Mr. Davis

Condo Hotels

Condo-Hotels: A Niche Market for High Quality Deals

By Gavin Davis, Director, Neptune Hospitality Advisors, Inc.

As an active advisor to clients in the hotel debt and equity capital markets, I find the above statement particularly troublesome. It is no secret that hotel capital, both debt and equity is abundant in part due to relatively healthy lodging fundamentals, drastically reduced hotel loan delinquencies, positive forecasted investment returns especially relative to other commercial real estate sectors and potentially a longer hotel investment cycle due to predicted lower supply growth. If creative financing or a lack of alternate financing is the impetus behind the condo-hotel craze, this is pause for concern in light of the superabundance of capital in the market. Before reading further, it should be noted that condo-hotels can and do work in certain circumstances. Such circumstances are few and far between to warrant the type of attention that has been droned on this niche within the lodging sector. Our firm is currently working on financing for condo-hotels that would be regarded as quality projects. Interestingly, these projects also underwrite as stand-alone hotels and do not use the condo-hotel structure as means for otherwise unattainable financing.

Condo-Hotels, the Basics

The term condo-hotel is used indiscriminately in reference to a variety of hybrid real estate projects containing both residential and hotel components. Two common types of condo-hotel projects are the traditional hotel (lower floors) with primary residences (upper floors) that are not rented to the public and a hotel where the guestrooms are sold to individuals as condominiums who then contribute their individually owned units into a hotel rental pool. The latter encompasses a wide spectrum of projects from those that offer a relatively small portion of total guestrooms as condominium interests to projects that are entirely comprised of condos. Variations on mandatory or voluntary condominium participation in the hotel rental pool, condominium owner usage of their individual units, condo-hotel brand affiliation, access to hotel amenities by condominium owners, parking privileges, housekeeping and room service are a few of the components of a condo-hotel project that create its seemingly endless permutations.

As the condo-hotel units are sold off individually, the financing risk in the form of a mortgage is passed from developer/hotel owner to individuals. Ultimately, this allows a project that traditionally might receive 65% senior debt as a hotel development to be financed at a much higher leverage level. In turn, the developer is able to defray both debt and equity capital costs onto presumably less sophisticated individual investors while drastically shortening the developer's time to recoup profits on a given project.

Why the Emergence?

Condo-hotels have emerged as a result of a confluence of prevailing market interests including but not limited to strong residential real estate returns over the past few years, attractive residential real estate financing, positive lodging fundamentals and developers desire for additional financial leverage and reduced risk. The importance and relation of residential housing markets to the condo-hotel equation can not be underscored enough. If interest rates were at levels closer to historic norms instead of near historic lows, residential asset pricing would not be as frothy.

Condo-Hotel Demand Driven by Residential Real Estate Returns

It is the financing of residential real estate that has contributed almost solely to the run-up in housing prices across the nation and especially in coastal areas not supply constraints. Residential real estate financing is cheap historically speaking and traditionally highly leveraged relative to commercial real estate. Residential real estate financing levels are largely a function of affordability; that is residential real estate buyers on a whole will utilize financing to a point where they can afford to. When interest rates fall (as they did), the cost of financing becomes cheaper. Overtime, residential buyers bid up residential asset pricing to the point of affordability (or beyond) again, thereby off-setting any decline in real interest rates with higher asset pricing.

This situation is exacerbated when floating rate debt is used because it is typically less expensive than fixed rate financing and exhibited the most dramatic decline over the past few years. San Diego County, one of the residential markets exhibiting the strongest growth over the past few years, saw over 80% of residential loans utilizing an adjustable rate mortgage in 2004 (far above historic norms) and many of those were interest only loans. This would seem to imply that individuals high on year-over-year housing price appreciation are stretching to take equity interests in residential real estate by utilizing the lowest cost of capital while at the same time exposing them to interest rate risk. Interestingly, with floating rates up sharply year-over-year on a percentage increase basis, the Federal Reserve Beige Book (June 15, 2005) cites home foreclosures increasing at a statistically significant rate year-over-year (greater than 17%) in at least one top-15 MSA while others remain distinctly robust.

It seems that some believe that residential real estate defies cyclicality and that it is not subject to conforming to fundamental investment relationships such as home price appreciation versus rent escalation and home price appreciation versus personal income growth (which are both currently off kilter by historic measures).

