Government Regulations and Condominium Hotels: Another Case of an Unwelcome Guest?
September 13, 2006
James M. "Jim" Norman- Ft Lauderdale
Does it seem that when people discuss the future of condominium hotels, this is what you hear?
“A storm of litigation over condominium hotels is inevitable; the only question is when?”
“Purchasers are going to sue when they become unhappy with their investment in a condominium hotel.”
“The disputes will be endless, because condominium hotels will have all the issues of residential condominiums, plus owner-operator hotel issues.”
“The plaintiffs’ lawyers are impatiently waiting.”
If disclosure is the vaccine against litigation, and the Securities and Exchange Commission (SEC) has given the developers and marketers all those Intrawest no-action letter guidelines to prevent condominium sales from becoming investment securities, states heavily regulate the structure and marketing disclosures for condominium projects, and cities control construction and zoning, why all those dire predictions?
Maybe all that regulation is an example of government violation of the law of unintended consequences.
When Is a Condo Hotel Subject to SEC Regulation?
When developers talk about condominium hotel regulations, in most cases, they are referring to the SEC. No court has yet definitively set forth a test to determine what makes a condominium hotel a security that is subject to SEC regulation. As a result, developers and purchasers are forced to rely upon non-binding “no action” letters and the 1973 SEC Release No. 33-5347 that merely provide guidelines to avoid being labeled a security. Under these guidelines, developers cannot do the following:
• advertise that a profit will be made
• discuss the terms of rental agreements until the purchase sale agreement has been executed
• impose material restrictions on the owner’s use of his unit (with very limited exceptions)
• make the rental program mandatory or allow the owners to participate in a pooling of their units
• offer (as they can in the rest of the world) a guaranteed minimum return for a period of time
If these guidelines are not followed, then the condominium hotel could be deemed a security subject to registration with oversight by the SEC. That could mean very significant time delays, expense, and numerous obstacles upon resale.
The general thrust of the SEC’s guidelines is that a purchase of real estate (including condominium hotel units) should not be structured or sold as an investment. Ignoring the guidelines risks application of the penalties of the federal securities laws.
The Whole Story
Let’s look at this from a disclosure point of view. Since some 80-85 percent of condominium hotel unit purchasers do, ultimately, wind up participating in rental programs (never say “rental pool” because lawyers will yell at you), one might conclude that purchasers do have investment on their mind. Such is the inherent nature of real estate. Shouldn’t the “whole story” be given to those purchasers as they are considering a purchase? Given the cost of condominium hotel units, isn’t it fair to expect that they will have a certain level of business sophistication and are able to put together the pieces of their equity, debt and project returns from operations by looking at disclosure documents in evaluating whether or not to “invest” in one project versus another, or in a condominium hotel unit at all?
Some common discussion points among lawyers:
• Were the securities laws really even intended to apply to real estate purchases?
• Are the SEC registration avoidance requirements actually preventing or inhibiting disclosures that would in reality help prospective purchasers and limit future disputes and claims?
• How can the hotel operator be assured of sufficient rooms to sell if rental programs are purely voluntary, and, even after the contracts are signed, have limited duration?
The Zoning Law Dilemma
Zoning laws determine whether a developer can build a hotel in a certain area, based the standards and definitions in the particular ordinance. For example, if a given area is zoned for hotel use, a condominium hotel will also be allowed, as it is a hotel, but under condominium ownership. Local governments are allowed to regulate use, but not ownership modes. Restricting a condominium hotel in a hotel zoning district because it has multiple owners is generally not permitted. However, local government is allowed to restrict residential condominiums in appropriately drafted hotel zoning districts.
By local ordinance, areas zoned for hotels may require transient occupancy, rather than extended residential use. In such cases, owner occupancy generally can be restricted without running afoul of SEC guidelines. However, problems will arise if developers are involved with the preparation or adoption of such a transient occupancy ordinance, or if a developer imposes restrictions harsher than that required by ordinance. The risk of problems with the SEC is far less if the ordinance requiring and describing transient occupancy was in place when the developer acquired the property, but would you bet your project on it?
Who Knows Best?
State condominium laws that make contracts entered into by the developer voidable by condominium associations pose risks relating to the continuity of management agreements, franchise and license agreements. If the brand is lost, the value of the condominium units may well fall. Experience with residential condominium associations suggests that condominium boards do not always act rationally or in the long-term best interests of the unit owners. What will happen when the condominium board decides to terminate a brand manager, or thinks they know better than hotel companies what kinds of beds, pillows, sheets and showers belong in a hotel room? Will the condominium associations versus developer and general contractor construction defect litigation so regularly seen in residential condominiums become a part of the condominium hotel landscape?
The states do not ignore the sale of condominium hotel units. Like miniature versions of the SEC, individual states may require detailed filings before a developer can offer condominium hotel units for sale in that state. New York and New Jersey are examples of states with substantial requirements. Others have a wide variety of exemptions from registration.
Who Will Speak for the Owners in Condo Hotel Matters?
A newly formed organization, the National Association of Condo Hotel Owners (NACHO), may well serve to further the interests of condominium hotel unit purchasers and owners. With a unified voice speaking for the unit owner side, NACHO may be able to help persuade government regulators to treat the condominium hotel for what it is – a unique hybrid real estate product – rather than for what it is not.
Some condominium hotel developers do contemplate registering their projects in order to sell the units as securities. As they navigate the spider web of federal, state and local regulations, they begin to think that all the time and all the money involved might just be worth it. Then, they start worrying about “missing the market” because of the delays and realize that “once a security, always a security” and they may be burdened with annual SEC filings and legal and accounting fees. The last realization is that the resale of a unit will involve both a real estate broker and a securities broker. That’s why registration is a rare thing.
Something is wrong when legislation intended to protect: inhibits disclosure; makes it difficult for a condominium hotel to operate as a hotel; precludes knowledgeable parties from contracting for real estate as they desire; and creates a multilevel maze of laws, rules and regulations. A tremendous amount of time and energy is expended in “working around” and complying with, all the governmental requirements. Where is the benefit to the condominium hotel unit purchaser? What is gained when the “owner use” restrictions of the SEC make it risky for developers and local government to work together to insure that the condominium hotel is actually able to operate as a branded hotel and protect the tourist tax revenues to a local government that wants to expand the tourism element of its economy?
Change is needed, but as things stand, it’s hard to see just who is really being protected, and from what.
For more information, e-mail Jim Norman at jim.norman@hklaw.com or by calling toll free, 1-888-688-8500.
The author wishes to acknowledge the contributions and assistance in producing this article that was provided by Holland & Knight summer associates John Chapman and Joanna Sackel.
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