Urban Land, March 2005, published by Urban Land Institute: Condo Hotels: How to Make Them Work Part 1

This is Part I of a two-part series. This article by Jim Butler and Guy Maisnik was originally published in the February 2005 issue of Urban Land Magazine by the Urban Land Institute (ULI), © 2005. ULI is the copyright owner of the article. This article is reprinted with the permission of ULI.

Perhaps the greatest satisfaction of working in the real estate industry is that a single transaction can produce so many winners. Properly structured deals can offer up rewards for buyers, sellers, developers, lenders, consumers, builders, managers and operators, communities, and entire local economies. On the flip side, poorly structured deals often end up badly for all involved and get played out in expensive litigation. This is the context in which the
industry must approach the current condo hotel boom. Can condo hotels be a win-win-win-win situation? Undoubtedly, yes. Can they also be a lose-lose-lose-lose situation? Yes again—and developers, lenders and other participants need to be protected against the inevitable fallout.

Why such extreme scenarios? A successful condo hotel project demands that intricate legal and operational threads, each representing the competing interests of numerous parties, be woven together. A tightly woven deal involves such
complex structuring that even the most sophisticated of dealmakers can miss the many layered details in their rush to participate in this profitable wave of development. Yet, it takes only one pulled thread for this delicate project tapestry
to unravel.

The term "condo hotel" is used indiscriminately to refer to a divergent array of products with both residential and hotel components. Some condo hotels consist of a traditional hotel with primary residences that are not rented to the public. Others involve a hotel operation where some—or even all— of the rooms are condominiums owned by individuals who may make them available to hotel guests through a hotel rental agreement. Condominium units may be branded with a hotel’s name, or not. Condominium owners may or may not have access to hotel amenities such as housekeeping, room service, spa privileges, parking, and the like. The income derived from renting a condominium unit as a hotel room may be accounted for by each unit (the general trend in the United States because of securities laws) or pooled and divided among participating condominium owners on a pro-rata basis.

Condominium participation in the hotel’s rental management program may be voluntary or mandatory. Condominium owners may have unrestricted use of their units, or may be precluded from using them except during specified windows of time or on a space-available basis.

The current boom in condo hotels is driven by an unprecedented alignment of the economic interests of developers,
consumers, hotel operators, and lenders. For hotel developers, the condo hotel model is a financing bonanza.
Construction debt for hotel projects typically runs 50 to 60 percent of cost. When condominiums are added to a
hotel project, equity credits earned through condominium presales can provide debt financing approaching 90 percent loan-to-cost leverage. Developers are achieving significant front-end profits on the sale of condominium units in this scenario. And because the "hotel amenity" component creates a 15 to 40 percent premium value over the sale price per foot of comparable units, developers are also keen on the condo hotel model.

Consumers, particularly baby boomers nearing retirement, have an interest in owning real estate for both personal reasons and investment purposes. Owning real estate in a resort location, with hotel-style amenities and conveniences that are provided by a condo hotel, can be an attractive option. Add the investment potential—particularly through appreciation—and the possibility of defraying costs of ownership by renting the units out as hotel rooms, and it becomes easier to see why boomers are buying them. Also, the condo hotel has become a favored exchange property to effect tax free exchanges under Internal Revenue Code Section 1031 and to facilitate the enormously popular tenancy in common (or TIC) market.

Most hotel operators are happy to have a new supply of properties with which to expand their brands and to generate
fees from the management and franchising of the condo hotels. They may also earn additional fees from renting out the units placed in the hotel rental management program and for managing various condominium homeowner associations
(HOAs). They may even participate in royalty fees derived from licensing their names to the condominiums and collect a percentage of the sales price of units sold.

Lenders are finding the financing of condo hotel conversion and development projects attractive because the presales of units eliminate substantial risk during the construction phase. Typically, such projects have a fast payoff as the condominium units are sold, transferring the lending risk to the mortgagee for the individual unit holders.

However, there are some drawbacks. The legal structure, design, construction, marketing, and hotel operation all affect one another. Seemingly simple changes in one aspect have a ripple effect on all the others. Throw in the concerns of
hundreds of individual unit owners and there can be a potential minefield of problems. Once there is a rend in the overall fabric of a condo hotel deal, it can be impossible to mend because consent may be required from some or all of the divergent stakeholders.

Developers can refer back to the thorny legal issues surrounding the early timeshare market and apply those lessons when structuring condo hotel deals. Further, many traditional condominium developers entering the condo hotel arena know more than they probably care to know about construction defect litigation. The adverse impact of these concerns will be mitigated if the deals are carefully structured on the front end. Developers need to be hypervigilant in the marketing of for-sale units in a condo hotel project. If sales and marketing representatives are not properly trained and monitored, they can trigger liability under securities law that could ultimately wipe out a developer’s potentially heady profits.

From a legal standpoint, federal and state securities law implications have a dominant influence on the structure and
marketing of condo hotels. While a simple condominium sale usually does not involve the sale of a "security," a security will be involved once a condominium sale includes almost any discussion of rental management services—through a hotel or otherwise—unless strict limitations are faithfully observed.