Will Condo-Hotel Demand Wane in the Face of a Less Robust Residential Housing Market?

It remains to be seen that if interest rates rise from historic lows (likely) and financing costs are higher as a result (likely) and if projected residential real estate price appreciation slows, is null or is negative, whether the promise of hotel rental pool contribution can substantiate and support consumer demand for the condo-hotel product by end unit buyers very broadly speaking. How will this affect individual condominium interest values in a condo-hotel? Probably similar to the re-sale value of timeshare deeded real estate interests have on Ebay. Without a liquid secondary market for condo-hotel units yet, it is questionable if these units will hold their value (values which are high by both hotel valuation metrics (e.g. price per room) and residential valuation metrics (e.g. price per square foot)) against a backdrop of a cooling residential real estate market.

Supply of such condo-hotel projects will continue as developers will look to transcribe major portions of equity and debt financing to others and in turn mitigate their own risk. However, demand from investors should cool alongside the general housing market with the exception of projects with sustainable underlying lodging fundamentals (i.e. projects that would be sensible as stand-alone hotels). Though, an aging demographic buyer set seeking 2nd and 3rd homes will still be an active source of demand.

Where Does a Condo-Hotel Structure Make Sense?

Condo-hotels can be sensible projects in high-end urban (e.g. the Plaza, New York City) and resort markets (e.g. several beachfront locations) that exhibit strong underlying lodging and residential real estate fundamentals. It is likely that such a project would be underwritable on its own as a stand-alone hotel and that the Condo-Hotel structure is being utilized by the developer for reasons other than as a vehicle to complete an otherwise unfinanceable project.

It will take approximately one investment cycle for a sample of condo-hotel projects to determine if the carrying costs (mortgage, maintenance, insurance, etc.) for unit owners are sufficiently covered by the share of net operating income that such unit owners receive and any annualized asset appreciation. The net operating income received by the unit owner helps defray some carrying costs, but it is likely not a good investment vehicle. Again, broadly speaking my view is that the condo-hotel units will hold value in a manner similar to timeshare ownership at the mean with the exception being projects with strong underlying lodging and residential real estate fundamentals.

Condo-Hotel Structure Untested

Given the confluence of market trends that have supported the emergence of condo-hotel projects, it remains to be seen what will happen if such trends diverge, slow or reverse entirely. The financial model is yet untested given that lenders on the units hold collateral that is itself structurally part of a larger real estate asset, which begs the question what happens in the instance that an individual unit is foreclosed upon and lodging and real estate trends cool resulting in lower asset prices. The unit will never be able to be separated from the hotel, which inherently can create structural problems from asset value and lending perspectives.

In addition to general discussions about what a condo-hotel is and why they are abuzz, this article is limited in size from a more detailed discussion surrounding condo-hotel specifics such as legal, structure, design, construction, marketing and hotel operations. The legal structure of condo-hotel projects is also cause for considerable review and it would be wise to engage the assistance of a law firm with considerable condo-hotel experience.

It is remarkable to see such a devotion of press surrounding condo-hotels given what a small niche they currently occupy (note the irony). It is amusing to hear the industry cocktail banter about the truly marginal condo-hotel projects being proposed. My favorites include a proposed hotel to condo-hotel conversion in the rural Midwest where both lodging and real estate fundamentals were particularly weak and the invariable mid-scale limited service hotel projects that seek to utilize the condo-hotel structure to make deals a reality that are otherwise unfinanceable. As an active arranger of hotel financing and condo-hotel financing, Neptune Hospitality Advisors welcomes your condo-hotel projects for review and our potential assistance in raising funding.

Gavin Davis is Director of Neptune Hospitality Advisors, Inc. He oversees soliciting and prospecting capital sources, the preparation of investment memorandums and proposals, facilitating the due diligence process, financial modeling and evaluation of all potential transactions. He started with CIBC World Markets as a financial analyst. He held positions with Prudential Real Estate Investors and REIT Legg Mason Wood Walker. Mr. Davis holds a BS from Cornell University’s School of Hotel Administration. Mr. Davis can be contacted at 858-964-5675 or gavin@neptuneha.com Extended Bio...

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