Condo-Hotels: How Developers and Owners' Associations Can Avert a Hotel Implosion
By Irvin W. Sandman and Kelly C. Aldrich
January 17 , 2006
A full-page article entitled “It’s a Hotel. It’s a Condo. No, It’s Both!” was published in the business section of USA Today in September, 2005. Hoteliers and developers are not accustomed to seeing the lodging industry’s business trends make national news in the general press. The USA Today article clearly demonstrates that the condo hotel rage is in full swing.
The article also plants seeds of concern. It notes that officials in Hollywood, Florida are reviewing hotel condominium projects totaling 2,500 units. With the exception of one traditional hotel application from Marriott, the article states, all the hotel-related applications before Hollywood officials are for hotel condominiums.
Why are so many hotel projects condo hotels? Are projects being pursued that should not be completed? If a borderline condo hotel is completed and sold out, how can its owners’ association or the developer (if he is still in the game) help avert an implosion?
Why are so many current hotel projects condo hotels?
In contrast to a traditional hotel developer who normally faces many years of work before a return on capital is expected, a condo hotel developer expects to sell some or all of the guest rooms to individual unit owners upon the completion of the hotel. In essence, the condo hotel developer is able to realize a sale of much of the hotel several years earlier than the developer of a traditional hotel. Also, construction loans for condominiums are often cheaper and easier to obtain than hotel construction loans—the developer benefits from these differences, as well. And if the condo hotel is managed by a major branded manager, the units typically sell for a premium over other condominiums. In short, the condo hotel developer expects (and has been achieving) higher rates of return than those achievable by traditional hotel development.
Are projects being pursued that should not be completed?
Because the return on investment expectations for condo unit owners may be well below the expectations for a hotel developer, one can conclude that many condo hotels are being built that could not be built as hotels. But at some point, even the lowered expectations of condo unit owners might not be met. What is this point? Most would agree that this point is clearly reached when revenues from the hotel’s commercial operation do not even cover the expenses of the operation. At that point, the unit owners likely will receive no return on the rental of their units. Certainly, one would then expect to have many angry unit owners. Short of that, if the net return to a unit owner is well below what owners of traditional condominium units in the vicinity are receiving for simple, weekly rentals, then one would also expect to have at least some angry unit owners.
If a condo hotel developer’s projections show that the net income to unit owners is unlikely to meet these reasonable investment expectations, then the developer should question whether the hotel should be built. This questioning process might put the developer to the test. Sales projections might show that the units will sell out quickly and for a nice profit. This is a powerful motivator that can lead the developer to ignore the unit owners’ reasonable expectations. Industry observers believe that, as a result, many condo hotel projects that should be declined are currently being considered and pursued.
If a borderline condo hotel is built, how can its owners’ association or the developer help avert a litigation implosion?
The condo hotel developer should recognize that, if a development is inevitably going to produce angry unit owners, the short-term profit is likely to be eaten up quickly by later litigation. As we have written in other articles, condo hotel unit sales must be carefully structured and conducted to minimize the unit buyer’s argument that the sale constituted a sale of a “security” under the securities law. Please see "The Condo-Hotel: When Might the Securities Laws Apply?" Even if a developer does its best to avoid the securities minefield, the risk cannot be avoided entirely. The reason is that there is always pressure on the sales people to make sales. Buyers typically do, in fact, want to hear about projections. Industry analysts are finding that sales people often bend to this pressure, despite instructions and training to the contrary, and provide the buyers with oral statements and forecasts that constitute securities violations. And even if the sales person does not do so, an angry buyer who is getting a very poor return could well “remember” oral statements to support a securities law claim.
A satisfied owner typically does not sue to get out of the deal. In contrast, owners who are angry and regret their investments are likely to find a way to sue for rescission under the securities laws. Obviously, then, the best way to avoid a condo hotel litigation “implosion” is to pursue only well-conceived projects that have strong prospects of meeting the reasonable expectations of all stakeholders, including unit owners.
As stated earlier, however, most people in the hotel industry have a strong sense that many condo hotel projects currently being pursued are likely to fail to meet owner expectations. Assuming that the train cannot be stopped and that questionable projects are completed and sold out, what then? Some projects, possibly, are so ill-conceived that the path to implosion is inevitable. But it is very likely that many projects only have an uncertain future—time will tell if they will meet owner expectations or ultimately implode. For the “borderline” case, there are things that can be done to avert a litigation implosion.
Completed condo hotel projects often end up in one of two configurations. In the first configuration, all of the hotel’s commercial areas are turned over to and run by the condominium homeowners’ association (HOA). In the second configuration (which is found in many of the more recently-developed condo hotels), the developer retains ownership of and runs the commercial areas. In each case, the suggestions for avoiding a litigation implosion are similar:
1. Employ best practices. The party responsible for the hotel’s commercial elements— whether it be an HOA or developer—essentially takes on the role of the hotelier. The hotel industry is a mature industry, and extensive best practices have been developed in all aspects of the business. The HOA or developer must become as familiar with these practices and know-how as the average owner of a similar hotel in today’s hospitality industry. In fact, the HOA likely is required to employ these practices in order to comply with the duty, imposed by many State condominium statutes, to run the hotel with “ordinary and reasonable care."
2. Position and brand the hotel appropriately. If the hotel is an upscale or luxury product, with significant banquet space for business meetings, the HOA or developer include consideration of the brand for the hotel’s commercial operation. If the HOA is in charge, applicable condominium statutes or simply contract expiration can present the opportunity to replace the hotel’s brand or management. In that event, the HOA should measure variables between branded, unbranded, and third-party management options, seek out appropriate brands, branded managers, and independent management companies, and request them to bid. The HOA should then negotiate the contract with skill and knowledge of an experienced hotel owner.
3. Engage appropriate consultants. The HOA or developer should assess its expertise with cold objectivity. If there are holes in needed experience or expertise, then the holes should be filled by engaging appropriate consultants. Specialized assistance is available in the industry for everything from positioning, to insurance, to purchasing, to yield management.
4. Manage the branded manager with an asset manager, as appropriate. The oversight of a branded manager is, itself, a refined skill. If experience with this skill is lacking, then the HOA or developer should consider what similarly-situated hotel owners do. Over the last decade, the industry has seen significant growth in companies that serve as “asset managers.” These companies take on the responsibility of overseeing branded managers and getting the most out of their performance. Employment of a capable asset manager could make the difference between a performing and a nonperforming asset.
How can legal counsel help?
The rewards of condo hotels in the current market environment are hard to resist. Given the risk of a litigation implosion, developers should carefully consider all of the long-term risks, as well as the rewards. And if a borderline project is completed, the stakeholders, whether the HOA or the developer, must employ best practices of the industry. Experienced counsel can assist in analyzing the risks, can help identify and engage appropriate branded managers, consultants, and asset managers, and can review policies and procedures to ensure that hotel industry best practices are employed.
For the complete, comprehensive article on the issues, including a review of the applicable law imposing duties on homeowners' associations, see "Condo-Hotels: How Developers and Owners' Associations Can Avert a Hotel Implosion".
Please feel free to contact Irvin W. Sandman (206.340.9641 or isandman@grahamdunn.com) or Russell C. Savrann (206.340.9665 or rsavrann@grahamdunn.com) for more information.
