What is a Condo Hotel, Why Does it Work, and Why is it Challenging?
What is a Condo Hotel, Why Does it Work, and Why is it Challenging?
By Irvin W. Sandman
May 24, 2007
Condo hotels, the industry’s hot new segment, has been given prominent billing at virtually every hotel conference in the past three years. The writing on the subject, however, can seem dense and confusing to the uninitiated. This article provides an introduction to condo hotel concepts and is intended to give an accessible entry point into the field. It also seeks to provide to those familiar with condo hotels a concise, boiled-down summary that crystallizes some of the bigger-picture concepts.
1. What Is A Condo Hotel?
In a condo hotel, rooms are owned separately as condominium units. This first point is somewhat obvious: to have a “condo hotel,” condominium units are needed.
Second, in a condo hotel, condo units are rented by the hotel through a rental program. Every hotel has rooms inventory. In a condo hotel, separately-owned condominium units are intended to be made part of the hotel’s inventory through a rental program. In some condo hotels, all of the hotel’s rooms are sold as condominium units. In others, only some of the rooms are sold, and the developer retains a portion or a majority of the rooms as “fixed inventory.”
“Mixed use residential hotels” are sometimes confused with condo hotels. Mixed use residential hotels are typically found in urban markets. In this concept, an urban hotel, frequently four or five diamonds, is built with high-end residential condominiums on the upper floors. These condominium units are intended as residences. They are not intended to be a part of the hotel’s rooms inventory. Thus, condo hotels and mixed use hotels are different animals.
2. What Are the Advantages of Condo Hotels?
The condo hotel concept is driven by its advantages to both the consumer and the developer.
Advantages to the Consumer. Typically, the condo hotel concept is employed in places where condominium ownership is desirable for part-time use, such as a resort location. To understand the advantages of a condo hotel to the consumer, one can look at the consumer’s alternative in the resort context. Before the advent of condo hotels, a consumer who wanted full ownership of a resort condominium unit only had one real alternative: to buy a unit in a traditional resort condominium development.
Consider this comparison from two perspectives: when the consumer is not staying at the condominium; and when the consumer is staying there.
In a traditional resort condominium development, what does the consumer do when he isn’t staying at the condominium? He can let the unit lie vacant, thereby foregoing any income potential. Alternatively, the buyer can try to rent out the unit out himself. This alternative, of course, consumes much time and trouble. A third alternative is to hire an outside agency that would rent the unit out by the week. In any rental scenario, however, the marketing of the unit is problematic. The development’s underlying documents usually do not require owners to maintain their units with any consistency. As a result, any guest interested in renting the unit will have very little confidence about the unit’s quality–there is no consistent “value proposition” for the building, the development, or the units in it.
The condo hotel concept answers these concerns. The rental of the unit is handled professionally. The units are typically required to be maintained in a consistent way. The marketing of the unit is more effective, and the unit owner need not waste his time and effort. In other words, the condo hotel has an improved value proposition to the consumer, providing a better answer to the question, “what do I do when I’m not using the unit?”
The condo hotel concept also has an improved value proposition when the consumer is staying at the unit. In a traditional resort condominium, the owner’s experience is very much like an apartment. A condo hotel, in contrast, provides the unit owner the expanded amenities of a hotel: room service, front desk check-in, housekeeping, and other amenities. It is easy to see why many buyers would find these benefits an improvement over a traditional resort condominium unit.
Advantages to the Developer. The condo hotel concept also provides significant advantages to the developer. The traditional hotel developer has a long road between the time he envisions a project and the time he is able to realize a return on equity. The developer must obtain entitlements for the project, build it, open it, and then, over typically three years, stabilize the operation. Only then can the developer expect to see a return on investment or realize a profit through a sale or other liquidity event. This process can take five years or longer. In contrast, a condo hotel developer can realize a substantial return on investment much earlier, because the sales of the units usually close around the time the hotel opens for business. Additionally, the condo hotel developer has access to an additional source of secured financing: the pool of lenders that provide financing for traditional condominium development. This added source of capital can reduce lending costs.
3. Why Are Condo Hotel Developments Challenging?
Condo hotels are challenging because they raise both legal and practical complexities that don’t exist in traditional hotel developments.
