News for the Hospitality Executive
Restructuring Distressed Condominium Hotel Projects
|by Jim Butler and Peter Connolly
December 23, 2008
Part 1: The background and structure of the typical condo hotel
What to do when the hotel is performing but the condo structure is dragging it down
A significant number of condo hotels came on line as the credit crisis was brewing and now, many of them are facing problems. In many instances, the "hotel" part of the condo hotel is performing reasonably well, but the underlying condo ownership structure is dragging it down.
In the context of the current credit crisis, many believe the "new" condo hotel structure is a failed concept. However, much of what is written about condo hotel workouts fails to distinguish between a) condo hotels that are failing as a result of hotel performance issues and b) condo hotel failures that are directly attributable to the condominium structure rather than to basic hotel economics.
Economic problems due to hotel non-performance
Condo hotels that have economic problems resulting from either expenses that are too high or revenues that are too low are no different than any other hotel when it comes to workouts. But while the same principles apply, the process itself is much more complicated because you are dealing with many individual unit owners -- not just one hotel owner -- and all those owners will need to be cajoled into accepting restructuring pain. Professionals familiar with the complexities involved in hotel workouts, can competently (and painstakingly) untangle these kinds of failed condo hotels.
Economic problems due to the condo ownership structure
On the other hand, dealing with condo hotels that are struggling financially as a result of the condominium ownership structure -- regardless of hotel performance -- requires professionals with an entirely new skill set.
Important background on condo hotels
The early days. In the early 1970s, a number of condo hotel projects were developed, principally in resort areas. At a time when condominium financing generally was in its infancy, the concept of using hard contract pre-sales for equity "credit" with construction lenders was one happily embraced by the development community. Using the condominium financing structure allowed the developer to take advantage of the condominium pre-sale "credit," thus reducing the hard equity required for construction and increasing construction loan leverage.
Typically, the developer sold individual room units to consumers. The consumer purchased a unit and when he or she was not using the room, the hotel operator (generally not the developer) would put the room in a rental program to be rented to hotel guests. From this, the room owner would receive either a specific percentage of room revenue or a percentage of the profit generated by the room after the payment of operating expenses.
Why most early condo hotels failed
1. Agreements between hotel operations and condo ownership didn't mesh. The agreements that attempted to merge hotel operations with condominium ownership simply did not work very well in the early days. Many projects were unable to be maintained appropriately because the agreements did not provide the hotel operation with a source of funding for working capital, capital expenses, etc.
2. The SEC determined that condo hotel sales were subject to securities registration. In 1973 the SEC issued a Release concluding that if a condo hotel unit was sold based upon its income potential, or if the unit owner was required to place the unit in the hotel rental program, or if the income and/or expenses of the hotel operation were being pooled among the unit owners, then the condo hotel offering was an offering of securities requiring registration. Since virtually all hotel condos being developed at the time had those precise requirements, the structure quickly disappeared.
The second wave of condo hotels
In 2001, having had considerable success with it as a second home investment vehicle in Canada, Intrawest asked the SEC for a "No Action" letter stating that condo hotels could be sold in a way that did not offend the 1973 Release. The SEC agreed in 2002, and by 2004 the condo hotel structure was back in vogue.
To achieve compliance under the "No Action" letter, the new breed of condo hotel offering provided very little information to prospective unit purchasers about the rental arrangement and none about the likely financial results of room ownership. Since nature abhors a vacuum, real estate investors, sensing that the condo hotel was a solid real estate play for income property at a lower price point than buying residential condominiums, and with a rental arrangement (albeit unknown) already in place, made up their own financial results.
They were, of course, wrong.
Most unit owners paid too much
By late 2005, it was clear that many unit purchasers were not enjoying the financial success that they anticipated and, as their stories were reported in the marketplace, condo hotels began to lose popularity among consumers. Largely unfamiliar with the economics of an operating hotel, unit owners were unhappy with the disparity between what they paid to the developer and the market value of their unit.
Financing for unit purchasers is no longer available
By late 2006, at the same time that the consumer purchasing market was becoming smarter, the emerging credit crunch essentially eliminated the availability of end user financing for condo hotel units. The condo hotel as an asset had always been characterized as a riskier loan than a second home financing, often carrying a 100 to 150 basis point premium to vacation home and timeshare mortgages. This rating had very little to do with the underlying credit of the borrowers, but was more a function of the unknown resale market for condo hotel units, coupled with the FDIC's unfortunate experiences with the first round of hotel condos back in the 1970s. In any case, these loans were subprime by definition and are now not available at any price.
200 projects stuck in the pipeline
While there are no official statistics, in early 2007, Smith Travel Research estimated that there were slightly over 200 condo hotel projects in the U.S. which were either in late pre-development stages or under construction. There were also many existing hotels which were in various stages of conversion to condo hotels at the same time, the owners of those hotels electing to use the condo hotel structure as an exit strategy.
