| If the condo-hotel project is |
In 2002, the Securities and Exchange Commission (SEC) issued a significant “no-action letter” to Intrawest, which at the time was the leading developer of mixed-use ski resort villages in North America. The letter contained specific guidelines, or “safe harbors,” for how Intrawest could market and sell condo-hotel product without engaging in the sale of a security under U.S. securities laws.
Many developers viewed the letter as the SEC guidelines for how to develop condo hotels, and the result was a boom in the industry. Successful condo-hotel developments popped up at the base of ski areas, at beach resorts, and in many metropolitan areas.
The boom went bust in 2008 because many of the condo hotels were unable to close on unit sales when prospective buyers faced the economic challenges of the Great Recession. Now, more than three years later, from Miami to Las Vegas, many of those same condo-hotel projects remain broken.
Today, developers, investors, and lenders can salvage condo-hotel projects through conversion of the project to a traditional hotel, or through the sale or rental of the condo hotel units as multifamily units.
The condo hotel looks and feels much like a traditional hotel, with a front desk and guest rooms, as well as various facilities and services, such as shops, bars, restaurants, conference space, a spa, and recreational facilities. Some condo-hotel projects are affiliated with a national hotel brand.
But condo hotels differ from traditional hotels in one fundamental respect: the ownership of the guest rooms. Whereas at a traditional hotel a single entity owns all the guest rooms, a condo hotel is developed with the intention of selling each of the individual guest rooms to a different purchaser. The result is numerous owners—an important distinction in the context of repositioning broken real estate. It is far easier to reposition a distressed asset with a single owner than one with multiple owners.
The Recession Created a Wary Purchasing Pool
| South Beach, Miami. The recession hit the travel industry particularly hard. |
Why did the condo hotels fail to flourish as their developers, lenders, and buyers hoped and expected? Although some condo-hotel projects may have been misconceived or structured improperly and would have been doomed even in a strong economy, many failed solely because of the perfect storm brought on by the recession.
The economic slump caused many buyers to reconsider their decisions to purchase units in a condo hotel. Some buyers could not, or thought they could not, afford ownership of a unit on the terms and conditions to which they had agreed—understandable for buyers who experienced or feared the loss of their jobs or a significant decrease in the value of their savings. Other buyers, even those who could still afford their units, questioned the value proposition, wondering whether their units were going to be worth the agreed-upon purchase price and whether they would increase in value.
Buyers’ wariness was exacerbated by two other factors. Lenders were no longer willing to make condo-hotel loans on the same terms as traditional loans for a second home. Using Fannie Mae and Freddie Mac guidelines as cover, the lenders increased interest rates and decreased loan-to-value ratios and length of terms. In short, the cost to a purchaser of financing a condo- hotel unit increased dramatically. In many cases, no financing was available even if the purchaser was willing to proceed with the purchase.
The recession also hit the travel industry particularly hard. Occupancy and rates plummeted to the extent that anticipated rental income appeared much less certain, leaving prospective owners worried that expected revenues might not cover their costs of ownership.
In the face of these factors, many buyers considered walking away from their contracts, even if they faced forfeiting sizable earnest-money deposits.
In response to the crisis, many developers and their lenders reacted poorly and made questionable decisions.
Refusal to Negotiate Resulted in Fewer Closings
In many cases, developers did not properly perceive the lack of commitment from buyers and placed far too much weight on the value of their “firm and binding” contracts and earnest-money deposits. Just as important, many did not appreciate the time, money, and effort required to enforce their contracts. As developers completed construction and notified buyers it was time to close on their units, many buyers asked to be released from their contracts or informed the developers that they could not (or would not) close. Aggressive buyers went on the offensive, suing developers for violation of the Interstate Land Sales Act, federal securities laws, and state real estate laws and requesting rescission of their contracts and return of their deposits.
Some developers and lenders understood the climate, reacted quickly and decisively, and were able to close many of their contracts. They negotiated reduced purchase prices and other concessions early in the closing process and, perhaps most important, while buyer financing was still available. In many cases, the momentum from these initial closings led other buyers in the project to follow suit and close on their units.
On the other hand, many developers and lenders who refused to renegotiate now find themselves in a challenging situation. In many cases, these developers or lenders own 60 to 100 percent of the units in their condo hotel, with loans well past maturity and little hope of payment anytime soon.
Two approaches are most popular among developers and lenders dealing with these broken condo hotels: retaining the condo-hotel structure while changing the manner in which the property is marketed and operated, or converting the condo-hotel project to a fractional product. Both approaches have their drawbacks.
