Hotel Online  Special Report
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The Global Hospitality Advisor

-Catching the Buzz
on Condo Hotels



A Roundtable Discussion
Condo hotels are now integral to the industry
December 2004
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Jim Butler: Condo hotels may be the hottest thing to hit the hospitality industry in more than 10 years.  Approximately 65% of all the projects we are working on at JMBM’s Global Hospitality Group have a condo component. Who wants to talk about what is driving this condo hotel frenzy?

Peter Connolly: I will start with that one, Jim. It is not hard to understand the temptation to view condo hotels as the answer to every hotel developer’s prayer—and every condo developer’s too. In a hotel financing environment in which 50% loan-to-cost construction loans have become the norm, condo hotels offer the opportunity for a developer to gain the equity "credits" for pre-sold units that traditional condominium 


Jim Butler
Chairman of JMBM’s
Global Hospitality Group
developers have used for years to obtain construction loans that approach 90% loan-to-cost leverage. And both hotel and condo developers get very enthusiastic when they see hotel condos selling out all or major parts of the project in pre-sales at substantial premiums to the price per foot of otherwise comparable product without the hotel component.  The premium pricing and preferred financing have worked miracles from South Beach to Boston and from Manhattan to the Hawaiian Islands.

Brian Ehrlich: As everyone on this panel knows, the condo hotel trend is just unfolding and constantly evolving as the regimes, structures and operations become more finely tuned. At Kor, we are very comfortable with the condo hotel concept. While there are a few spectacular projects with the hotel condo units selling quickly at a multiple of the price for "ordinary" condos, we think the better model is a realistic and conservative one. At Kor, we believe that a well designed and executed condo hotel project is unique. The condo units in such a property can sell for a premium over "regular" condos ranging from 15% to 40% per square foot due to the services provided to the condo hotel owner that are inherent in being part of a hotel operation such as housekeeping, maintenance, and room service—as well as the uniqueness in design, sophistication, and overall product offering that comes along with being a Kor designed and managed hotel.

Connolly: On the revenue side, it is apparent from the rumored sales numbers of projects like the Trump International Hotel in Chicago that condo hotel units with appropriate branding and service levels can command substantial price premiums over either traditional condominiums or traditional hotels on a dollar per square foot basis.

However, there is no "free lunch" in the condo hotel business as entirely new areas of business and legal risks arise from condo hotels that are not present in the traditional hotel development arena. Condo hotels are part of a condominium environment that will ultimately vest considerable legal and business authority in an association made up of the unit owners.  Ask any experienced, traditional condominium developer about so-called "habitation" class actions by homeowner associations, or about how premiums for completed operations and project protective liability insurance coverages have doubled or even tripled in recent years, and the picture of life as a condominium developer takes on a patina that is not all rosy.

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2005 Roundtable Participants
Daniel S. Abrams
Executive Vice President
iStar Financial Inc.

Bruce Baltin
Senior Vice President
PKF Consulting

Bill Blackham
President and CEO
Eagle Hospitality Properties Trust, Inc.

Peter Connolly

Rich Conti
President and COO
Boykin Lodging Company

Brian Ehrlich
Director of Hotel Development
and Acquisitions
The Kor Group

Thomas R. Engel
President
The T.R. ENGEL Group, LLC

Jim Holliman
Senior Vice President
San Diego National Bank

Daniel Lesser
Senior Managing
Director-Industry Leader
Hospitality & Gaming Group
Cushman & Wakefield, Inc.

Mark V. Lomanno
President
Smith Travel Research

Guy Maisnik
Partner
Jeffer, Mangels,
Butler & Marmaro LLP

Bill Reynolds
Chief Investment Officer & EVP
MeriStar Hospitality Corporation

Jonathan P. Roth
Principal
Canyon Capital Realty Advisors LLC

Christof Winkelmann
First Vice President
Head of International Hotel Financing
Aareal Bank AG

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Daniel Lesser: Condo hotels are hot. In some markets, such as New York City, the condo hotel phenomenon has been so hot that we have actually seen a decrease of more than 6,000 "regular" hotel rooms as residential condominium converters and developers have purchased several major hotels such as the Plaza, the Mayflower, the Empire, and the InterContinental Central Park South. The fact is that today the economics are such that in several urban markets such as New York, for some existing hotels, residential development is a higher and better use than continued lodging use. As the economics of the hotel industry continue to improve, look for the pendulum to start to swing back towards hotel development being a higher and better use than residential/condominiums.

Daniel Abrams: At iStar, we really like the combined condo and hotel concept. We are a little less certain about condo hotels, although we are involved in financing some of these projects as well. The ability to substantially reduce one’s exposure to the hotel portion of a project by selling other portions of the property is a great idea. But there is a lot of product coming to market, in addition to a whole lot already done, which may test the demand side of the equation.

