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Condo Hotels — New Trend or Flash In The Pan

By Robert M. Chasnow

During the 1970s and early 1980s, a few dozen condo hotel resorts were seen on some Hawaiian shores and Colorado ski slopes. Some were even SEC registered and came complete with an accountant’s table of revenue and profit projections, but disappointing investor returns, lawsuits and the Tax Reform Act of 1986 largely snuffed the market.

However, in the past five years, condo hotels have reemerged as a hot spot in the resort and hospitality real estate market with a list of more than 100 U.S. projects – mostly in Florida, Colorado and Hawaii (based on recent compilations from on-line sources). Condo hotels have also emerged in large urban areas such as Miami, Chicago and Las Vegas.

Two Main Types of Condo Hotels

Developers have created two main types of arrangements that people associate with a condo hotel. The first type (type 1), which will be discussed in more detail in this article, consists of a hotel building with units (keys) which are individually owned but rented out by hotel management in the normal course of regular hotel operations.

With this type of condo hotel, a guest at the hotel would be unable to distinguish their hotel room, or any other aspect of the hotel, from any other hotel property of the same brand. The second type (type 2) is often referred to as “hotel residences,” “condominium hotel residences,” or “mixed use hotel and attached condos.”

Type 2 consists of a hotel with an internal section; for example, certain floors, a separate wing, or attached building, which may or may not be marked, that have been sold as condominium units for first or second home residential purposes but with rental program options. Often these units are constructed in the layout of true apartments with two or more bedrooms and baths, and a full kitchen.

Owners of these condominium units have access to hotel services and amenities; for example room service and a large fitness facility, but often have a degree of separation from the hotel itself. Naturally, projects are designed and executed in a range of gradations combining elements of the two types, but the above-mentioned two types are the main two trends in condo hotels. This article will focus on the type 1 condo hotel.

Legal Steps for Type 1 Condo Hotels

For creating a type 1 condo hotel there are four main legal steps (assuming proper zoning and entitlements):

1. Create a condominium regime. If one assumes (a) the approved use or zoning of an existing building is a hotel use, and (b) no environmental, historic landmark, or political impediments exist, then most likely the key legal step will be to impose a condominium regime on the hotel spaces and rooms.

In drafting the condominium governing documents, and subject to the state condo laws, (a) take into account the special features and operations of running a condominium with owner use at the same time as operating a full service hotel and (b) provide for, in many cases, the developer/operator’s need for long-term control over the condominium.

2. Determine whether the developer wants to offer the condo hotel units as a federal security or non-security and proceed accordingly to compliance with the requirements either for a securities offering or a non-securities offering.

3. Register the condominium regime, whether to be offered as a security or not, under the state’s condominium registration law, which most U.S. states have in place.

4. Market the property with duly licensed and trained marketing, sales and rental staff.

Federal Securities Issues: Registration or Private Placement

For many developers and hotel companies considering this product type, step two above – deciding whether or not the condo hotel should be offered as a federal security or not – involves new issues and weighing factors that are hard to measure. Under the heading of “security,” condo hotel units may be offered either (a) pursuant to the “private placement” exemption from registration under the Security Act of 1933, or, in fact, (b) as a fully filed and registered security.

At first look, in concept, a security offering by private placement to accredited investors is attractive from the vantage point that it allows the sponsor to make sophisticated financial projections of income to the purchasers/investors and generally places the offering on an investment footing rather than on a personal use and enjoyment footing.

On the other hand, projections, even those of third-party experts, tend toward optimism. When projections are not met, problems arise in the form of lawsuits and liability against the sponsor, sales agents and related professionals including the maker of the estimates.

A series of such suits effectively ended the cluster of condo hotel offerings (mainly from resorts located in Hawaii and Colorado) from the period of roughly 1977 to 1985. Only if financial projections, and the sales process generally, are carefully controlled and truly conservative would risk of downstream trouble be minimized.

In considering the question closely, there may be little advantage to an SEC registration compared to a private placement because the main advantage of registration over private placement would be that the offering could be made to the “general public” without regard to minimum income/net worth standards.

However, where a single unit in a condo hotel will be priced probably in the high six to low seven figures, very few who are not accredited investors would be qualified at such prices. Although in theory, some projects may be candidates for private placement or a full securities registration, virtually all condo hotels offerings today are offered as a non-security.

Considerations for a Developer/Hotel Company Who Wishes to Offer Real Estate as a Non-Security

The U.S. Supreme Court has held that when a buyer “buys” something from or invests money with a seller who has represented that the buyer will profit from the seller’s post-sale efforts, the transaction has the hallmarks of a securities transaction. Mainly by means of a 1973 policy statement based on such U.S. Supreme Court precedent (Guidelines) and two recent “no action” letters, the SEC has marked a path which if closely followed could result in an offering of condo hotel units that would not be considered a security under federal law.

