Urban Land, March 2005, published by Urban Land Institute: Condo Hotels: How to Make Them Work Part 2 | Articles

This is Part II of a two-part series. Part I appeared in the March 2005 issue of the Global Hospitality Advisor. 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.

The hotel structure needs to be designed to handle the specific operator’s particular market segment in a given location. The hotel operation needs an adequate supply of rooms on a predictable basis.

First and foremost: how many of the condominium units will be available as hotel rooms and when?
Will an adequate number of rooms be available to handle large group meetings, usually booked 12 to 24 months in advance?
How much meeting space will be needed?
How many seats are in the restaurants and lounges?
Is there a sufficient and stable supply of rooms to efficiently maintain needed staff and service levels for everything from front desk to maintenance and room service?
Will there be enough hotel business derived from rental of rooms to support traditionally unprofitable or less profitable
hotel operations that condominium owners expect or demand, such as food and beverage?
How can cost allocations be kept flexible enough to meet experience and evolution, while protecting the reasonable
expectations of the condominium owners?
How can the operator be assured that capital will be available for the maintenance required to provide uniform room quality at required levels to satisfy hotel guests?
How does the operator deal with a large number of condominium unit owners on issues requiring owner consent?
How does the operator fairly allocate room rental allocations among condominium owners and placate unhappy unit owners who find that their units are less desirable or produces less income than they hoped?

If the condo hotel structure cannot provide the operator with sufficient rooms and profit potential, the operator may exercise a termination right. Termination by the operator may mean that condominium owners and the lender find that the units cannot be put to productive income-producing use, and the project will fail. However, if the operator can manage the property reasonably well, then there are fewer of the typical operator concerns in a traditional hotel project that must accommodate owner exit strategies, such as termination on sale of the hotel or upon other specified events. In fact, condominium unit owners and lenders may be more concerned about having the operator "locked in" to protect their respective interests and property values for long periods of time than in other models.

Challenges for the Developer

The natural tug of interests between a hotel owner and an operator in the context of a traditional hotel provides certain
checks and balances on the power of each, that may not be present if the developer has no ongoing permanent stake in the project. Developers will want to go into the deal with the following issues on the table:

Does the condo hotel developer expect to make all of its profit on the front-end sales of the units, or is it expecting to have value and cash flow from the residual hotel?
What support, if any, will the developer lend to the project if cash flows in the cyclical hotel business run short, or if capital is needed to maintain the property?
What capital calls and limitations are the homeowners associations (HOAs) subject to in order to support the project?
What balance of hotel operator concerns and unit owner freedom maximizes the value and profit of the condominium
program?
Will unit owners be more inclined to sign up for the voluntary rental management agreement with the right operator if their use of their unit is limited, or does the value of having the potential for an income stream offset the inconvenience of limitations?
Has the developer balanced the legitimate interests of the condominium unit owners and the operator in negotiating the form of hotel management agreement?

Challenges for the Condominium Unit Owner

Managing and satisfying the condominium unit owner’s expectations will be a challenge, particularly given the securities law restrictions on information that can be provided to purchasers. A buyer who pays a huge premium for a condo hotel over the price of a comparable "ordinary" condominium may be in for a rude surprise when the resale value of the property is disappointing or the owner’s share of hotel revenues, after the operator’s share, furniture, fixtures and equipment or FF&E reserves, and other carrying costs, is insufficient to cover debt service, insurance, HOA assessments and other costs of ownership, much less provide a reasonable return on investment. Sophisticated condominium buyers will want to know the following:

How will developers and operators keep an inappropriate speculative fever from breaking out, with unrealistic
expectations of cash flow and profit from placing units in the hotel rental management program?
Will the unit owners or the HOAs have the right balance of power and wisdom to effectively work with operators in the
joint cooperative effort needed for the project to succeed?
Can purchasers regard their condominium as an investment in real estate that may appreciate over time and that may not provide the return the investor would like on a near-term basis?
Will the investor get good financial advice on realistic cash flow possibilities, and the capital expenditure or CapEx
requirements of using units as hotel rooms?
Will the investor learn what hotel investors have known for years—namely, that the typical FF&E reserves of 4% to 5% of gross income may be enough to cover routine costs of maintaining a typical new hotel property, but over the long term, the capital required is substantially greater and comes in spikes at certain stages in the hotel’s life cycle?
How will the condominium owner control an inefficient operator or one who does not maintain the property well?
What can be done to ensure fair rotation of available condominiums rented to hotel guests?
Who will asset manage the operator when there is no single owner of the hotel property, but only individual unit owners and HOAs possibly lacking in hotel expertise?

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