One Solution: Cut Prices and Reduce Services
After spending a year or two unsuccessfully trying through litigation or other means to compel buyers to close on their units, many developers and lenders have decided to retain the existing condo-hotel structure, but with an enticement for buyers. This approach generally relies on purchase price cuts and reduced hotel services to lower the overall cost of ownership of the unit. It also often involves one of two changes to branding:
- branding an unbranded condo-hotel project with the hope that a brand and a central reservation system can lead to higher occupancy and rental rates, and thus higher revenue to offset the cost of ownership; or
- removing the brand from a project intended to be branded in order to reduce costs through reduced services and the elimination of franchise fees and higher hotel management fees imposed by the brand.
The problem with those approaches is that they fail to address the fundamental problem—the lack of availability and the corresponding increase in the cost of condo-hotel financing that has rendered the expense of ownership too high for prospective buyers. In theory, a developer or lender could reduce the price of the condo-hotel unit enough to solve that problem; however, so far, few developers or lenders have been willing to make dramatic price cuts.
Another Solution: Divide Units and Maintain Services
In the other approach, developers act on their belief that the primary problem with attempting to sell a whole-ownership condo-hotel unit is the price. They act on their sense that if they were to sell units as fractional product instead of as whole ownership, they could pitch the same level of facilities and service at a dramatically reduced price affordable for buyers who could not afford to buy the whole-ownership unit. Moreover, because the aggregate price per square foot is so much higher for fractional interests than for whole ownership, the developer can still turn a profit.
Fractional projects, however, have struggled just as much as condo-hotel projects in this recession because the time and money required to sell a fractional project is far greater than that for a whole-ownership project, due to the number of fractional interests involved. For example, when a 250-unit project is divided into fourths, eighths, or 12ths, a developer must find 1,000, 2,000, or 3,000 buyers of those interests. In addition, there is no established resale market for fractional product, and fractional financing is just as expensive and difficult to obtain as condo-hotel financing.
Or Minimize Losses: Convert Condo Hotels to More Traditional Uses
Other options exist for repositioning a broken condo hotel. To successfully reposition a broken condo-hotel project, the developer and the lender must accept and understand three things:
- The unlikelihood that the originally projected returns will be salvaged. In fact, a strong possibility exists that the project will lose money and that the loss could be substantial. But the right path can minimize the loss.
- The strengths the project has from a design/physical standpoint—whether the units are 400- to 600-square-foot (35–55 sq m) hotel rooms and efficiency apartments, or 1,000- to 3,000-square-foot (90–280 sq m) units with two to four bedrooms.
- The state of the market, and the highest and best use for the project in this market.
These factors most often should lead a developer to decide to convert the condo-hotel project to either a traditional hotel, which the developer can either sell or operate, or to a multifamily project—either rental apartments or for-sale residential condominiums. Either option is likely to be preferable to the more common alternatives of retaining the existing condo-hotel structure or converting the project to fractional ownership.
The sale of a project in bulk as a hotel will result in lower proceeds than if the developer had succeeded in selling the guest rooms as individual condo-hotel units. Alternatively, holding and operating the project as a traditional hotel may not enable the developer to recoup the capital investment for the several years that may elapse before the property can be sold as a hotel.
Nonetheless, if the project is designed with smaller units and is located in an area where a traditional hotel with the right basis and efficient operations can turn a profit—such as a gateway city, the central business district of a secondary city, or a popular beach resort—the decision to convert the project to a traditional hotel may represent the highest and best use for the project and ultimately minimize the loss for the developer or, more likely, the lender.
If a developer converts the condo-hotel project to either rental apartments or residential condominiums, it is unlikely that projected returns will be salvaged. However, if the project has one-, two-, and three-bedroom units and is located in an area where rental apartments with the right basis and an efficient operator can turn a profit—such as New York City, Chicago, or Denver—this might be the best use for the project. Similarly, if the project is in an area with a shortage of residential condominiums, this might be the best use. In order to convert a condo-hotel project to residential condominiums, renovation may be necessary to remove certain features—such as a front desk check-in facility—in order for buyers to qualify for traditional home financing.
To successfully convert a broken condo hotel to either a traditional hotel or rental apartments, the developer must be the single owner of all of the units. This is the case whether the developer intends to sell the project to a third party or to obtain new financing in order to hold and operate the project. If the developer has previously sold units in the condo-hotel project, it will need to buy them back or to follow local rules in order to undo the condo regime. Nonetheless, if that is the highest and best use for the project in that market, that is the path the developer and its lender should take to fix their broken condo hotel and minimize their losses.
