Condo Hotels: Three Years into the Concept
Condo Hotels: Three Years into the Concept
By Irvin W. Sandman
May 1, 2007
Condo hotels have been the industry’s new, hot segment for the past three years. At virtually every hotel conference, the topic has been given prominent billing. Interest in the segment has not been only conceptual. Most new resort development projects have considered and often implemented condo hotel features.
This article will discuss some current thinking, trends and ideas that have surfaced in the last twelve months.
1. Boiling Down the Concepts
What is a condo hotel? How is it different from mixed-use hotel developments? What are the advantages to the consumer and the developer? Why are condo hotels “a better mousetrap”? Why are they so challenging? When the segment was new, the answers to these big-picture questions were not clearly communicated.
Over the past year, an effort has been made by many to boil down the big-picture concepts, so that they are crystallized for the initiated and can be communicated to the uninitiated. The thinking within the industry has reached some stability. As our contribution to this effort, please refer to “What is a Condo Hotel, Why Does it Work, and Why is it Challenging.”
2. A Challenge To The Concept That The Condo Hotel “Has To Work As A Hotel”
One has often heard at condo hotel conferences that a condo hotel “has to work as a hotel.” This assertion has come under some challenge, or at least it has been tempered, over the last 12 months.
When does a hotel “work?” From the point of view of a traditional hotel developer and owner, the project must typically show enough projected gross operating profit to (i) service debt financing on debt equal to about 60% of the projected cost of the hotel, and (ii) provide at least a 12% internal rate of return on equity.
But when does a hotel “work” from the point of view of a unit owner? A unit owner has expectations that are very different from those of a hotel developer and owner. A typical unit owner buys a condo hotel unit instead of an ordinary condominium unit. The unit owner doesn’t expect the same level of gross operating profit and return that the typical hotel developer might. The unit owner typically is happy if the owner can have good use of the unit and can also cover the expenses of holding the unit, including maintenance expenses and monthly dues. The unit owner is very happy if the unit creates enough income to contribute substantially to the unit owner’s debt service on the unit.
Obviously, therefore, a hotel project’s expected cash flow might be insufficient to satisfy the expectations of a hotel developer, but still might be sufficient to satisfy the expectations of the unit owners. As a result, there are some hotel projects that can work as a condo hotel, even though they do not work as a traditional hotel.
When might the developer want to make sure, however, that the project can work as both a hotel and a condo hotel? This question is a good segue into the next topic of this article.
3. The Condo Market Has Stalled
Reports are clear that the “condo mania” of the last two or three years has now subsided. When condominium values were increasing rapidly, many speculators came into the market. Now that the market for residential and vacation condominiums has flattened, and is perhaps receding in some markets, the speculators have fled the market. How much of the condominium market “froth” was produced by speculation and a herd mentality? The answer to that question is not clear. However, one indication of the environment is that many calls are now coming in to real estate lawyers with a telling question: “I’ve signed a purchase agreement for a condo – how do I get out of it?”
The flattening market for residential condominiums has already produced at least two results. First, traditional condominium construction lenders have pulled back, and debt financing for condominium construction is much more difficult to find. In this environment, traditional hotel loan financing is comparatively easier to find, in contrast to previous years. Second, with the shaky residential condominium market, it has become certainly less clear whether condo hotel units will be absorbed when the time comes to close on the unit sales.
What if a condo hotel project is completed and the developer cannot sell the units, or the unit buyers forfeit their deposits and fail to close? The answer is readily apparent: the developer then has, in effect, a traditional hotel.
In other words, in the current environment, the wise developer will make sure to begin development of a condo hotel project only if it works both as a hotel (i.e., it creates enough profit to satisfy a traditional hotel’s developer’s expectations) and as a condo hotel (i.e., it meets the potentially lower profit expectations of a typical unit owner). Otherwise, the developer will be taking on substantial risk: If the unit sales do not materialize, and the developer needs to hold onto some or all of the units, then the developer will need to obtain traditional permanent or mini-perm financing when the project is completed. Doing so will only be possible if the forecasts support a traditional loan-to-value ratio. If they don’t, the developer will have to substantially increase the cash equity he has in the project. And if the hotel is barely a break-even proposition from an operating perspective, traditional debt financing may not be available at all.
