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The Global
Hospitality Advisor
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June 2005
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.
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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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 [email protected] http://www.jmbm.com The premier hospitality practice in a full-service law firm |