The condo hotel industry is coming to grips with its first-ever construction boom. Ground-up developments — virtually non-existent five years ago — are outpacing conversions three to one as hotel developers build projects in Las Vegas, Orlando, Chicago and other prime markets. The run-up is occurring even though the concept's complex operating strategy has yet to prove itself on a large scale.

Condo hotels enable individuals to buy hotel rooms, occasionally use them, and pocket income by renting the units to hotel guests. The concept surfaced some 30 years ago in the U.S., and until recently the niche industry operated predominantly in Florida.

But after the 9/11 attacks and a foundering economy drove the hospitality industry to the brink of depression early this century, hotel developers have increasingly embraced condo hotels to fill a financing void left by reluctant lenders: By selling units, developers raise more equity and require less debt in projects.

Even in today's healthy hospitality industry — Smith Travel Research reports that profits rose 35.3% to $22.6 billion last year — luxury developers are chasing condo hotel deals to help pay for their projects. In fact, 80% of the 50 luxury hotels in the construction pipeline include condo hotel units, private residences or timeshare interests, according to Lodging Econometrics, a real estate research and consulting company.

But more questions than answers surround condo hotels, including whether there is enough demand to support the proposed developments, and how condo hotel unit buyers will react to their first taste of declining income when tourism begins to slow at some future point.

At the very least, real estate experts predict, disgruntled condo hotel unit owners will barrage the industry with lawsuits within the next three years, particularly if they bought the units anticipating a return on investment (See sidebar p.95).

“Well-capitalized, well-thought-out and properly managed condo hotels that work as a hotel first make sense,” says Jim Butler, an attorney and chair of the global hospitality group with Jeffer Mangels Butler & Marmaro, a law firm based in Los Angeles. “But developers have become over-enthusiastic and have wandered away from some basic sound principles.”

A cycle is born

Some 136 condo hotels comprising 41,654 condo hotel rooms are in the construction pipeline, reports Lodging Econometrics. Developers are building 105 projects from the ground up and converting 31 conventional hotels into condo hotels.

The rapid ramp-up signals the first condo hotel cycle, real estate experts agree. Indeed, the fact that both Lodging Econometrics and Smith Travel Research only recently began tracking condo hotels underscores the cottage industry's broad lack of recognition.

Bruce Weiner, president and COO of Turnberry Ltd., a developer of condo hotels based in Aventura, Fla., suggests the run-up over the past 18 months has some pretty fresh legs. “I don't think [condo hotel development] has crested,” says Weiner, whose company also develops conventional hotels and condominium towers. “If a hotel works in a market, then a condo hotel should work.”

Developers are testing that theory in Las Vegas, where the nearly 12,000 condo hotel units proposed are the most of any market, reports Lodging Econometrics. Early this spring, Turnberry opened the first condo hotel in Sin City when it delivered the first of three 575-unit towers known as The Signature at MGM Grand. The sold-out second tower will open this fall. A third tower, which has about 80 units remaining, will open next year.

By all accounts, the Signature has performed like a mint: MGM Grand owner MGM Mirage, which is a 50/50 partner with Turnberry in the project, anticipates raking in some $205 million in front-end profits from the condo hotel unit sales in all three towers. Meanwhile, Turnberry shoots for internal rates of return of more than 20% in its condo hotel projects over a typical three-year sales period.

Bust potential

Las Vegas is a magnet for condo hotels, but the market is showing definite signs of overheating. “People are buying condo hotel units like commodities,” says Richard Lee, a spokesman with First American Title Co. of Nevada. “They're buying online without coming to Las Vegas and walking on the property.”

Meanwhile, soaring construction costs, rising interest rates and hasty development proposals resulted in a rash of cancellations over the last year.

The high-profile Las Ramblas backed by actor George Clooney is but one of several projects to disintegrate in Las Vegas. In downtown Boynton Beach, Fla., Miami-based Panther Real Estate Service returned deposits to potential buyers of units in The Promenade early this year.

Some communities may begin restricting condo hotel development, too, suggests Scott Berman, U.S. advisory leader for hospitality and leisure in the Miami office of PriceWaterhouseCoopers. Unlike conventional hotel rooms, condo hotel rooms don't generate bed taxes. Indeed, hotel room revenue grew 10% in Miami-Dade county in April this year over April 2005, according to Smith Travel Research. Over the same period, however, bed taxes grew only 3.3%, according to the county.

“It's too early to tell how many properties we're going to see built over the next 10 years or whether condo hotels will mirror the growth of the timeshare industry,” says David Neff, a partner and co-chair of the hotel, resort and timeshare practice group for the DLA Piper Rudnick Gray Cary law firm in Chicago. “We're really at the beginning stages.”

Backing away

Some real estate experts anticipate condo hotels will follow the same path as timeshares, which experienced robust growth a couple of decades ago only after major brands got into the business. A similar scenario appeared to be unfolding 18 months ago when brands took notice of the lucrative upfront profits condo hotels could generate. Flags can pocket licensing fees of 5% to 10% from condo unit sales — depending on the project and franchise — just for name affiliation.

