J & N REALTY, INC.

Regulations for Condominium Hotels  

CONDOMINIUM HOTELS are one of the most popular real estate trends in the hospitality industry, proliferating throughout the country and around the world during the past decade.  Yet many real estate attorneys, developers’ counsel, and hospitality counsel do not know how to create what are commonly referred to as condo hotels, why they are a popular financing and development model, or how to address the Securities and Exchange Commission implications of these vehicles. 

A condominium is an “[o]wnership of a separate interest (the Unit) coupled with a fractional undivided interest in the common areas owned either as tenants in common or through an Association.”  While a condominium hotel generally looks and operates just like a traditional hotel—with specified hotel rooms, or “units,” owned by individuals—no standard definition of a condominium hotel exists.  In fact, the term “condo hotel” is often used indiscriminately to refer to a number of variations on the theme.  For example, at some condominium hotel properties, certain rooms are designated for rental to transient hotel guests, while other rooms are designated as condominium units to be owned by individuals who do not participate in any of the services or receive any of the amenities provided to the traditional hotel guests.  

The most common type of condominium hotels, however, are those in which certain units in a hotel are designated as condominiums to be owned by individuals who participate in all the services of the hotel.  In addition, within this type of condominium hotel, individuals might own a unit as a primary residence, benefit from the hotel’s services, and be unable to rent out the unit to transient guests.  In others, the condominium owner purchases his or her unit primarily as an investment vehicle or vacation home, renting out the unit during some or all of the year. 

In California, creating a condominium hotel requires a subdivision map approved by a local government pursuant to the Subdivision Map Act.  In addition to local regulations governing construction of the hotel project, each of the condominium units is considered a separate parcel, which must meet local government conditions for design and improvement of the development.  These conditions can be extensive, requiring dedications, off-site construction, payment of fees, and preparation of CC&Rs. 

In addition, the sale or lease of five or more condominium units also falls under the jurisdiction of the State Department of Real Estate (DRE), pursuant to the Subdivided Lands Law.  Subdivisions that fall under DRE jurisdiction cannot be offered for sale or lease until the DRE has confirmed that they meet all statutory requirements—known as affirmative standards—for intended use of the property.  The DRE issues a Conditional or Final Public Report detailing information about the project that must be disclosed to all purchasers, including a description of the proposed management of the project.  Because a condominium is an interest in property, developers are subject to all normal land use requirements, and purchasers are entitled to the full array of legal protections applicable to the sale of property under California law. 

The first condominium hotels were reportedly built in Miami Beach in the early 1980s.  However, the popularity of condominium hotels took off in the late 1990s as developers aggressively started selling condominium hotel units, attracted by the potential for up-front fees from condominium purchasers prior to the completion of a hotel project.  Through the sale of condominium units, developers could obtain financing for hotel construction or renovation projects even prior to construction.  Preselling condominium units also helped developers obtain loans because the developer or lender no longer needed to rely solely on the financial projections of incremental profits associated with hotel room rentals traditionally associated with the cyclical hotel industry. 

Moreover, condominium hotel units reportedly command a 30 to 40 percent premium over the sale of traditional residential condominiums.  The opportunity to realize a quick return on investments even prior to construction caused condominium hotels to sprout up throughout the country, and they have been particularly attractive to buyers in the luxury segment.  In addition, many potential buyers were lured by the attraction of purchasing a condominium hotel unit, often in a luxury hotel or resort destination, as an investment based on the potential for appreciation of the unit and receipt of fees from rental of the unit to transient hotel guests.  Indeed, the luxury segment of the condominium hotel industry received another boost when brand management companies and celebrities jumped on the condominium hotel bandwagon, lending their popular names and/or management expertise and track records to condominium hotel projects.  For example, George Clooney, Michael Jordan, and others become involved with luxury condominium projects, some of which have been canceled.  Hotel management companies, from boutique hotel operators to most of the major hotel brands, have condominium hotels in their pipelines, including Hilton, Hyatt, Ritz-Carlton, Four Seasons, and Starwood. 

Finally, from a lifestyle perspective, it is not surprising that condominium hotels have been particularly attractive to buyers in the luxury segment.  After all, who has not imagined living in a hotel and partaking in all its amenities, such as valet parking, room service, on-site restaurants, spas, and much more?  In contrast to a traditional residential condominium, condominium hotel unit owners also benefit from living in a residence managed by a world-class team, making repairs and providing day-to-day management expertise that might typically be the domain of a condominium association.  

