Condominium Hotels in Today’s Market: A Product Whose Time Has ...?
 
May 15, 2008
 
Lynn K. Cadwalader- San Francisco

Overview and Current Trends

The condo hotel phenomenon has been one of the most significant events in the real estate and hotel industries over the past 50 years. Its explosion into the market this past decade was promoted by all walks of resort developers, condominium developers and converters, and hotel owners and operators. Condo hotels gained particular popularity in resort markets such as Miami and other South Florida and Caribbean locations, Las Vegas, Hawaii and in various ski resort locations, followed closely by a “second wave” of condo hotel developments in urban centers and other destination cities. Although the market was initially dominated by luxury five-star brands, a lot of mid-scale product also entered the market.

Condo hotels are hardly new to the resort development arena and have long been a recognized as popular resort product in Latin America and Europe. Condo hotels structured as securities offerings with a mandatory rental pool feature were popular in the 1970s and 1980s, until the 1986 Tax Reform Act stripped the investment of much of its tax advantages. The fall of the stock market, low interest rates and significant investment dollars made available by retiring baby boomers, all converged to make real estate investment a viable option for many consumers.

In this regard, condo hotels present an interesting paradox – consumers are buying the product as an investment, but unless registered as a security, the product cannot be sold and marketed as a security. Herein lies the crux of the issue.

Disgruntled Purchasers Want Rescissions and Refunds

Unhappy condo hotel owners and purchasers wanting to get out of their contracts are claiming that they bought the units as investments (not for personal use) which should have been registered with the SEC. These buyers claim that the way the units were marketed created an expectation of profits (investment returns and cash flow) resulting from the efforts of the rental program operator. If registered as a security, a detailed investment prospectus would have been made available to them before the purchase, warning about the risks associated with the purchase. A successful securities law violation claim allows the buyer to rescind the purchase and receive their money back without having to prove fraud or misrepresentation. Litigation by disgruntled purchasers usually includes a wide range of other claims, from violation of the federal Interstate Land Sales Full Disclosure Act to common law fraud.

Benefits and Drawbacks of Condo Hotels

So, why the rush to develop and sell condo hotels when there were so many other real estate products in which to put one’s development dollars? A historical perspective provides some answers. The condo hotel boom was driven by the unprecedented alignment of several economic factors which provided benefits to all parties involved in the condo hotel market:

• Developers. For hotel developers, the condo hotel model was a financing bonanza. Construction debt for a hotel project typical runs around 50-60 percent of cost. When condos were added to the project, “equity credits” earned though condo pre-sales provided debt financing of up to 90 percent of the proposed project cost. Further, by addition of the hotel amenity component and the rental program, the developer gained a 15-40% premium over the sales price per foot of comparable units.
• Consumers. For consumers, the option of owning real estate for both personal use and investment reasons was very appealing. The units were available for vacation use, while rental income helped defray the cost of ownership when the owner was not using the unit.
• Hotel Operators. Hotel operators were ecstatic about having a new supply of properties made available for hotel use, without having the burden of owning the underlying asset. Further, the hotel operator could generate significant fees from management, franchising and the providing of centralized services. Condo hotels were seen as a way to accelerate brand expansion and penetration into new markets on a rapid basis.
• Lenders. Financing of condo hotels was attractive to construction lenders because the presale of units eliminated much of the construction phase risk. Typically, pre-sold projects resulted in a fast construction loan pay-off, which transferred the lending risk to the unit owners and their lenders.

Sound like a winner? Not always. In certain markets, where condo hotel units comprise only one part of a large hotel-enhanced, mixed-use development project, condo hotels have worked well. However, in other markets, and with pure condo hotel projects, other issues have created major drawbacks:

• Integration of Complex Relationships. The condo hotel requires the integration of complex relationships including legal structure, design and construction, sales and marketing, hotel operations and residential condominium operations, and the integration of mixed uses and the sometimes competing interests of the various project components. In condo association-friendly states like Florida and California, issues and problems previously limited to residential condominium projects impacted both developers and operators.
• Overbuilding. Overbuilding in the market in general and in specific locations have thrust a glut of condo hotel units into a declining market already saturated with unsold residential condominium units.
• External Factors. The recent downturn in the economy has resulted in a slowdown in tourism. Terrorism and other factors can also affect the condo hotel market. In addition, closer scrutiny of lending practices could lead to a tighter money supply as well as more government oversight and regulation.
• Sales and Marketing – Securities Issues. One must be hyper-vigilant in the sale and marketing of the condominium units and the rental program offered in connection with the units in order to not violate securities laws. Most claims by purchasers attempting to get out of their purchase contract or to rescind their purchase include allegations of securities law violations in the sales process.
• Unrealistic Expectations of Buyers. Condo hotel unit buyers may have unrealistic expectations of rental revenue and resale potential. Buyers should expect rental revenue (after payment of required rental program costs and the hotel operator’s split) to offset some, but not all of the costs of ownership. This was clearly not the case with respect to many condo hotel unit buyers, who often don’t read, understand or pay attention to disclosure and disclaimer documents.

In a mixed-use project, which may include a condo hotel as a complement to its traditional hotel, residential, fractional and amenity components, an additional layer of complexity is added due to the variety of uses and interests involved in the project:

• integration of different components (use, ownership structures and common interest community structures (master and sub-condominiums)
• establishing different use rights and service levels
• establishing and maintaining the uniform look and feel of the resort
• management of the various project components and cross-termination rights
• overlay of regulatory aspects of common interest communities

Are Condo Hotels Still a Viable Real Estate Product?

Condo hotels clearly have made a lasting impression in the real estate market that will not be soon forgotten. The condo hotel market is currently in the process of adjusting by shedding its flippers, speculators, and poor quality/poorly planned and operated projects. What will be left when the wheat is separated from the chaff, will largely be successful condo hotel projects in specific viable markets which are (i) part of a larger mixed use project with a significant “core” hotel component, (ii) operated by recognizable brands, (iii) sold at normalized “baseline” pricing, and (iv) with realistic expectations of the value the rental option brings to the table.

As with most real estate products and market cycles, well-planned, well-executed and well-constructed condo hotel projects in the “right” markets will remain a product whose time has come and will stay. In a market with challenges, marginal, poorly planned projects will wind up falling by the wayside, ultimately to be resurrected in a different form by creative developers.

For more information, email Lynn Cadwalader at lynn.cadwalader@hklaw.com or call toll free, 1.888.688.8500.