The information provided in connection with a condominium sale cannot emphasize the economic or tax benefits of the rental arrangements, despite the investment motive of many condominium purchasers. A developer gets in trouble with the securities laws if he promotes the "investment" nature of a condominium—whether a "normal" condominium or a
condominium in a condo hotel. However it is not illegal for a buyer to have an investment motive. But the developer cannot pander to that motive, and instead must sell "real estate" and associated values such as lifestyle, service, amenities, and factors other than investment value and likelihood of profit or appreciation.

In fact, about the only statement that can be made to a prospective condominium purchaser in literature or discussions is a bland statement to the effect that "ownership may include the opportunity to place your condominium in a rental
arrangement." Any further inquiry by a prospective condominium purchaser must be referred to the rental management company, which must maintain physically separate offices and staff. The rental management company’s staff (but
not the condominium sales staff) can provide interested purchasers with condominium sales and rental history of
comparable properties, but this information cannot be edited or compiled.

Virtually all condominium and condo hotel regimes seek to avoid security status, using the guidelines handed down by the Securities and Exchange Commission (SEC), including a relative breakthrough in 2002 in the Intrawest "no-action" letter, which limits marketing the investment nature of the condominiums to prospective purchasers, pooling rental income of the units, and the restrictions developers may place on an owner’s use of the unit.

Ironically, avoiding security status requires that no one provide projections of rental rates or expected occupancies. This deprives condominium investors of a great deal of relevant and helpful information for evaluating their purchase. It also tempts aggressive salespeople to furnish the prohibited information on the side, which upon discovery could turn the whole scheme into an illegal offering of a security with attendant civil and criminal penalties, not to mention rescission rights for unit purchasers, which could run for many years.

Avoiding security status also means that the condominium unit purchaser can make only a voluntary decision to participate in the condominium rental management program after the purchase of the unit (at least after executing the condominium unit purchase documents, but possibly before closing of the purchase if the rental management agreement is contingent on such closing). For this reason, it would also be impermissible to place other restrictions on the condominium owner’s personal use of his or her unit [such as might be contained in covenants, conditions and restrictions (CC&Rs) or HOA documents] until after the unit is sold. A few rare exceptions may be available by
private SEC no-action letter whereby some restrictions on use may be required to comply with local zoning laws or
entitlements. And in certain instances, condominium owners may be encouraged to put their units into the rental
management program by product location (e.g., a ski resort), design considerations (e.g., a 300 square foot unit that is not suitable for long-term use), and economic incentives such as a greater share of revenues for use of the unit as a hotel room if the room is placed in the hotel rental management program for longer periods of time.

However, if the unit owner’s decision to use the hotel rental management program is voluntary, and occurs after the purchase of the unit, the hotel rental management agreement, or a sale-leaseback, can extend for a long period of time (such as five or ten years) and can limit or prohibit the unit owner’s personal use of the hotel condominium. The agreement can also include other restrictions on the unit owner such as requiring a specified minimum notice prior to the owner’s use of his unit. Of course, the more onerous the restrictions on the owner’s use of the unit, the less potential buyers are likely to pay or the less likely many people are to buy the unit at all. Onerous restrictions in the rental program agreement may also deter owners from placing their units in the rental management program, defeating a major goal and value of having condominium units as part of the condo hotel.

So why not structure the deal as a security and avoid these limitations? The advantages include the ability to pool income and expense from the project as a whole, to require mandatory participation in the rental program and to impose restrictions on owners to ensure an adequate inventory of hotel rooms, the ability to promote the project on the basis of the hotel rental management agreement, use projections of hotel rentals, and getting around many of the artificial restrictions required to avoid security status.

However, most developers shun securities compliance as too expensive, time consuming, and ill-suited to the customs and practice of real estate sales. They do not want to offer and sell their units only through registered securities brokers and salespersons, or to comply with strict disclosure and liability rules. Many states have "merit review" of securities offerings, imposing daunting warnings of risk, high suitability standards, and limitations on the method of offering. The private placement exemption prohibits public solicitation of customers, and the intrastate offering exemption might work in some unique locations and circumstances, but is simply not feasible in others. Any misstatements or omissions of relevant information spawn securities fraud liability that potentially lasts for years.

There is no single formula that will make a condo hotel successful. Viable structures will vary by situation, regime, and circumstance. Developers need to appreciate that hotels are a different kind of real estate, and that condo hotels are a hybrid with unique issues, as well as significant opportunities. The conflicting needs and interests of all parties must be reconciled through a complex layering of CC&Rs, HOA documents, rental management program agreements, hotel
management agreements, operating business plans, and the like. Achieving a structure with the right balance of profitability potential and long-term viability is critical for a win-win-win-win project. If done properly—with the right expectations of all involved, and also the right structure, sponsorship, and integration of the hotel and condominium components—there could be a bright and long-term place in the mixed-use spectrum for condo hotels. The alternative presents an unnecessary blight on the industry that could last for years.

Look for Part 2 of this series, Condo Hotels: How to Make Them Work Part 2.

Contact Jim Butler at 310.201.3526 or jbutler@jmbm.com; contact Guy Maisnik at 310.785.3588 or GMaisnik@jmbm.com.