Condo-Hotels, Expanding the Options for Lodging Development

By Anwar Elgonemy – Vice President, Jones Lang LaSalle, San Francisco

How do Condo-Hotels Work?

By no means a novelty, the condo-hotel model is showing resurgence due to rising condo prices and the current “Midas Touch” perception of residential real estate.

The most successful condo-hotels are those built as hotels first and then as condominiums second, as public space is needed to sell hotel rooms, while unit owners share in the popularity and success of the lodging operation. Alternatively, many deals have floundered where the developer built the tower as a condominium, and later sought to create a rental program and piece together the public space and amenities.

For a hotel to operate smoothly when a different person owns each unit, it is imperative for a management company to have a contract with the owners. The management company can be either the developer of the property, or a group directly related to the developer.

However, more increasingly the management company is a third party hotel operator, such as Hilton, Hyatt or Four Seasons, among others, that the developer and unit owners agree should manage the guest rooms for the unit owners, and the facilities (such as food & beverage outlets, recreational amenities and meeting space).

The industry is currently shifting its strategy toward the outright sale of the hotel management opportunity to nationally affiliated hotel companies, operating these properties similarly to that of a conventional hotel operation. This has been achieved by separately deeding all of the hotel-like features mentioned earlier as individual condominium units; these commercial condos are then sold to a hotel operating company. Along with rental agreements from the individual condo buyers, this allows the hotel operator to effectively manage the property as a hotel.

In order to place a unit in a rental program, a management and rental agreement is first signed between the unit owner and the hotel management company. This agreement provides for a number of variables, primarily:

• A portion of the revenues received from the nightly sales of rental units flows through to the condo owners, usually a 50-50 split, after a 10% Service Fee.
• The hotel management company/operator retains the remaining portion of the rental revenue stream.
• A Usage Agreement is implemented between condo owners and the operator, providing for the implementation of an FF&E reserve that is maintained by the hotel company.
• The FF&E furnishing packages within rental condos need to conform to certain standards. Failure to comply with such standards may either require immediate refurbishment at the unit owners’ expense, or the expulsion of non-conforming condos from the rental program.

Responsibility for the maintenance and repairs of common space is allocated among condominium unit owners, based on their pro-rata shares. A Homeowners’ Association (HOA) is usually set up to retain ownership of such areas and oversee the collection of dues from unit owners. These dues typically cover reserves, common area maintenance, and property insurance and utilities expenses.

Property taxes are usually paid for directly by the condo owners, and the hotel manager pays for its costs of operations, such as salaries and other direct hotel expenses.

Additional particulars pertaining to the successful operation of condo-hotels are highlighted as follows:

• Unit owners should be restricted to a maximum of eight weeks of personal use during the year.
• Rental contracts renewable on an annual basis.
• In order to guarantee availability for owners, a 60-day notice of intent to occupy a unit must be given by individual owners.
• Quarterly statements showing a detailed breakdown of all unit activity and owner’s account activity should be issued to unit owners.
• To ensure an equal distribution of bookings of the units in the rental program, a rotational booking program should be used.
• If there is an unusual or extraordinary event, the hotel guest should be charged for damage to the owner’s unit. Normal wear and tear is to be anticipated and should be the responsibility of the unit owner and replacements should be made from the unit’s reserve account.

Different Perspectives

The Condo Owner For the condo buyer, these types of developments can offer enhanced financial returns when owners choose to place their units in a rental pool. Individual owners usually can put their units in the hotel-room rental pool while they’re not using them and get a portion of the proceeds. Better yet, they get access to the same amenities and services as hotel guests.

By capitalizing on a hotel’s national affiliation, reservation system, brand recognition and management expertise, unit owners are more likely to receive a higher level of rental income through a rental pool agreement with a recognized professional operator, despite having to share a portion of their units’ revenues.

The Condo Developer The condo-hotel structure offers a number of potential benefits for the developer. First, it provides a method to help finance the development of hotels; the sale of units gives the developer an assured source of revenue to repay a portion of the construction loan upon the completion of the hotel, and the closing on the sale of the units. Additionally, a developer can benefit by marketing the hotel amenities to a buyer.

Developers of successful projects generally can obtain construction financing without reaching the lending threshold of 50% presales for a planned condominium development (along with a 20% down payment on the loan amount). Developers of condo-hotel projects are attracted to this development approach due to their ability to quickly “monetize” the management function of the property. That is, the sale of the hotel management opportunity becomes similar to another condo unit that can be sold for immediate profit.

If the hotel management opportunity is sold upfront during the sell-out phase of the residential condominiums, the developer may be able to receive rental revenues from the completed (and sometimes unsold) units being rented to hotel guests.

In developing this tier of property in the U.S., it is important to note the potential for securities law issues to arise out of the sale of condo-hotel units. The sales of condominiums may be deemed to be the sales of securities if certain conditions stipulated by the SEC exist at the time of sale.

