahead

Butler predicts that condo hotels will earn a permanent place in the hospitality landscape. “There will be a sorting out and an improvement in the breed. We see some parallels to the timeshare market. In the early days, timeshare was a great concept, but until institutional brands and practices took over, there were a lot of failed projects, litigation, bankruptcies and consumer disappointments that gave timeshare a bad name. But once the quality players took over and did it right, the long term viability of timeshare and vacation ownership was assured. The same will be true for well-engineered condo hotel regimes.”

The message from these experts is clear: Condo hotels are a great concept. They just need quality implementation.