Legal Complexities. Condo hotel developments present several additional legal challenges. First, there are securities law risks that do not exist in traditional hotel development. When a developer sells a hotel room as a condominium unit, a question arises: Is the developer selling real estate or an investment? The issue is crystallized when one boils down and evaluates the developer’s pitch to the prospective unit purchaser. The pitch could be: “I will sell you a condominium unit. You give it back to me for much of the time, I’ll rent it as part of the hotel’s business, and I will make you a whole lot of money.” Alternatively, the pitch could be: “I’ll sell you a condominium unit. Here it is – have fun with it.” In the former pitch, the developer is clearly selling a security, and securities laws would apply. In the latter pitch, the developer is selling only real estate, and the securities laws would not apply. To avoid securities law risks, a detailed list of do’s and don’ts have developed, arising primarily out of the Intrawest no action letter.[1]
Second, unlike traditional hotels, a condo hotel developer must also comply with state and local condominium laws. These laws are primarily disclosure laws designed to protect prospective unit buyers by providing them with information that the state’s lawmakers thought would be valuable. The laws also provide for the specific ways that the condominium regime can be created.
Third, legal complexities can arise out of the application of zoning laws to the condo hotel. Is the condo hotel a condominium? Or is it a hotel? The zoning laws often are not clear. This means that the developer must evaluate those laws and work with the local authorities to resolve zoning classification issues and questions, such as whether a unit owner must pay a transient occupancy tax when occupying the unit.
Business Complexities. In addition to the added legal questions that arise in condo hotel development, there are also practical complexities that do not exist in traditional hotel development.
First, the hotel developer has three kinds of lenders to consider, rather than just one. There may be a traditional hotel construction/permanent lender, as is usually the case in hotel development. But there may also be a condominium lender that is experienced in the special features of condominium development loans, such as the process for sales and deed releases. And the developer needs to consider the needs of the retail lenders who will be loaning money to the purchasers of the condominium units–the way the developer configures the rooms can affect the pool of retail lenders available to the unit purchasers.
Second, the success of the project may depend on the market for residential condominiums, rather than just on the market for hotels and the supply and demand for guest rooms. Dependence on the residential condominium market might be fine when that market is hot. When it is not, however, fallback strategies may be required.
Third, there is uncertainty over rooms inventory. To avoid the application of securities registration laws, the condo hotel developer cannot force the unit buyers to enter into the hotel’s rental program. As a result, the condo hotel developer cannot be sure how many rooms will be in the hotel’s inventory, and this uncertainty makes revenue forecasts more challenging.
Fourth, there are normally-straightforward regulations that take on complexities in the condo hotel context. For example, developers are familiar with ADA compliance, and they know how to make sure that sufficient numbers of ADA-compliant rooms are constructed. But how is this done when all of the rooms are intended to be sold as condominium units? Another example is the application of liquor licensing laws. A hotel’s liquor license normally allows delivery of alcoholic beverages to rooms in the hotel. Does the license allow delivery to units that are separately owned?
Finally, the developer may be forced to continue as the owner of the “hotel unit.” Branded hotel companies don’t want to enter into management agreements with a condominium association. If a branded management company is involved, it will typically require the developer to create a “hotel unit,” composed of the commercial and common areas of the hotel, and require the developer to continue to own and run this hotel unit after the hotel rooms are sold. This structure can create conflicts of interest between the developer and the unit owners in the longer term, and can also create litigation risks.
The challenges of condo hotel development are many. But the industry and its counselors have done well to meet them over the last several years. The intellectual foundation of condo hotels has been set on solid ground.
4. Are Condo Hotels Here to Stay?
Condo hotels have two significant advantages that will endure. They are an excellent solution for people who want to own a resort condo unit and don’t want to leave the unit vacant or hassle with renting it. Condo hotels also provide the developer the opportunity to obtain a return of equity earlier than would be available in a traditional hotel development. These benefits are likely to continue to be very attractive until a better solution is devised. We can expect condo hotel units to be a feature in most resort developments in the coming years.
[1] Intrawest Corporation (available November 8, 2002).