Hotel Online  Special Report
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The Global Hospitality Advisor

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Avoiding The Pitfalls of
Condo Hotel Structuring
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Steps To SEC Compliance


June 2005


By:  Peter Connolly, Esq.

The hottest financial structuring device to hit the hotel development business in years is the re-emergence of the condominium hotels—both as new construction projects, as well as converting existing hotels into condominiums. 

For new construction, a condo hotel structure allows developers to reduce the required equity component from as much as 40 percent of construction costs to as low as ten or 15 percent by using presales for equity credit.  Likewise, conversions of hotels to condo hotels provide an effective exit strategy, allowing the developer to harvest equity appreciation on a basis that is more related to the desirability of the product and its location than traditional valuation methods based on capitalized income streams.

So why isn't everybody doing condo hotels?  First, not every hotel should be a condo hotel.  Location, property ambience, and service level or branding have to act as a major investment drivers for people to want to buy a hotel room.   Second, the sales and marketing of condo hotels is fraught with considerable danger for developers who are not very careful of to whom and how their properties are sold.  While condo hotel rooms may be generally thought of as real estate,  some contracts to purchase condo hotel rooms, particularly if the sale is tied to a rental program or involves pooling of rental income or expenses, may be considered a security.  If it is a security, the sale must be registered with the Securities and Exchange Commission (SEC) or exempt from registration; both are processes with which hotel and condo developers have little experience.  The sale of an unregistered, non-exempt security gives buyers the right to rescind the contract, nullifying the purchase agreement altogether, and forcing the developer to repay to the buyer all the initial purchase money.  In addition, insufficient or inaccurate disclosures may leave the developer liable for securities fraud.

The SEC has indicated in a series of  no-action letters that consider a condo sale a security, and   will not require projects to be registered if the developer sells hotel condo units in accordance with the following requirements:

1. The developer doesn't emphasize the economic benefits of a rental program managed by the developer or a third party;

2. No representations are made regarding the tax benefits of ownership;

3. The availability of a rental program is only communicated to potential buyers in response to direct questions from the buyer regarding rental activities, and is not advertised or marketed;

4. Any written materials provided to potential buyers contain only publicly available, historical financial information about comparable facilities (in the case of a new development) or publicly available historical information about the hotel (in the case of a conversion) and avoid projections, estimates, forecasts or other forward looking financial information involving speculation as to how a hotel room will perform in the rental program;

5. No contract with any buyer for unit rental services is entered into before the buyer has entered into a purchase contract for the condominium unit;

6. The rental management services do not involve pooling of either revenue or expenses; and

7. There are no material limitations on the ability of an owner to occupy a purchased unit except for those imposed by local zoning or similar regulations.

Thus, in order to meet the SEC guidelines, a developer must carefully design a sales and marketing program that sells the condo hotel unit as a piece of real estate and essentially ignores any rental program in its entirety. 

Generally, in order to accomplish this objective with real world sales people, developers totally separate the sales function from the rental function.  When a buyer asks a condo hotel sales person about the rental program, the reply is to "go see the lady in the rental office down the hall."  The theory, and it appears to be correct, is that if buyers want to be involved in the rental program, they will find it on their own.  The developer can point the way when asked, but cannot promote the rental program as a reason to buy the hotel room.

But careful design is not enough, particularly in markets in which the developer intends to rely on outside brokers, in place of or in addition to the developer's own sales force.  The only way to assure that the sales program is implemented correctly is to have a comprehensive training program for sales people that explains the securities issues, offers scripts and other helpful means to avoid problems and threatens severe retribution for transgressions that might even appear to be minor.  The training program must be mandatory for anyone selling the developer's hotel condo units, and should be recurrent, that is, a monthly refresher to keep people on their toes should be part of the plan.

Finally, a prudent developer will want to implement a compliance and documentation program that records who has been trained and when.  Such a program would also include acknowledgements by the buyer in the hotel unit purchase contract that the rental program was not an inducement to buy the unit and that no forecasts or projections were provided to the buyer.  Having the sales people affirm in writing as part of the sales process that they followed the training program and did not provide prohibited information also serves a couple of goals.  Not only will it will be good evidence on that inevitable day that there is a claim that the developer violated the securities laws; it is a potent reminder to the sales person of the seriousness of the subject.

If it all sounds very cumbersome — it is.  However, a number of well-advised developers are successfully navigating the potential pitfalls and producing remunerative condo hotel projects all around the country in products ranging from five-star, city-center hotels to waterpark resorts. 


Peter Connolly practices hospitality law at Los Angeles-based Jeffer, Mangels, Butler & Marmaro LLP.  Connolly’s extensive hospitality experience spans over 30 years, including 18 years as general counsel of Hyatt Hotels.  Connolly leverages his unique hotel operator and developer experience for the Firm’s Global Hospitality Group clients.  Connolly can be contacted via email at  PConnolly@jmbm.com, or by phone at (310) 203-8080.