A Maze of Regimes Using the ‘Hotel Condo’ Label

Butler: Everyone speaks of "condo hotels" as if they were referring to a clearly defined concept that everyone understands. In fact, as you know so well Guy, the term is used to describe an almost infinite variety of regimes. Tell us a little about that.

Guy Maisnik: The term "condo hotels" is used to describe a wildly divergent array of product that has a residential and hotel component. The extremes are demarcated by regimes at one extreme with vertical, stacked condos and hotel rooms integrated into a full-service hotel environment where all of the hotel amenities and services are shared to another extreme with a horizontal development where the condos and hotel may adjoin one another but have little or no interaction.

In some regimes, the hotel operation has no rooms whatsoever that are dedicated solely to hotel purposes. In these properties, the hotel operation only has rooms to rent to the extent that condo owners place their units into the hotel rental pool. Other regimes mimic traditional hotels with a dedicated number of hotel rooms, but the dedicated minimum number of rooms may be complemented by condos placed in the hotel rental pool. In between all the extremes, there are an almost infinite number of variations, with condos being branded or unbranded, voluntarily in the hotel rental pool or mandatorily committed to it, with owners in some regimes having unlimited use of their condo to others where they have limited use per year, advance notice required for use of the unit, and a limit as to the maximum number of condo units that can be occupied by owners at any time.

Each condo hotel regime will have its own issues relating to management, state condo regulatory rules, state and federal securities regulation, tax planning, insurance (especially in rehab projects), common uses, secured financing and remedies, construction and risk analysis. In either case, a wise developer and lender will analyze each of these areas of impact before setting the documents in motion. Each change in the structure will have a ripple effect through each of these areas with attendant financial and legal consequences.

Butler: And how about the impact of the complexities of these merging uses? Aside from the profit potential, what tips would you offer to those looking at condo hotels? Many seem to be rushing headlong in that direction without understanding some of the critical issues.

Maisnik: You raise a good point, Jim. The mix of hotels and condos, though not new, in ski parlance can be a black diamond game. There is a significant learning curve for hotel and condo developers and lenders. Developers and their lenders looking at the condo hotel business will need to understand how the condo and the hotel businesses work separately and then understand the complexity caused by the convergence of these two very different businesses. They will need to get familiar with the regulatory and legal infrastructures surrounding condominiums and the intricacies of hotel management agreements and operations, and the impact each will have on the other. Careful consideration must be given as to what type of condo hotel regime will be used and where and how those condos will be marketed.

Bruce Baltin: The explosion of interest in projects mixing condominiums with hotels raises critical questions on designing the "right" regime, as Guy calls it. And the regime structure needs to be tailored to the project, the developer and the consumer. Depending on whether the project is located in a leisure market or urban center, and a host of other factors, the condos may be used as primary residences, as vacation homes, with or without rental expectations, and strictly for personal use or for investment purposes.

As in all development trends, the fundamental logic of pairing condos with traditional hotel uses makes great sense for both buyer and seller, in the right circumstances. There will be some successful projects and others will not be so successful. The trick is putting together the right development program, sales and management team, and the best regime for each particular project.

Connolly: We should not lose sight of a fundamental requirement—a condo hotel must work financially as a hotel. Among the challenges confronting the developer in initially setting up the condominium schemes is ensuring that the residual hotel—comprised of the public spaces, back of the house, F&B outlets and meeting spaces—will have sufficient revenues, either from consumer sales or expense allocations to the unit owners, to offset the costs of operating and maintaining those traditionally less profitable (or even non-revenue producing) elements of the business. The condo hotel scheme must also address the long-term capital requirements of the project in establishing reserves for renovations not only of the rooms but also the balance of the project. Doing so while avoiding the "securities" proscriptions against pooling of revenues or expenses requires great care at the outset of a project’s initial conception and documentation.

Ehrlich: There are a lot of operational issues that need to be addressed (service delivery, accounting, communication, inventory control and management, investor relations, etc.) in a clear and well-thought-out way. To be sucked into this business simply by the lure of proforma profits on the condo sellout is a recipe for disaster. You need a group who has a well-thought-out plan for individual site operations as well as a network of projects throughout the country with a development sponsor who is not simply going to pick up the stake once sales are finished and disappear. You need someone who is making the condo hotel business their business!

How Deep is the Demand for Condo Hotels?

Baltin: The demand for condo hotels is tied to people’s appetite to own real estate and the widely held belief that the real estate market is attractive for investment now, particularly compared to alternate investments. Well designed condo hotel regimes represent a good investment, because they offer a place for people to enjoy living or staying at property they own, and to have the tax and investment benefits—and risks—of real estate.

