Condo Hotel Developments and Hotels With Residential Rental Programs Are Fraught With Complexity
By Loren Balsam Chief Investment Officer, hotelAVE | January 2024
While subpar development yields and challenging financing markets stall traditional hotel development, some developers are pivoting to a condo hotel or more typically, hotel with for sale condominiums and an optional rental management program as a path to getting out of the ground. If developers can extract most, if not all, of their development costs through a sale of the hotel/condo inventory and finance the building as for sale condo units then this may be an easier path to development.
Despite a potentially easier route of construction finance, condo hotels and hotels with a residential rental management program add another layer of both transactional and operational complexity. On the legal side, the sale of hotel condominiums requires the establishment of a condominium association (an "Association") with a budget and bylaws and the requirement of at least annual meetings of owners. Moreover, condominium associations are often creatures of state enabling legislation with varying degrees and types of restrictions on their creation and operation.
In addition, the sale of residential units in projects intended to offer rental programs requires careful execution as to avoid violating Federal or state securities laws in connection with an emphasis (i.e., any focus) on economic returns, requirements that units be placed in a rental program or the pooling of revenues or expenses across multiple units in the rental program. Any offering that fails to properly address these issues may be determined to be a securities offering, exposing the developer to challenges by the SEC or, worse than that, may result in a claim by unit purchasers that results in a right of the unit owner to rescind its purchase and receive a refund of the purchase price. In projects comprising both developer retained hotel rooms and for sale condominiums complicated budgeting is necessary to properly allocate expenses between the hotel and condominiums and address reserve requirements applicable to hotel FF&E, on the one hand, and condominium reserves for building systems on the other.
On the physical side, hotel condominiums are often branded, and thus require the interior finishes to comply with brand standards. Unlike traditional condominium development where units are delivered to buyers "decorator ready", condo hotel or rental program units may be completely furnished with brand compliant furniture, fixtures and equipment and operating supplies and equipment.
Developers will also have to establish the rental management agreement ("RMA") terms that govern owner usage and the economics of participating in a rental management program. There are varying terms in RMA's, with the most common being 1 - 3 years. Developers will want to restrict the amount of owner usage, particularly during peak season to maximize transient rental revenue potential. Developers can structure the RMA program to incentivize users to maximize the availability of the unit to the hotel front desk as hotel inventory and minimize the cost of ownership.
In terms of rental economics, typically there is a fee taken off the top for some combination of rental costs, credit card fees and the cost of management and then the remainder is subject to a revenue split between condo owner and developer. Revenue splits vary widely, ranging from 40% to as much as 70% going to the condo owner. This structure is attractive to condominium buyers because the burden of marketing and operating the units remains with the developer and property manager and they are not subject to hotel operating losses although condominium ownership costs may not be covered. However, developers should be careful to incentivize participation in the RMA within the bounds of applicable securities laws. If the rental management program is not effectively structured, marketed and managed, then there is the risk owners do not initially participate in the program or do not renew participation, choosing instead to engage with local market brokers or Airbnb to rent their units (depending on by-law provisions). This would collapse the value of the front desk.