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The Global Hospitality Advisor

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Regulating Condo Hotels

Bad Condo Hotel Municipal Ordinances
Will Discourage Good Projects

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This article first appeared in the May 2006 issue of Urban Land, published by the Urban Land Institute (ULI). ULI is the copyright owner and this article is reprinted with permission.

by Catherine DeBono Holmes, June 2006

With the increasing demand for condo hotel building approvals around the country, municipal governments have scrambled to develop zoning ordinances that will allow high quality condo hotel developments, while at the same time preserving the transient occupancy tax (TOT) revenues that are so important to municipal income, assuring an adequate supply of transient hotel rooms for tourists, as well as for business and leisure travelers (to support tourism, and municipal facilities such as convention and conference centers); and controlling additional costs for and burdens on local infrastructure such as schools and city services.  

Cities in hot markets like California, Florida, New York and Nevada have looked at examples from some of the early adopters of condo hotel zoning ordinances, while some cities have sought help from local attorneys aimed at further refining the approval requirements for condo hotel developments.  

Developers need to review carefully these detailed ordinance provisions, as they may, in some cases, be counterproductive to the sale and operation of a condo hotel.  In addition, developers must be cautious about their own involvement in the adoption of municipal ordinances, as they run the risk of converting the offering of their condo hotel units into an offering of “securities” under federal securities law. This dreaded event can be disastrous for developers. In dealing with municipal ordinances concerning condo hotels, the unwary should take heed of the following dangerous traps. 

Restrictions on Unit Owner May Jeopardize SEC Status

Overly restrictive use and rental conditions in an ordinance on owners of condo hotel units could, under certain conditions, result in the units being characterized as securities under federal and/or state securities laws. In the past, through a series of “no action” letters, the Securities and Exchange Commission (SEC) has permitted limited zoning restrictions—including prohibitions on the use of a condo hotel unit as a permanent residence and requiring unit owners to make units available for rental—without finding that these restrictions caused the condo hotel offering to convert into a “security.”  However, developers need to be aware that the SEC's no-action letters are not binding on the courts, and the SEC can change its position depending on the facts of each offering or upon changes in the SEC's views in general. Therefore, developers cannot rely on previous no-action letters as protection against any potential securities claims by regulators or purchasers.

The SEC recently advised informally that it will examine the totality of all restrictions and requirements on unit owners, including those imposed by zoning ordinances, in determining when condo units will be deemed securities. Therefore, developers should not assume that any restriction on unit owners contained in a zoning ordinance will automatically be acceptable to the SEC or other authorities in their determination of whether the condo units are securities.
 
Standards for Hotels and Hotel Operators  May Be Unreasonable

One recently proposed ordinance would have required every condo hotel to be operated under a “brand” included in the “upscale segment” or “luxury segment” defined by J.D. Power and Associates, and upon completion, to meet the published requirements to receive a rating of no less than a Mobil 4-star or AAA 4-diamond designation. While these designations may sound like a reasonable assurance that every approved condo hotel will meet the highest quality of operational standards, they may impose undue restrictions upon the developer and create unrealizable expectations. 

Many condo hotel developers, as well as potential purchasers of condo hotels in future years, may prefer to be managed by an owner rather than by a "brand.” In addition, most hotels that are regarded as luxury hotels, and that are commonly spoken of as Mobil 4-star or 5-star hotels or AAA 4-diamond or 5-diamond hotels, are not in fact holders of the actual designation from Mobil or AAA. The higher luxury hotel ratings (e.g., 4- and 5-diamond or star ratings) involve some very subjective and elusive qualities, and even if a hotel achieves such a rating, the rating might be lost on technical grounds without a noticeable reduction in quality. However, in either event, the developer’s hotel could fail the test and be in violation of the municipal ordinance. 

It is preferable that zoning requirements speak in terms of hotels being operated as “upscale” or “luxury” hotels, without specifying either that they are required to be operated by a "brand" or that they maintain a particular Mobil or AAA ranking. 