4. The Brands are In, Out, In … ?
Over the last several years, branded hotel companies have blown hot and cold on the condo hotel concept. At first, the securities law risks seemed very problematic to these companies. Also, the challenge of managing for any individual unit owners seemed daunting. The need for a single, creditworthy owner to participate in the owner/management relationship created another impediment. On the other hand, branded management companies were attracted by large fees (sometimes as high as 5% of unit sales) available to management companies who allowed their brands to be associated with condo hotels. Additionally, in the last several years, most new resort developments have included a condo hotel feature, and so branded management companies have felt a real need to participate in the segment.
Most branded management companies have now re-worked their management agreement forms to accommodate condo hotel opportunities. None of the major branded hotel companies currently state publicly that they will not consider a condo hotel project. Several, however, will only consider a condo hotel if the developer retains sufficient fixed rooms inventory to support a stable hotel apart from the condominiumized rooms inventory.
5. New applications and markets
Many of the condo hotel projects over the last three years have been larger, upscale or luxury products in destination resorts or in centers with significant tourist flow. Developers are experimenting with the concept, however, in some new ways.
A. The Regional Resort Condo Hotel
Some developers are experimenting with the condo hotel concept in secondary, regional leisure markets. This application of the concept has 50 to 120 rooms. It has no branded manager. All units are sold and the developer does not retain a “hotel unit.” When sufficient units have been sold, all of the commercial and common areas are turned over to the condominium owners’ association.
This use of the condo hotel concept can be viewed, in essence, as a traditional regional condominium product, with the addition of the central “amenities” that make condo hotel units attractive. The main added amenity is, of course, a rental program–the ability to rent the unit through on-site hotel functions. Other amenities can include, for example, room service and housekeeping. As is the case with their larger counterparts, these smaller condo hotel projects can achieve zoning benefits that might be unavailable to the developer of a traditional residential condominium project.
The “regional resort condo hotel” must be carefully thought out to keep it simple–condo hotel structures that have been used in large, high-value projects are too expensive for this smaller-sized project category. Also, careful thinking is needed to avoid securities risks. For example, one needs to make sure that a developer isn’t creating, in essence, a for-profit business that will be operated by the unit owners through their association. Given the experience and knowledge obtained over the last several years, however, competent counsel and developers can now resolve these concerns adequately to make the condo hotel concept viable in this context.
B. The Corporate Condo Hotel.
Hotels are often built around locations that large corporations have chosen for their corporate headquarters. Sometimes corporations participate as equity partners in these hotels. Other times, the corporations simply pay the costs associated with the many room nights consumed by the employees who visit company headquarters.
Several owners of these kinds of hotels are developing or seriously considering the development of new rooms inventory that would be sold as condo hotel units. The intended buyers of these units would be the corporations themselves, and possibly high-level vendors that serve the corporations. Hotel owners are also considering condominiumizing a portion of their existing rooms inventory with the same potential purchasers in mind.
This application of the condo hotel concept can easily work from a legal and documentation perspective. Of course, the open question is whether, in each case, there is sufficient product demand to support a compelling return to the developer.
6. New Ideas in Rental Programs
There are now many well-considered rental program agreement forms in circulation. The issues involved in rental program agreements have been thought through quite well. Some newer concepts have surfaced recently that are worthy of note.
A. Staggered Termination.
If a developer retains the “hotel unit” and, accordingly, the economic risks associated with the hotel operation, then the developer is always concerned about ensuring maximum participation in the hotel’s rental program. If all of the rental program agreements expire at once, one can envision a risk: as the expiration date approaches, the unit the unit owners could get together and negotiate with the developer en masse. This could be a scary prospect for the developer. An easy solution to this problem is to stagger the termination dates so that very few, if any, rental program agreements terminate at the same time.
B. Multiple Rental Program Packages.
There is no legal reason why a developer needs to offer only one rental program deal. Not all unit owners have identical needs or desires. Again, if the goal is to get maximum participation in the rental program, it makes sense to offer more than one program, each of which will work from the developer’s standpoint. For example, different revenue splits can be offered, depending on: the number of days the unit owner must make the unit available for rental; whether the unit owner is willing to accept blackout periods during high-demand periods; or whether the term of the agreement is longer or shorter.