Issues for Owners, Developers, and Managers 

When the increase in condominium hotels became a frenzy in the late 1990s, many industry observers expressed concern about a number of potential issues that might arise.  This was because the concept of the condominium hotel is unlike prior trends in the hospitality industry, such as timeshares and fractionals.  For example, how would management companies manage properties in which some tenants are transient guests and others are individual unit owners or represented by condominium associations?  How would a brand management company enforce its brand standards, and upgrades of those standards, against individual condominium owners?  How would a management agreement obtain approvals, if necessary, from each condominium owner?  Would owners place a sufficient number of their condominium units into the hotel’s reservation pipeline to maintain the profitability of the hotel for the management company?  How would conflicts between management companies and homeowners’ associations be resolved? 

Others have noted that traditional legal documentation applicable to hotels and condominiums—such as management agreements for hotels and residential condominium association documents—would be unworkable for condominium hotels.  The unique nature of a condominium hotel requires that hospitality attorneys become well versed in laws applicable to condominiums, and attorneys for condominium hotel owners, managers, and developers must become familiar with local government rules for zoning, impact fees, and, in some cases, unique rules applicable to condominium hotels.  In California, any guidance concerning the development of a condominium hotel must be informed by an understanding of potentially applicable rules and regulations promulgated by the local city or county exercising jurisdiction over the hotel site, as well as the applicable regulations of other agencies—such as the California Coastal Commission—for hotels located in the Coastal Zone. 

Many local governments have clear zoning regulations and controls for hotels and for traditional residential condominiums as well as special rules for timeshare developments.  However, just as many local governments do not define “condominium hotel” in their zoning codes, thereby creating confusion whether a condominium hotel is a permitted use and whether a condominium hotel should be subject to residential or commercial development standards and exactions. 

Moreover, developers, management companies, and their attorneys involved in condominium hotels must now become familiar with the bylaws of homeowner associations, as well as local rules concerning minimum required occupancies for unit owners and maximum stays for transient guests.  Some of the new issues concerning condominium hotels have likely been worked out by the various stakeholders in condominium hotels, and others have required a judicial resolution. 

For example, a federal district court held that condominium hotels are required to comply with the accessible construction requirements of the Americans with Disabilities Act and must ensure the availability of disabled-access condominium units.  Unit Sales and Securities Laws While all these issues present challenges for those involved in condominium hotel projects, perhaps the inquiry most frequently posed as condominium hotels gain in popularity is whether the sale of a condominium unit might constitute a sale of a security under federal securities laws.  Sale of a condominium hotel unit could be governed by both state DRE and federal SEC regulations.  The issue of whether the sale of a condominium unit is governed by federal securities laws is significant because of the potential implications for condominium hotel business practices and the potential liabilities and remedies available to buyers and sellers of condominium hotels.  This important issue might soon be resolved as the result of 

an explosion of recent (but not unexpected) lawsuits in which condominium hotel buyers—perhaps motivated by the state of the real estate market or a realization that their condominium hotel units might not achieve expected investment returns—are relying on federal securities laws to seek rescission of their purchase and sale agreements and to pursue other available remedies. 

The offer for sale of real estate generally does not involve the offer of a security.  However, because a condominium hotel unit might be associated with a rental or management program, it can, in certain circumstances, be deemed a security.  If so, unless the sale is exempted, the sale must be registered with the SEC and comply with the SEC’s rules and regulations, including its disclosure and antifraud provisions.  As a result, if the sale of a condominium hotel unit is deemed to be the sale of a security, the level of disclosure required for condominium hotel promotional materials will likely increase drastically, as the condominium hotel promoter will become an issuer of securities subject to the antifraud provisions promulgated by the SEC.  For the condominium hotel unit buyer, the purchase of the unit becomes an investment decision, with the protections afforded under applicable securities laws.  Moreover, if the securities laws apply, and if developers or brokers do not comply with the additional requirements applicable to the sale of securities, they could face serious criminal and civil liabilities.  Condominium hotel sellers also could be deemed securities brokers or dealers within the meaning of the Securities Exchange Act and may be required to be registered.  Finally, if a condominium sale is considered a security and the sale is not registered, the buyer could void the sales contract. 

The definition of a “security,” as developed by the courts, is derived from the economic realities test established by the U.S. Supreme Court.  In SEC v. W. J. Howey Company, the Supreme Court applied what it termed “economic realities” and found that “a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party” is an “investment contract” and, therefore, a security.  The California Supreme Court has established the “risk capital” test in addition to Howey.  Despite the different formulations of Howey and the risk capital test, the U.S. Supreme Court has noted that the risk capital test is an “approach that is virtually identical to the Howey test.”  The risk capital test analyzes whether the funds in a given venture will be used to develop or acquire the business or enterprise in which the interest is offered.  If that test is satisfied, then the interest is deemed to be a security.  The extent of the development of the business at the time the interest is purchased would therefore be an important factor when determining whether the sale of a condominium hotel unit is deemed to be a security.  However, no case law currently exists to definitively answer the question of whether a condominium hotel sale constitutes a security.  Most commentators thus have looked to two statements by the SEC for guidance: a 1973 SEC Release and a 2002 “no action” letter.  In 1973, the SEC issued a release to address the “uncertainty about whether offers of condominiums and other types of similar units may be considered to be securities.” 