In these SEC issuances, it consistently draws a distinction between the sales program and agents, on one hand; and the rental programs and agents, on the other. The Intrawest no action letter, cited by industry lawyers as the leading statement of relevant standards for condo hotels, posits strict separation between the sales process and the process of entering into a rental agreement, including separate offices for sales versus rentals and no employees in common. We have derived the following 10 guidelines from these sources:

1. No emphasis on returns. The marketing and sales program including but not limited to oral and written statements of, or distributed by, the sales agent, may place no emphasis on economic benefits the purchaser might receive, such as a return on their investment from rental of their condo hotel unit, the managerial efforts of the affiliated manager/operator of the condo hotel, any tax benefits, or appreciation from the resale of the unit. The sales agent should not provide any rental information including but not limited to rental history or rates of comparable properties or units in the area.

Based on the above point, certain applications are to be encouraged and others to be avoided. Among practices to be encouraged are: (a) the condo hotel should be presented to prospects as a luxury hotel ideal for vacations and other part-time uses; (b) sales literature and publicity should be carefully prepared and reviewed by counsel so as not to describe the units as investment opportunities with economic benefits to be derived from participation in a rental program or otherwise from management’s efforts; and (c) sales personnel should be carefully trained and supervised to ensure compliance with the guideline including specific scripts, frequently asked questions, and consistent messages across media and methods.

Among practices to be discouraged are: (a) no representations should be made to prospective purchasers in the condominium program documents or otherwise with respect to expected or projected revenue from any of the condo hotel units; (b) no statement express or implied should be made that the units are an investment opportunity; and (c) no rental information can be provided by the sales agent.

2. Generally no limit on occupancy established in sales documents. No limits on occupancy by the owners of their units can be placed in the sales documents other than those established by law.

3. No emphasis on rental returns. The marketing and sales program, including but not limited to oral and written statements of, or distributed by, the rental agent, may place no emphasis on economic benefits the purchaser might receive, such as a return on their investment from rental of their condo hotel unit or the efforts of the rental management company.

4. Single statement on rental. According to Intrawest, advertising of rental management services is limited to a single sentence to appear, at the developer’s choice, in some or all sales literature: “Ownership may include the opportunity to place your condo hotel unit in a rental agreement.”

If a potential purchaser directly inquires to a sales person by email or other means as to the availability of rental services, only a rental agent may reply. The prospect’s inquiry may arise in several ways and would be handled according to the way in which the inquiry arises. Regardless of what point in the sales process the inquiry is received, all responses should be provided by a rental agent.

5. No rental projections. During any discussion between a prospect and a rental agent, the agent will not use oral or written statements with projected rental information. No projections or representations of any kind may be made as to the potential profitability of a condo hotel unit placed in the hotel rental program.

The rental agent may use publicly available rental information such as rental history and rates of comparable units in the area. Any information provided to prospective purchasers must be in form of raw data that has not been modified by sampling, statistical analysis or by any other means. However, any such statement or document containing permitted information and provided by the rental agent to the prospect is only allowed to be provided in response to the prospect’s specific inquiries.

6. Timing of sale and rental arrangements. No rental agreement contract may be entered into before a contract of purchase is signed for the unit, but a rental agreement contract can be entered into between the time a unit purchase agreement is signed and a deed is conveyed; the effectiveness of the rental agreement must be contingent upon the closing of the sale of the unit.

7. Voluntary choice on entering rental arrangements. The choice by a purchaser must be a voluntary one to enter into a rental agreement for the sponsor’s rental program; the prospect must be allowed to purchase a unit even if the prospect does not wish to subscribe to the rental program.

8. No rental pooling. The rental agreement may not include a provision for pooling or aggregating of rents and sharing pooled revenues among the unit owners. Sharing of revenues is a hallmark of a “real estate security” and must be avoided.

9. Rental program limitations. Reasonable limits on occupancy by the owners with respect to their own units are allowed in the voluntary rental program agreement.

10. Permissible term on rental arrangements. Intrawest provides for a rental management agreement with a term of up to five years. The Marco no action letter allows the purchaser the option of signing a rental management agreement for a length of five or ten years. Neither letter provides detail on renewal provisions.

The guidelines described above are derived from a combination of the Guidance and the no action letters with a minimum of detail added that is not found directly in the sources. Because no action letters are not considered by courts or by the SEC as binding precedents (except with respect to the party requesting the letter), these guidelines are not necessarily indicative of the SEC’s position should it launch an enforcement action.

However, the closer this framework is followed in a reasoned and conservative fashion, the greater the chance an SEC enforcement action or a private individual or class action brought against such a program would not prevail. This area is evolving, without settled judicial precedents; thus, close adherence to the sales and marketing guidelines described based upon advice from experienced counsel is well advised.

Mr. Robert Chasnow is an attorney and partner in the law firm of Holland & Knight LLP and is a senior member of the firm’s Resort, Timeshare and Hotels International Practice Group. Mr. Chasnow is experienced in the laws affecting condo hotels. For more information, see www.hklaw.com/timeshare.

Mr. Chasnow can be reached at robert.chasnow@hklaw.com or call 202-828-5004. He would like to thank Christina M. Pederson, a law clerk in the Washington, D.C. office of Holland & Knight, for her assistance in writing this article.