Setting the stage: how typical condo hotels are structured
In the new, typical condo hotel structure, the condominium common property consists of the room floor corridors. The unit owners own the guest rooms. The developer or its successors own the public spaces (restaurants, spas, meeting spaces, etc.) and the back of the house areas. The condominium documents generally require the unit owners to fund their own debt service, taxes and FF&E, as well as a portion of the undistributed operating expenses, public space FF&E and common area expenses of the hotel. The unit rental agreements, which are generally additional agreements with requirements beyond those in the condominium documents, invariably have provisions restricting unit owner usage and requiring unit owners to provide working capital and make capital expenditures needed to meet specific hotel or, if applicable, brand operating standards. Most unit rental agreements are for terms of one to three years (securities concerns and the lack of meaningful alternative rental opportunities for the unit owners led to the short terms).
This is the structure that must be "unwound" and re-structured so that a workout can be accomplished. Sound complicated? It is.
Part 2: Critical differences between restructuring condo hotels and traditional hotels
It is important to note that there is nothing systemically wrong with the condominium hotel financing structure. It has its place in the permanent "tool box" used by developers and their advisors to structure hotel projects. However, in the current credit crisis, the structure provides impediments to permanent financing or exit that need remediation.
The basic strategy for working out condo hotels must be to "uncondo" them.
Why even good condo hotel projects are failing
In the current market, there are a number of solid assets which were structured as condo hotels during their pre-development phases, and generated enough unit pre-sales activity to get built. These hotels are now open or opening, and the developers are closing the sales of their pre-sold units to pay down their construction debt. However, because both the market for unit sales has dissipated and end user financing has disappeared, these projects now cannot sell out to new purchasers. And many of the existing pre-sold contracts are not closing, as the purchasers either cannot find financing or are electing to lose their deposit rather than close on assets of questionable value.
Developers in "take-out limbo" and unit owners in shock
The developers of these projects are left in "take-out limbo." No conventional financing lender will place a mortgage on the residual hotel (the unsold units and public spaces) because no one knows what it means to foreclose on part of a hotel, and no financial buyer will acquire the leftover parts in order to own pieces of a condo hotel from which there is no easily identifiable future exit. A developer that cannot sell out its units will not be able to pay off the construction loan. At the same time, unit owners that do close on their units are beginning to learn, in many cases, that the economics of the hotel business are different than the economics they expected when they purchased their unit.
The basic strategy for working out condo hotels must be to "uncondo" them.
Not your traditional hotel workout - the developer cannot be the workout entity
The basic strategy for working out condo hotels must be to "uncondo" them. Again, it is important to note that these hotels may be performing as well as originally projected by their developers. The problem they now face is that the existing condominium structure is preventing either a sell-out or a take-out. Absent some way to infuse new capital into these projects they will ultimately become economically untenable.
As with all workouts, there will be some marking of equity to market in the rationalization of the ownership structure, and the recognition that the original unit prices were not market value. The original developer risks securities class action litigation if it attempts to buy back the units it sold from the same buyers at a discount to the price it sold them for. So, in most cases, the workout entity for this type of workout cannot be the original developer.
A third party purchaser is required: risk and opportunity
A third party purchaser will be required to drive the workout plan. Because there are no financing and sales exits available for the third party if it fails to "uncondo" the property, the value of the remaining units must be adjusted by what appraisers would call a "marketability discount," and reduced to justify the risks taken by the purchaser. In order for the third party to make a risk justified return, the discount to fair market value (not the unit purchase prices) will need to be very substantial.
The fundamental principles of hotel workouts must be observed, but with special consideration to the condo hotel structure.
Five Rules for getting all stakeholders aligned in the workout
The fundamental principles of hotel workouts must be observed, but with special consideration to the condo hotel structure. The workout plan must offer some hope to all stakeholders.
Converting to a traditional ownership structure the property can be financed
The basics of the workout plan revolve around terminating the condominium. All condominiums are essentially corporations and can be terminated based on a) state and local laws on termination and b) the termination provisions of the condominium documents. In most cases a supermajority of the units must vote in favor of terminating the condominium corporation. The condo hotel workout plan is centered on convincing a sufficient number of unit owners that terminating the condominium is the only hope they have to preserve any asset value in their units, so that when combined with the units purchased by the workout purchaser, the supermajority number of units will vote for termination. Once the hotel has been converted to a unified and more traditional ownership structure, it can be financed or brought to market on a conventional basis.