However, in order to avoid coming under the scrutiny of any securities agencies, or being obligated to register under the Securities Act of 1933 (both costly and time consuming), developers may take several measures while planning condo-hotel projects. These encompass:

• Refraining from setting rental revenue expectations for prospective buyers – the responsibility of generating financial projections should lie with the interested purchasing parties.
• Instituting a third-party agent to oversee the sales of condo units and distribute rental program information, thereby relieving developers from directly promoting rental programs.
• Permitting condo owners to either rent their units to third parties, or not rent their units at all.
• Allowing owners to appoint a rental management company of choice to manage the rental of their units. Although selecting a manager other than the condo-hotel’s management company would be counterproductive in attempting to effectively maximize rental income.

The Condo Manager/Operator This type of development also provides an interesting approach for hotel operators. In some respects, it is similar to owning a hotel outright, because the operator does own some real estate (the commercial condominium units appurtenant to running a hotel); however, individual condo buyers own the actual guest rooms. As such, the overall cash investment by the manager is not as great as that found in typical hotel deals. To a certain extent, the manager is essentially granted a long-term management contract, because a long-term management relationship is expected to exist with the condo owners.

What Are the Benefits of Condo-Hotels? The investment-oriented condo-hotel concept has numerous advantages such as greater product consistency, fewer ownership conflicts, as owners do not live in the units, and a more even distribution of revenues since units are a regular part of the hotel room inventory.

The following table highlights the pros and cons of condo-hotels from the standpoint of owners, traveling consumers (guests), developers and manager/operators.

PROS & CONS Condo Owners

Pros

• Fewer owner-management conflicts with respect to unit consistency and revenue distributions
• Defrayed mortgage costs to buyers
• Larger units are more appealing to buyers
• Vacation-hungry consumers are turning toward condo-hotels for refuge
• Standardized furniture packages already incorporated into the price
• The rental option allows owners to take in extra dollars rather than boarding up their apartments for six or more months a year, and gives them access to many hotel perks
• Tax breaks associated with mortgages and depreciation, as well as the cash flow from renting-out the units, have made condo-hotel units a profitable venture
• Owners share the rent revenue with the hotel, a feature that can help them pay-off a mortgage sooner

Cons

• Ownership of common areas
• Product homogeneity
• Low returns in highly-priced markets

Traveling Consumers

Pros

• Offers an experience identical to that of an upscale resort hotel, in terms of services and amenities Room availability during peak periods
• Availability of a wide variety of services only found in hotels

Project Developers

Pros

• Immediate cash inflows from the sale of condo-hotel units
• Initial capital investment in the land and hotel building is recovered rapidly (with a profit) as the individual units are sold
• Developer may retain the right to act as the agent and collect a commission should one unit owner wish to sell to another individual eventually
• Mixed-use properties like condo-hotels help solve the riddle of financing: they are attractive to lenders because a significant portion of the initial development costs can be recouped up front from pre-sales
• Way to raise capital without going to a traditional lender
• It’s often easier to get financing for condo-hotels than pure-play hotels
• Big-name hotel companies such as Four Seasons, Fairmont and Ritz-Carlton are eager to accommodate the condo-hotel model
• If the developer has its own management company, there will be continuing income from the management fee for room rentals, as well as income from food & beverage and recreational areas
• Potential for exit strategies (not yet fully proven in the marketplace)

Cons

• Reluctance of chain-affiliations to professionally manage smaller-sized projects
• Conflicting development objectives; there can be reduced control over future expansion because of the desire of the current individual owners to prohibit it for aesthetic reasons, or from a fear that their income might be diluted as more hotel units are added
• Unless the developer-owner agreement prohibits it, there could be reduced revenue to the developer if all owners decide to use their units only during the peak season
• Complex accounting issues
• Issue of unregistered securities in the U.S.
• If the units do not sell readily, the developer must carry the burden of the losses involved until all the units are sold

Property Managers/Operators

Pros

• Amenity combinations increase unit sales prices and hotel operating income as they spread costs over a larger base
• Hotel company lending management expertise
• Even when the hotel and condos are in separate adjacent buildings, the combination facilitates financing, management, marketing and amenities
• Condo-hotel units offer additional room inventory
• Marketing costs are significantly lower than for time-share units

Cons

• Often excessive start-up and operating costs
• Any appreciation in the value of the condo units accrues to the individual owners
• Reduced opportunity to use leverage
• Must split hotel room revenues with owners
• Possible loss of contract

Conclusion

Although still unknown how units will sell a second or third time or during periods when hotel operations are trending the wrong way, condo-hotels currently offer a means to finance construction of new properties. There is a large amount of underutilized hotel portfolio in certain parts of the U.S. and numerous hotel owners are interested in converting part or all of their properties to condo-hotels.

There is little doubt that condo-hotels are an intriguing approach to the development of lodging properties, and as its use becomes more common in the market, levels of understanding by both the lodging industry and the condo-buying arena are projected to increase.

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Based in San Francisco, Anwar Elgonemy draws on over 10 years of lodging investments experience. Since joining Jones Lang LaSalle in 2001, he has been involved in hotel advisory, transactions and debt placement assignments. Elgonemy holds an MBA from Thunderbird and a Bachelor of Science from The Glion School in Switzerland.

Contact: Anwar Elgonemy Vice President Jones Lang LaSalle One Front Street, 3rd Floor San Francisco, CA 94111 tel (415) 456 1709 fax (415) 421 7736 Anwar.Elgonemy@am.jll.com