The SEC concluded that an offering of securities will arise if the condominiums: 

• Are sold with an emphasis on the economic benefits to the purchaser that will derive from the managerial efforts of the promoter or a third party from rental of the units. 

• Include participation in a rental pool arrangement. 

• Require the purchaser to make the unit available for rental for any part of the year, use an exclusive rental agent, or otherwise materially restrict occupancy or rental of the unit. 

Nonetheless, the 1973 release states that “an owner of a condominium unit may, after purchasing his unit, enter into a non-pooled rental arrangement with an agent not designated or required to be used as a condition to the purchase.” 

In 2002, the SEC issued a “no action” letter to Intrawest Corporation, a condominium hotel developer in Canada, concerning “the offer and sale of condominium units…coupled with an offer or agreement to perform or arrange certain rental or other services for the purchaser.”  Intrawest wanted to institute a sales and promotional program for its U.S. developments that would disclose the existence of the rental management programs as one of the services offered.  It sought to do this without an SEC registration.  To that end, Intrawest represented, among other things, that 1) under no circumstances would prospective purchasers be led to believe that they will profit from unit ownership other than by property value appreciation, 2) representatives of the rental management company would only provide information in response to specific inquiries, 3) Intrawest’s rental management program would be completely voluntary and separate from the Intrawest sales program, 4) sales representatives would not receive additional compensation or other incentives for unit sales tied to rental management agreements, and 5) Intrawest would not discuss the terms of any rental management agreements until a purchase and sale agreement was executed.  

Based on the facts presented by Intrawest, the SEC stated that Intrawest’s sales and rental model did not create a security as defined by Howey and the 1973 release because, among other things, the promotion and sale of units did not emphasize any economic benefit to the purchaser derived from managerial efforts or rentals and did not offer participation in a rental pool. 

No court has yet to weigh in on the issue of whether the sale of a condominium hotel unit constitutes a security.  However, at a minimum, to avoid being deemed a security, a condominium hotel unit sale must not be tied to any pooling of rents and must be advertised, marketed, and sold as a piece of real estate.  Further, the sale must be structured carefully to avoid any association with a management or rental program.  While disputes requiring a resolution of this issue may be determined on a case-by-case basis, the manner of an offering and the economic inducements held out to prospective purchasers will be critical to the determination of whether a condominium hotel unit sale constitutes the sale of a security.  Dissatisfied buyers have begun the rush to the courthouse to test the theory that condominium hotel unit sales are securities, so promoters of condominium hotels must be scrupulous with their sales efforts. 

Indeed, disgruntled condominium hotel owners and investors are relying on federal and state securities laws in an attempt to rescind their purchase agreements and seek damages.  A federal district court case in Florida filed by the owners of condominium hotel units at the Clearwater Cay Clubs Resort in Clearwater, Florida, alleges that the resort’s vendors and developers violated federal securities laws and Florida state securities laws by fraudulently inducing them to invest in condominium hotel units.  Specifically, the plaintiffs allege that the defendants promised them “substantial profits” from the investments through guaranteed income from a pool of short-term rental units as well as capital appreciation due to a large-scale conversion/development.  Based on the allegation that the sale of a condominium hotel unit constitutes a security, the plaintiffs allege that the units were required to be registered with the SEC.  Since they were not, the plaintiffs are seeking damages.  Similar lawsuits are being reported with increasing frequency.  Plaintiffs are alleging the violation of federal securities law by the sale of condominium hotel units as investments without the units being registered with the SEC.  They are seeking monetary damages and the rescission of their purchase agreements. 

If the SEC’s 1973 release and 2002 “no action” letter are reliable guides, the success of the recent lawsuits alleging violations of securities laws will depend on whether the promotion and sale of the condominium hotel units emphasized any economic benefit to the purchaser derived from managerial rental efforts.  If buyers, as alleged in the Clearwater Resort lawsuit, were led to believe that the purchase of a condominium hotel unit would generate guaranteed income from rental arrangements, courts may well find that federal securities laws apply and were violated. 

The craze for condominium hotels has led many to question the viability and longevity of this type of real estate vehicle and to ponder the potential implications of federal and state securities laws.  The first lawsuits in which unhappy condominium hotel unit buyers allege that they purchased unregistered securities are certain to be closely watched by attorneys, purchasers of condominium hotels, developers, and management companies.  A court decision holding that a sale of a condominium hotel unit constitutes a security would be significant and would alter the current practices of those involved in condominium hotels—including, but not limited to, developers and management companies.