Stop selling and closing on units: convincing the lender this is best
The first step in this process is to stop selling units. If there are units under contract that have not closed, the lender and the developer need to agree not to close those contracts. While there are virtually no sales being made in the current market, whatever sales activity is occurring should cease immediately. It may seem intuitive that the sales process needs to end, but it should be recognized that the construction lender's first instincts will be to insist on closing existing contracts as a way of getting paid down and will push to sell more. That lender will have to be convinced that it will be more likely to receive full payment on the loan by permitting the termination of the condominium and the conversion to a traditional ownership structure. Again, as is the case with the unit owners, it will be difficult if not impossible for the developer who was the borrower to effectively manage that process with the lender.
Equity write downs: convincing unit owners this is best
The heavy lifting in this workout process clearly will be dealing with the unit owners. A group of frustrated people need to be told that they made substantial errors in their hotel investment analyses, and that the only chance they have for an exit is an equity write-down now in exchange for hope of a recovery later. This process will be difficult, time-consuming and frankly, painful, as the unit owners will have to work their way through the stages of denial and anger on the way to acceptance.
In all cases, the workout plan should include some of the amenities that presumably caused these individuals to buy units in the first place. For example, extending the same owner use price that was available under the unit rental agreements for a few extra years, or providing ownership recognition to these people are not overly expensive gestures that may make the bitter pill of financial disappointment a bit easier to swallow.
What should the new structure look like? It depends on units sold.
There are several options for the replacement structure that should be considered for the condo hotel workout, largely dependent upon the number of units which have been sold as a percentage of the total units in the hotel. If only a small number of units have actually been sold and the transactions closed, it may be advisable, depending upon the mood of the unit owners, simply to buy them back.
If the majority of the units have been sold, then it may be preferable to restructure the entity as a partnership with the unit owners becoming limited partners. There are certainly a variety of structures in between those extremes that may be deployed, depending upon the individual project circumstances. At this point in the process, the tools used in traditional workouts, such as carried interests, preferred returns on new money, and the like, can be used to minimize the de facto write-downs to make the offering one that will get the unit owners over the goal line. A lender or potential purchaser embarking upon this type of workout should consult their hotel lawyers and advisors about both local legal requirements and the correct approach for their particular situation.
"Key" money -- bringing in a brand
Since new money will be needed to accomplish these workouts, sources of funds need to be identified. In addition to the normal equity sources, consideration should be given to bringing a brand into the workout mix, and requiring either "key" money or equity as the price of brand expansion. One of the better attributes, at least for workout purposes, of the most recent condo hotel development boom is the fact that most of these projects are not branded, as the major lodging companies avoided them. In the current economic climate, the brands recognize that the easiest path to increased distribution is rebranding rather than new construction, so key money should be available . The timing of the introduction of a brand into the workout process will need to be carefully evaluated, however, as most of the major brands will not want to be associated with the "uncondo-ing" activities.
Does a condo hotel workout sound complicated? It is, or anyone would be able to do this work and we wouldn't call them "workouts!"
But consider that a carefully crafted plan to fix a broken condo hotel
can unlock considerable value in the kind of hotel asset that you would
like to include in your portfolio. The work is time consuming and complicated,
but the opportunity is unprecedented.
Butler is one of the top hotel lawyers in the world. GOOGLE “hotel lawyer”
or “hotel mixed-use” or “condo hotel lawyer” and you will see why.
He devotes 100% of his practice to hospitality, representing hotel owners,
developers and lenders. Jim leads JMBM’s Global Hospitality Group®—a
team of 50 seasoned professionals with more than $40 billion of hotel transactional
experience, involving more than 1,000 properties located around the globe.
In the last 5 years alone, they have brought their practical advice to
more than 80 “hotel-enhanced mixed-use” projects, a term Jim coined to
fill a void in industry lexicon. This term describes one of the hottest
developments in real estate-where hotels work together with shopping center,
residential, office, retail, spa and sports facility components to mutually
enhance the entire project’s excitement and success. Jim and his team are
more than “just” great hotel lawyers. They are also hospitality consultants
and business advisors. They are deal makers. They can help
find the right operator or capital provider. They know who to call and
how to reach them. They are a major gateway of hotel finance, facilitating
the flow of capital with their legal skill, hospitality industry knowledge
and ability to find the right “fit” for all parts of the capital stack.
Because they are part of the very fabric of the hotel industry, they are
able to help clients identify key business goals, assemble the right team,
strategize the approach to optimize value and then get the deal done.
Jim is the author of the Hotel Law Blog, www.HotelLawBlog.com.
He can be reached at +1 310.201.3526 or firstname.lastname@example.org.
|Also See:||Condo Hotels: Who Owns What? Who Controls What? Who Pays for What? / Jim Butler / July 2006|
|Workouts and Special Servicing for Hotel Mortgage Loans: What Is So Different About Troubled Hotel Loans / Jim Butler / November 2008|