C. Lease-Back Programs.
Some attorneys are suggesting that a pure sale lease-back arrangement is not a security. They conclude that, if only a lease-back arrangement is offered to unit buyers, the developer need not follow the SEC’s guidelines and no-action letters.
Most attorneys agree that the risk of actually winning or losing a securities-related claim by a unit buyer is only one consideration. Perhaps even more important is to avoid, as best as possible, the risk of litigation with arguable merit, even if the litigation could be ultimately defeated.
Competent attorneys do not agree on whether a lease-back structure will, by itself, dispose of any argument that a hotel condo unit offering is a security. As a result, one can conclude that, if a disgruntled unit owner seeks to rescind a sale, at least some competent attorneys will see the exclusive reliance on the lease-back arrangement as an opening, and will advise in favor of litigation. Under these circumstances, reliance on the lease-back solution, exclusively, would not seem prudent. However, if a developer believes that structuring the rental program as a lease-back arrangement makes economic sense, then the developer and his counsel might consider doing so, while still complying with the guidelines in the SEC no-action letters. Using the lease-back arrangement could then provide an added line of defense, and it may even afford a summary judgment opportunity to potentially avoid otherwise fact-intensive litigation.
7. Other Ideas To Encourage Rental Program Participation
Typically, if unit owners don’t participate in a rental program, then the operation will lose money. The usual strategy, therefore, is to try to make participation in a rental program a “no brainer” for the unit owner.
A trend has developed to use the condo documents to help accomplish this goal. One method of doing so is to provide in the condominium documents that the expenses of the hotel’s amenities must be paid by the unit owners, whether or not they participate in the rental program. If the individual unit owners only have to pay for the amenities if they sign a rental program agreement, then there may be an incentive for the unit owner to consider an alternative, off-site rental manager. By passing these costs on to the unit owners through the condominium documents, the incentive is avoided.
A second method is to require, again in the condominium documents, that the unit owners maintain their units in accordance with specified brand standards, including any standards that may be required by the applicable branded management company. If the unit owner must continue to invest money to keep up the unit in accordance with these standards, then, one would surmise, the unit owner would see the rental program as the way to obtain a return on the this investment.
8. Cottage Industries
As the condo hotel segment has begun to mature, “cottage industries” have sprouted to solve problems and satisfy special needs created by the segment.
A. Retail Lenders.
Most condo hotel units cannot qualify for FNMAE (“Fannie Mae”) or FMAC (“Freddie Mac”) financing. Where will the condo unit buyers get financing? At what cost? Why does the developer care? Obviously, even if buyers put down deposits, some may not be able to close unless they obtain adequate financing. A handful of mortgage brokers have begun to focus on this need. These brokers have access to lenders who are familiar with the condo hotel segment and have become comfortable lending to condo hotel unit buyers. A developer is well advised to coordinate with one or more of these brokers even as early as the project’s design phase. For example, a condo hotel unit that is not at least 600 square feet in size or that does not have a “kitchen” will be substantially more difficult for a unit buyer to finance, and any available financing will likely cost more. These considerations obviously are factors to be considered when the developer is configuring the project.
B. Marketing Consultants.
If a real estate sales representative, while trying to sell a condo hotel unit to a prospect, begins to make representations about how much profit a unit owner will make in the rental program, the representations could inadvertently cause the developer to be in the business of selling securities. The result can be securities law violations and risks of rescission and litigation. How does the developer manage the sales process to make sure this doesn’t occur? How does the developer adequately document the process and the sales representative’s activities to provide evidence that the process has proceeded in accordance with SEC guidelines, including the Intrawest no-action letter?
A number of consulting companies are addressing these issues by providing management of the sales process, including training, recordkeeping, and testing. In a large project, the stakes may be high and the problems difficult to address. These consulting companies may provide significant benefit, especially in these larger projects.
