Global Hospitality Advisor: Condo Hotel "Splits" Ask The Hotel Lawyer™

“Ask the Hotel Lawyer” is a regular column that provides practical insight into timely legal issues. In the last column, Jim Butler addressed the pros and cons of condo hotels. In this column, he answers questions about one of the all-important details of a successful condo hotel deal “splits.”

Advisor: “Jim, it seems like condo hotels are all the rage. You’ve been writing about condo hotels for some time now. Is this hybrid product here to stay?”

Jim Butler: Well, Smith Travel reports almost 100,000 rooms in more than 225 condo hotel projects are in the pipeline. That’s significant. And as condo hotel lawyers and advisors on more than 50 condo hotel projects, JMBM’s Global Hospitality Group® will certainly agree that they are earning a permanent place in the hospitality landscape.

Advisor: So, like other matters involving hospitality, JMBM is at the forefront of the condo hotel phenomenon?

Jim Butler: Yes, our condo hotel lawyers understand the condo hotel opportunity and challenge—from the initial evaluation as to whether a project should have a condo hotel element at all, to the business and legal aspects of entitlements, financing, construction, condo hotel docs and condo hotel regime structure. More and more of our developer clients are choosing the condo hotel as an element of their projects.

Advisor: A lot of condo hotel developer energy is focused on the issue of “splits.” What is that all about?

Jim Butler: This term refers to the “splits” or division of revenues earned from renting a condo unit, which a condo unit owner shares with the operator of the hotel. For example, let’s say that you own unit 201 in the Paradise Hotel & Residences. And let’s also assume that you put unit 201 into the hotel rental program. The “splits” refer to how much of the rental income you receive as a unit owner, and how much is kept by the operator or other parties. The guest staying in your unit may pay $1,000, but the “splits” refer to how much of that you receive.

Advisor: Splitting revenue sounds fairly straightforward. Why is this issue receiving so much attention?

Jim Butler: The hotel operator must have enough money to operate the hotel at the level of service that the people buying the room expect, depending on its brand or market position. For example, a guest at a five-star property will understandably expect more than a guest of a four-star property.

At the same time, the condo unit owner expects to receive cash through the rental program, and that cash has to satisfy the owner’s expectations.

Advisor: Isn’t there some kind of standard formula for establishing these “splits?”

Jim Butler: In the earlier days of condo hotel development, there often was a simplicity to the “splits” issue. Typically, condo hotels simply divided room rental revenues between condo unit owners and the operators— usually somewhere in the range of 50%-50%, but possibly ranging from 40%-60% to 60%-40%. These splits were an inexact way of dealing with expenses and were generally based on guesses as to future expenses and revenues. Too frequently, operators collected too little revenue to cover the expenses, and sometimes they collected too much.

Obviously, if the operator collects too little, the hotel cannot be maintained at the expected level of quality and service, and the operator cannot afford to lose money for very long. But, if the operator gets too much, unit owners will feel unfairly dealt with and will have less money to defray their costs of ownership.

Advisor: That makes sense—and it doesn’t sound all that mysterious—why is it hard to get a straight answer about what the right “splits” are?

Jim Butler: The straight answer is that the only way to fairly allocate expenses and income is to work with actual numbers, and charge each party a fair share of the expenses. In more complex properties, there are several potential players—the owner of traditional hotel rooms (if any), residential unit owners, condo hotel unit owners, timeshare or fractional owners, and retail or commercial unit owners (e.g. the owners of the spa, waterpark, restaurant, parking operator or sundries store). The allocation requires both a micro view of all the usage and benefit of each part of the hotel or resort facility, and a macro assessment of the financial viability of the regime suggested by allocations. In both assessments, the goal is to strike a fair balance of allocations that will assure proper maintenance of the physical and service standards and appropriate rewards.

Advisor: So, it is just an allocation based on actual expenses instead of projections?

Jim Butler: Not exactly. Our recommended approach does use projections with a periodic “true up” based on actual results. But the allocation process can get fairly complex and really requires an individualized assessment of each property, its facilities and usage—not to mention what will happen on future expansion.

Some costs may be allocated through condo docs. Others may be charged on voluntary or mandatory “unit maintenance agreements.” We often create something called "shared facilities” which are typically owned by the developer with costs assessed to all who use or benefit from the facilities. Still other expenses may be deducted before the “splits” (and may be in the hotel management agreement or HOA management agreement) or absorbed from one party or another from their “splits.”