Condo hotels have been around for decades. They were very successful—but they are very complicated. So when easy development money was available for hotels and condos, most people did not want to endure the extra work and complexities of a condo hotel, particularly when the general real estate market was not as strong as it is now, and because people were putting their money into the stock market and other places.

As long as the fundamentals work, condo hotels will be around to serve the needs of developers, consumers and operators.

Ehrlich: We like condo hotels and see this as a significant longer term trend. Kor is currently establishing a relationship with Falor Companies of Chicago and South Florida to manage a number of the various condo hotel projects that Falor is in the process of doing. Falor is purchasing existing hotels, primarily in South Florida and Chicago, as well as other major U.S. markets (both CBD and resort), and converting them to condo hotels through major renovations and the repositioning. Kor is responsible for running these properties effectively before, during, and after the conversion process is completed. In some cases, the hotels are being shut down while the renovation takes place and will be reopened by Kor once the condo hotel conversion is completed. In others, we are taking over management of the hotel and operating it while the renovation is going on and after it is completed.

The projects that Kor is involved in with The Falor Companies will be primarily 100% condo hotel projects, typically ranging in size from 50 units to 500 units. In the larger projects, a number of the units will not be sold and will be held by the developer in order to address issues related to group booking availability, to keep the pressure on pricing by creating scarcity, and to better manage inventory to maximize standard hotel operating performance. Aside from Falor, Kor is also developing two projects in the Caribbean that will have a condo hotel component to them, but will be part of a larger mixed-use development, including single family lots, pure condos/villas, and a smaller resort condo hotel component.

Kor continues to look at hotel projects around the country, including our target markets (Seattle, Portland, San Francisco, Los Angeles, San Diego, Santa Barbara, Phoenix/Scottsdale, Las Vegas, Denver, Chicago, Boston, New York City, Washington, D.C., and Miami) with an eye toward the typical hotel model as well as the condo hotel model. This provides us with another option in which to evaluate hotel deals (boutique, branded; hotel, condo hotel). It is all about increasing the number of options we have to look at deals given the fierce competition for deals today.

Christof Winkelmann: I believe there is a good demand for hotels with a condo component. Past transactions by Ritz-Carlton and Four Seasons have shown the success. Condo hotels on the other hand are somewhat more difficult. Security of individual unit owners is hard to evaluate and financing for the same even more so. Despite this, deals can be structured as past transactions are indicating and real case precedents in times of difficulty will have to be tested. I believe the important question is how deep the demand for this market is. Again, because of the attractiveness of quick and lucrative returns as compared to "traditional" hotels, these kinds of projects will be flooding the market in good locations. The key point is to watch supply growth within this market closely and to withdraw in time when demand is starting to slow down.

Jonathan Roth: The trend of converting hotel rooms into condominium units represents a very interesting phenomenon in the hospitality marketplace. While we have completed a handful of these transactions, we remain cautious about their viability. At the end of the day, the conversion process is nothing more than a creative finance tool. The majority of the projects being completed today are being sold as pure real estate and consequently are not being registered as a security under SEC rules and regulations. The desire to keep the transactions viewed as pure real estate is to avoid the cost in both time and money that it takes to register a project as a sale of "securities." With this, there is tremendous room for abuse by overly zealous developers and their commission-motivated sales force. That said, to a large extent, the industry will undoubtedly police itself through stringent lending practices.

Rich Conti: While condo hotels may be hot today, the learning curve that you guys are referring to can be very steep, and I am concerned that all developers and converters do not get it! (We have been doing them for four years.) As Peter said, a condo hotel must work as a hotel. It is not a vehicle that should be used on an underperforming asset. In fact, there will be some nasty surprises for players approaching the condo hotel structure from both sides—as hotel people find new issues from rental pool problems and residential liabilities and as condo developers get their first exposure to the hotel business and learn some painful lessons on how "hotels are different." Both sides will find surprises in the thorny and critical "security" issues. Jim, maybe you would like to comment on this a bit.

Condo Hotels:  Transmutation of ‘Real Estate’ Into ‘Securities’? ... and Some Critical Implications

Butler: I never knew the 15 years I spent as a securities lawyer at the beginning of my legal career would be so relevant to my hotel practice in the last 15 years. You have touched on a very important point, Rich. It seems to amaze everyone how combining a condo investment with even the option of a rental pool agreement can create a "security" and all that it implies. Suffice it to say that the law is clear that a "security" subject to SEC regulation includes an "investment contract." And while you can sell a condo outright without it being a security, if your sales force touts the investment value of the condo and you start talking with potential condo buyers about rental pool arrangement, you have likely converted an offering of real estate (the condo) into a security (the investment contract represented by the condo, appeal to investment nature, and rental pool agreement).