To comply with most state condominium laws, condominium disclosure documents must forecast expenses, dues, and reserves. Condominium documents must also create expense allocations that are “fair and reasonable” among the condominiums in the project. Additionally, the developer must set up accounting systems to keep track of the allocations of expenses as well as reporting expenses and income to each of the unit owners in the rental program. Several accounting firms, in particular those that have well-developed hospitality practices, have built up experience to address these problems effectively.
D. Industry Organizations.
Admittedly, most buyers of resort condo hotel units buy their units with the intent of using them a few weeks out of the year and renting them through the rental program the rest of the year. This is the nature of the condo hotel concept. To avoid securities law risks, however, condo hotel developers do not give buyers any significant information about the rental income potential from owning a condo hotel unit. In essence, the securities laws work to impede the buyers from getting any information about this important aspect of their buying decisions.
As a result, buyers are making purchase decisions in an information vacuum. This situation suggests that buyers are at risk of making poor decisions. Many people in the industry believe that this information vacuum can put the segment at risk by allowing ill-advised and ultimately doomed projects to be built and sold.
A group of people with interest in the segment’s success have sought to help unit buyers, and thereby the segment as a whole, by providing needed resources and information. This objective has led to the formation of the National Association of Condo Hotel Owners, an association with a somewhat whimsical but memorable acronym–NACHO (see www.nacho.us). NACHO’s stated mission is to “support and assists the segment to grow in a healthy and sustainable manner both for the benefit of the industry itself and for the individual condo hotel unit purchaser.” NACHO reports that it currently has over 4,000 individual members.
E. Workout Specialists.
As a sign of the times, there are some workout specialists that have been making appearances at condo hotel conferences. Although the number of truly troubled condo hotel developments is not overwhelming at this time, it is possible that these specialists will be useful in the future.
9. Municipalities Make New Zoning Laws
Over the last eighteen months, a number of local jurisdictions have passed zoning ordinances to address condo hotels. This type of legislation is a trend that is likely to continue, if the development of condo hotels continues its strength.
A. Why Do Municipalities Care ?
Usually, a hotel zoning classification gives the developer benefits. These may include higher density and reduced parking requirements. In exchange for these benefits, the city gets transient occupancy taxes and increased tourist flow. If a hotel developer takes advantage of these benefits, then the city wants to make sure that the project is indeed run as a hotel and thereby gives the city the benefit of its bargain.
B. The Good, The Bad, And The Ugly
Some zoning ordinances benefit the developer. An example of a beneficial ordinance is one that places restrictions on owner occupancy. This kind of ordinance helps the developer, because by restricting the number of days the unit owners can use their units, it encourages unit owners to rent out their units for the rest of the year. Presumably, improved rental program participation will result. An ordinance of this kind does not increase securities risks for the developer, unless, of course, the developer participates in efforts to obtain passage of the ordinance.
Ordinances that might be considered “bad” include those stating that, to fall within the “hotel” or “condo hotel” zoning classification, the hotel must have a minimum number of rooms (see, e.g., the requirement in Hollywood, Florida, that a condo hotel must have at least 200 rooms). This category of ordinance also includes facilities restrictions, such as an ordinance in Las Vegas that prevents hotel rooms from having “kitchen” facilities. Still other ordinances have stated that, to be acceptable within a condo hotel zoning classification, the hotel must be affiliated with a national chain (see, e.g., zoning ordinance in Hollywood, Florida). Each of these kinds of ordinances do not prevent the development of a condo hotel, but they certainly restrict the developer’s flexibility and may present hurdles that ultimately dissuade the developer from proceeding with the project.
There are also some recently enacted ordinances that fall into the “ugly” category. The most egregious are those that require unit owners to place their units in the hotel’s rental program. Why is this a problem? Under the applicable securities cases, such as the Howey decision, a security is defined as an offering under which the investor makes a money investment, a common enterprise exists, and there is an expectation of profits from the efforts of the promoter or a third party. This kind of ordinance, therefore, requires in essence that the developer offer and sell a security to the unit owners. As a result, to comply with the ordinance, the developer will also have to comply with all applicable securities registration requirements. The cost and time delay in registering a public securities offering and complying with the applicable securities laws can create insurmountable obstacles. In essence, the ordinance can make many condo hotel developments economically unworkable.
10. 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.