But now big operators are hesitating at the chance to splash their names atop the developments. Why? Condo hotels ultimately put a brand's name and experience at risk, says James Hunter, assistant vice president and assistant general counsel of lodging development for Washington, D.C.-based Marriott International.

Quite simply, flags don't have the same control over condo hotel rooms that they enjoy in conventional hotels. “If you're not a brand and don't have an image or guest experience to worry about, then maybe you have more tolerance for condo hotels,” Hunter says.

Still, major brands are dabbling in the concept. Marriott's Ritz Carlton flag, for example, operates the Ritz Carlton Key Biscayne in Florida. Starwood's luxury St. Regis brand, meanwhile, will manage the St. Regis Resort & Residences, Deer Crest in Deer Valley, Utah. The $260 million project, slated to open in 2008, includes 67 condo hotels, 180 conventional rooms and 26 conventional condos.

“Condo hotels aren't an easy concept for the brands,” acknowledges Stanley Castleton, CEO of Anaheim, Calif.-based DDRM Greatplace, which is developing the St. Regis Deer Valley property. The project marks DDRM's first condo hotel pursuit after building a conventional condo and hotel portfolio of $2 billion over two decades. “There were a lot of unknowns that we worked through and [St. Regis] was very, very careful.”

Revenues at risk

The loss of control worries begin and end with the rental programs run by the operators. Room owners and hotels typically split income 50/50 after the operator takes 10% of the gross. But the rental programs are voluntary, so if an owner opts out, the hotel operator loses control of the room and inventory, Hunter says. Moreover, if unit owners then rent the room out themselves or through a third-party program, visitors to the room may not have access to all of the hotel's facilities and services, which may reflect poorly on the operator, he adds.

Another pressing concern centers on making routine upgrades to maintain brand standards. In a condo hotel, room owners in the rental program generally agree to set aside income to fund the upgrades. But even with the arrangements, operators may have to chase down 300 separate owners to get approvals.

“There's a lot of potential friction and inefficiencies in that kind of structure,” Hunter says. Worse, owners may balk at the upgrade costs and drop out of the rental program, again leaving the operator without control, he adds.

Operational twilight zone

Complicating matters are so-called “third-dimension” issues related to structuring and operating condo hotels that emerge when the two distinct properties intersect, says Butler of Jeffer Mangels Butler and Marmaro.

Conventional condo building managers focus on exterior maintenance — hallways, elevators and parking lot maintenance, for example. In condo hotels, operators are focused on common areas, too. But they're more interested in what happens inside rooms to ensure product consistency and quality, Butler says.

“We've seen some great condo documents that condo hotel developers have put together,” he says. The documents work great for conventional condominium projects, he adds. “But they don't work for a condo hotel. We usually rip them up and start over.”

Joe Gose is a Kansas City-based writer.

TOP 5 CONDO HOTEL MARKETS

Las Vegas boasts the biggest construction pipeline with nearly 12,000 units under construction, or in various planning stages.

Market No. of Units
Las Vegas 11,942
Orlando 6,773
Ft. Lauderdale 2,357
Miami 1,535
Chicago 1,282
Sources: Lodging Econometrics, Appraisal Research Counselors


Buyer beware, advise condo hotel experts

Forget about weakening fundamentals and unproven operating strategies. The biggest unknown to strike fear in the minds of condo hotel developers and operators may be the folks they're turning to for equity — unit buyers.

More often than not, buyers of condo hotel rooms are betting on big returns but have little, if any, knowledge of the hospitality and tourism industry's cyclical nature. It's a volatile mix ripe for sparking litigation, condo hotel experts say, particularly given the fact that U.S. securities laws restrict condo hotels from being marketed and sold as investments.

Condo hotel sales spiels are supposed to purge any notion that the rooms will generate a return. But rampant real estate appreciation over the last few years has all but convinced many potential room owners that they're going to make money, condo hotel experts acknowledge.

“It's a very fine line,” says Patrick Ford, president of Lodging Econometrics, a Portsmouth, N.H.-based real estate consulting and research firm. “What the developer says in his sales and marketing program — and what the buyer hears — may be two different things.”

Indeed, that's the case regardless of how hard sales agents may try to downplay return expectations. Predicting a condo hotel room's appreciation is virtually impossible, for example, because a resale market has yet to emerge. Additionally, statements that pop up in public often fuel profit expectations.

Early this year, a spokesman for Newpark Corp. in Park City, Utah, which is developing a condo hotel in the resort town, told the Utah Business Journal that potential buyers saw the company's proposed condo hotel units “as a safe place to put their money and a good investment.”

Such lapses are sure to lead to a wave of lawsuits when the travel industry wanes and rental income plunges. Many condo hotel professionals predict that some operators may have to ask unit owners for special assessments to keep operating during the next downturn.

“There's a lot of mistakes being made right now and a high level of misunderstanding,” says Morris Lasky, president and CEO of Lodging Unlimited in Chicago, a hotel management and consulting firm. “Attorneys are champing at the bit saying, ‘We're going to be real busy three years from now.’”
— Joe Gose