 
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.

  • Our experience ranges from individual properties to billion-dollar portfolios.
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The Global Hospitality Group® is a registered trademark of Jeffer, Mangels, Butler & Marmaro LLP
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For more information:
Jeffer Mangels Butler & Marmaro LLP
1900 Avenue of the Stars, 7th Floor
Los Angeles, CA 90067-4308
Attn: Jim Butler
310.201.3526 • 310.203.0567 fax
jbutler@jmbm.com
http://www.jmbm.com

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Also See: Copyright Laws Applicable to Hotels / Jim Abrams / March 2005
Condo Hotels - How to Make Them Work / Jim Butler and Guy Maisnik / February 2005
The Condo Part of Condo Hotels; A Primer on How to Create a Common Interest Development / David Waite, JMBM / The Global Hospitality Advisor / February 2005
Catching the Buzz on Condo Hotels, A Roundtable Discussion / The Global Hospitality Advisor / JMBM / December 2004 
Outlook 2005: Hotel Industry Fundamentals, Where have we been? Where are we going? / The Global Hospitality Advisor / JMBM / December 2004
How to Master Your Next Disaster Protect your guests, educate your employees, and limit your liability / Julia L. Rider / JMBM / October 2004
Wage & Hour Class Action Lawsuits: Hospitality Employers Caught in the Cross Hairs / Marta Fernandez / JMBM / September 2004
Adopting Pet And Service Animal Policies To Avoid Lawsuits from Disabled Hotel Guests / Marty Orlick / JMBM / September 2004
Politics Over, New ‘Overtime’ Law Takes Effect; The Significant Changes / JMBM / September 2004
Hotel Franchise Agreements: Opportunities And Pitfalls / JMBM / September 2004
ADA Lawsuit Alert: Beware the Internet Surf-by; A new twist on the ADA drive-by lawsuit / JMBM / September 2004
Hotel Unions Challenging Work Rules Found in Hotel Employer / The Global Hospitality Advisor Handbooks; Claim Interference with Employees’ Rights to Organize / JMBM / October 2003
Wage and Hour Lawsuits and Audits Continue to Sweep the Hospitality Industry / The Global Hospitality Advisor / JMBM / October 2003
Prepare NOW for an ADA Attack; Myths and Tips on How to Minimize Exposure / The Global Hospitality Advisor / JMBM / October 2003
Sarbanes-Oxley Update / The Global Hospitality Advisor / JMBM / Arpil 2003
Equal Public Access or Access to Deep Pockets? The Hospitality Industry Remains a Target of Lawsuits by Disability Rights Groups Under the Americans with Disabilities Act / The Global Hospitality Advisor / JMBM / March 2003
Outlook 2003: A Roundtable Discussion / The Global Hospitality Advisor / JMBM / Dec 2002 
Time Bomb Waiting to Explode: Wage & hour Claims Over Exempt Employees / The Global Hospitality Advisor / JMBM / Oct 2002
I'm Mad as Hell, and I'm Not Going to Take it Anymore! / The Global Hospitality Advisor / JMBM / Oct 2002
Settlement Procedure Available to California Hotels Plagued by Prop 65 Cases - The Global Hospitality Advisor / April  2002 
Top Ten Investment Challenges Facing the Lodging Industry / Lodging Industry Investment Council / April 2002 
Decertifying a Union? The Employer’s Bill of Rights / The Global Hospitality Advisor / JMBM / April 2002 
Outlook 2002: A Roundtable Discussion /  Bruce Baltin, Bjorn Hanson, Randy Smith, Jack Westergom - The Global Hospitality Advisor / January 2002 
New Rules for Hotel Workouts: REMICs for Dummies / The Global Hospitality Advisor / JMBM / December 2001 
Living in the Wake: Predictions & Practical Implications / The Global Hospitality Advisor / JMBM / December 2001 
Avoiding Liability for Lay-Offs / The Global Hospitality Advisor / December 2001
The Worker Adustment and Retraining Notification Act: Impact on the Hotel Industry / JMBM 
When is an Apartment a Hotel ... and Who Cares? / The Global Hospitality Advisor / JMBM / September 2001 
The 'Perfect Storm' / The Global Hospitality Advisor / JMBM / September 2001 
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
Perspectives on Hotel Financing in 2001; Jim Butler, JMBM's Global Hospitality Group Chairman, Interviews Two Active Players in Hotel Finance / Jan 2001 
Robert J. Morse: Millennium’s New President / Interview with GHG Chairman Jim Butler / Nov 2000 


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