From there, the implications are profound. If the condo you are selling is a "security," you must either register it with the SEC and every other appropriate securities regulatory agency in the United States where you offer or market the condo, or have an exemption from registration. In addition, securities can generally be sold only through properly licensed securities brokers and sales persons, and there are strict restrictions on soliciting buyers, the manner of offering the condo securities and what can be said orally or in writing in any sales materials or presentations. It is quite a bit more complicated than that, but those are the highlights.

Maisnik: What makes the problem worse, Jim, is that experienced hotel and condo developers will be tempted to stick their heads in the sand because they just cannot believe—or do not want to believe—that the sale of a condo in a condo hotel regime could create a "security" and all the regulation and compliance that it implies.

Butler: And the "red tape" of registrations, licensing and monitoring compliance is one thing, but the consequences for violation of the securities laws can be very severe, including civil and criminal penalties, and rescission rights to the "investors" that may go on for a long time.

Conti: We think that condo hotels need to be sold as "real estate" and not as a "security" but there are many different opinions on how this works. This is one area where you better make sure you hire a lawyer who knows the hotel industry, the condo game, and really understands the securities laws. They all affect one another, and if you only understand one part of the game, you will lose!

Connolly: Rich is right that it may be essential for non-luxury product to be sold as "real estate." But selling hotel condos as "real estate" for residential occupancy and not for "investment" purposes raises numerous challenges under federal and state securities laws. A wink and a nod will not get you by the SEC’s test for a security. Reliance on the SEC’s recent "no-action letter" for exemption requires the application of exquisitely disciplined management of the sales and marketing process that will be a practical impossibility for many. Even with great care and attention paid to how units are brought to market, there is the risk that some regulator or court (in assessing a buyer’s claim of rescission) may conclude that a product that looks, smells, walks and quacks like a duck really is not a chicken. The prudent developer should at least consider alternatives to the "real estate" strategy, such as the private placement approach—at least in luxury projects where condo buyers may qualify as accredited investors.

Butler: How about the branding issue as it relates to condo hotels?

Tom Engel: Jim, for the past year and a half, the T.R. ENGEL Group has been hospitality advisor to owner-developers of a $550 million mixed-use project located in Boston’s historic Back Bay and South End. The key building within the master plan is a 36-story tower with 160 deluxe condominiums and a 170-room world-class hotel and spa.

As you know, being counsel to this project, we interviewed seven leading worldwide luxury and deluxe brands. We have concluded a couple things from all this. First, based on proposed "condo marketing fees," most luxury brands and operators are walking around with very inflated views of the trademark value of their brands. Second, we question the assumption that there is a strong condo hotel "exit market."

With no empirical evidence or comparables on capital appreciation, how can a condo hotel investor genuinely project the economic value of his or her condo hotel room investment? The jury remains out in TRE’s opinion.

Butler: Thank you all for your insights on the condo hotel phenomenon. Headlines and imaginations have been captured by the stunning returns on a few condo hotel projects such as the Mandarin Oriental in Manhattan and the pre-sales on the Trump International tower in Chicago. But a condo hotel is not a panacea. Those successes have come from great locations, powerful brands, lots of hard work, careful research, and an expert team of advisors. The Columbus Center project in Boston, which Tom Engel has been working on for several years—and my firm has had the privilege to advise on the condo hotel aspects of the project—is a case study in how to do it right. The preliminary expectations for this massive 1.3 million square foot mixed-use project including a 36-story condo hotel project are inspiring. However, there are projects where the condo hotel regime adds such complexity and expense that it cannot be justified and will leave many unhappy investors in its wake, with the specter of litigation looming for years. Sound planning and structuring by the right team will maximize the chances for success and minimize the likelihood of disaster.



The Global Hospitality Advisor ® is published four times a year for the clients, business associates and friends of Jeffer, Mangels, Butler & Marmaro LLP.

The information presented in this newsletter is intended as general information and may not be relied upon as legal advice, which can only be given by a lawyer based upon all the relevant facts and circumstances of each particular situation.

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For more information:
Jeffer Mangels Butler & Marmaro LLP
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Attn: Jim Butler
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Richard Kessler's Grand Theme Hotels - Interview with GHG Chairman  Jim Butler / March 2001
Stephen Rushmore's  Industry Trends / Top Markets, Predictions & Opportunities  / Jan 2001
Outlook 2001: A Roundtable Discussion The Global Hospitality Advisor / Jan 2001
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