So there may still be “splits" or specified percentage sharing of revenues, but the costs may be allocated through an array of different document or regime elements. In any event, by the time you get down to the “splits,” a lot of allocations may already have been made.

Advisor: Now, this is starting to sound complicated! Can you back up and tell us about “unit maintenance
agreements?”

Jim Butler: In a number of cases, our condo hotel clients determined that residential and condo unit owners should be required to meet quality standards of appearance and upkeep, and to pay designated fees and costs that allow the hotel operator to provide the services necessary to assure that the standards are met. We often specify the services that will be provided by the hotel operator to the residential and condo unit owners in “unit maintenance agreements.” These agreements might state that the hotel operator will be responsible for all housekeeping, repair and maintenance of the unit and specify the charges the unit owners will pay for these services. This could be required as a condition to buying a condo unit.

As most people understand, requiring participation in a maintenance agreement is not the same as requiring a condo unit buyer to participate in a rental program. Requiring such participation, or even inappropriate discussion of such a rental program prior to sale, could create a big SEC problem—turning the sale of the condo units into a sale of “securities.”

Advisor: And what are the “shared facilities” expenses?

Jim Butler: The “shared facilities” typically include many of the facilities that might otherwise be common areas in a pure residential condo. They also include non-revenue producing facilities that are necessary for the hotel or condo operation such as the bell desk and property security. For consistency, hotel operational issues, quality control, safety and a host of other reasons, these facilities are not owned by the homeowners associations but by the developer, operator or other third party.

As with each other item of expense, and the overall result, the key to a successful regime structure is fairness and consistency of the allocations of expense and revenues— whether on a per square foot, revenues generated or other rational basis.

Advisor: So, these are the reasons that simple “splits” don’t work anymore?

Jim Butler: Yes. The more upscale and complicated the property, the more there is to take into account. And of course, this whole structure is also affected by restrictions imposed by the state real estate regulators, the SEC, entitling agencies, operator standards, cash flow models, competition and other factors. Yet it is one of the most important aspects of structuring a successful condo hotel project and deserves all the time and attention it requires— particularly as some parts of it may be “baked in” to the CC&Rs and other documents that are difficult to change once the first condo unit is sold.

Advisor: What you are saying is that every property has specific issues that must be taken into consideration when structuring reasonable “splits.” Can’t you give us some kind of “rule of thumb” to follow to make sure splits are equitable?

Jim Butler: Unfortunately, no simple formula exists. In fact, unless the allocation of expenses and income of the condo hotel is carefully worked through by experienced professionals, the developer can be vulnerable to “gaps” that leave financial exposure to significant expenses that are uncovered. Not only that, but if the allocation of expenses is not worked through carefully, the developer can also be vulnerable to legal exposure for violation of state law
governing condominiums. And finally, poorly conceived splits can result in unsustainable hotel operations that disappoint the expectations of unit buyers. Lawsuits and serious financial problems often follow angry consumers.

Advisor: How can developers avoid this kind of disaster?

Jim Butler: Developers should get help from someone who has seen all the approaches to allocation issues, worked through the problems and rationales, and understands the evolution of expense allocations or splits in today’s complex environment. This is not an area where you want your professionals to learn on your job, at your expense!

Advisor: Any last words of advice?

Jim Butler: In the right situation, the condo hotel opportunity can be compelling for all involved-and is enabling development of some great product that otherwise might never be built. But badly structured condo hotels can be a developer’s worst nightmare, so it is very important to do them right. One of the most important things a developer can do is to get guidance from the right professionals who can help decide if the opportunity is right and can also help to execute a flawless plan.

Jim Butler is Chairman of the Global Hospitality Group® of Jeffer, Mangels, Butler & Marmaro LLP, a full-service business law firm with more than 160 lawyers in Los Angeles, San Francisco and Orange County. The Global Hospitality Group® has more than 1,000 transactions spanning the globe, representing $50 billion in total acquisitions, sales, developments and financings of hospitality properties and companies. Their experience ranges from individual properties to billion-dollar portfolios. Jim can be reached at 310.201.3526 or jbutler@jmbm.com.