Common Area Ownership

One recently proposed ordinance required that the common areas of a condo hotel be owned by the developer or an entity other than the condo hotel unit owners. Apparently, it was designed so that the homeowners association (or HOA) would not own the common areas of the hotel. However, the condominium regulations of some states require that common areas are owned by an HOA, or at least that their ownership might be transferred to an HOA, should certain events occur. In addition, some state laws do not allow cities to determine who owns property, requiring that ordinances be limited to restrictions on the use of property. 

Hotel Management Agreements

Another proposed ordinance required that a condo hotel HOA enter into an agreement with a hotel manager that would last at least five years. However, the condominium regulations in some states limit the duration of contracts that an HOA may enter into. In this case, the proposed ordinance would be in conflict with state law. Some hotel operators may not agree to enter into a management agreement with an HOA, although they might agree to one with the developer and the individual unit owners. The ordinance could then deny the developer the right to enter into a management agreement with a desired hotel operator. 

Budgets and Other Operating Matters

Some ordinances require the developer to submit a budget to the condo hotel HOA for the maintenance of the hotel.  Such an ordinance assumes that the HOA will be responsible for maintaining the hotel, which is not always the case. In fact, the standards for the operation of condo hotels, including the budgeting process and other operational matters, are undergoing significant changes, as developers around the country experiment with various types of operational models. Cities should allow for this process and not micromanage condo hotel operational matters.

Beware of Developer Participation in the Ordinance Process

Some developers understandably want to work closely with city building authorities to craft ordinances that the developers believe will provide necessary flexibility and will solve certain hotel operating issues by limiting owner use and occupancy rights. But this can prove dangerous. A developer who is overly active in an ordinance process that results in restrictions on the owners’ use and rental of their condo units could place the condominium offering at risk of being converted into a securities offering. The SEC has said that limited restrictions on the condo hotel owner’s use imposed by a preexisting ordinance will not cause a project to become a security. 

However, if a developer uses the ordinance process to create material restrictions on an owner's use, the SEC (or a court) could decide that restrictions on the owner’s use imposed by ordinance were in fact caused by the developer's own actions, and thus renders the condo offering a security. 

In general, developers should limit their participation in the ordinance drafting process. They can probably work to reduce municipally imposed restrictions on developers and owners as to use and management of a condo hotel, but these issues normally should only be brought to the attention of municipal officials in a conceptual way. In fact, the entire interaction with the city in the ordinance process must be carefully guided to avoid running afoul of important SEC considerations.

Municipalities Should Regulate with Care

Municipalities have legitimate reasons to regulate condo hotels, but they must do so carefully. Overregulation strips value from the condo hotel real estate and makes justifying the skyrocketing costs of construction more difficult. Undue restrictions also can deter purchasers from buying units and present operational issues that drive away high-quality operators that are essential to a successful project. 

Finally, overly restrictive municipal regulation of condo hotels could create insurmountable SEC problems for developers by causing the condo hotel units to become securities---either by overly burdensome restrictions on owner use and rental of condo units, or by involving developers too heavily in the ordinance process. Either road can lead to disaster and may convert the offering of condominium real estate into an offering of condominium securities. 

Most important for cities, bad ordinances with unnecessary and ill-conceived restrictions will discourage good projects that would otherwise benefit cities, developers, buyers of residential units, and the traveling public.



Catherine DeBono Holmes is a senior member of JMBM’s Global Hospitality Group® and a partner in the firm’s Corporate Department. Catherine assists clients with hotel management and franchise agreements, purchase and sale transactions, and condo hotel regime structuring. For example, Catherine provides national representation for a large hotel owner’s hotel management and franchise agreements. She recently assisted a client with a 1,500+ room convention hotel in successfully concluding a complex RFP process involving all the major hotel brands and negotiating a favorable management agreement. She devotes a significant part of her practice to advising condo hotel clients on many important business and legal aspects condo hotel regime structure and condo hotel documentation, including CC&Rs, HOA docs, unit management agreements, shared facilities agreements, rental management agreement programs, and securities compliance matters (structuring, documentation and training). Catherine can be reached at 310.201.3553 or cholmes@jmbm.com.
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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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