Global Hospitality Advisor: What Makes A Successful Mixed-Use Project?

Part One

The following dialogue is excerpted from a panel discussion at The Hotel Developers Conference™ held in Rancho Mirage, California in March and sponsored by JMBM’s Global Hospitality Group®. Panelists included Peter Connolly, Palladian Development; Robert Haiman, Remington Hotel Corporation; Tom Ito, Gensler & Associates; Jim Ratkovich, James Ratkovich & Associates, Inc., and Michael Mahoney, Triyar Hospitality LLC. Frank Janson of Chicago Title Company moderated the panel.

Janson: Let’s discuss the criteria used to determine a good site for a condo hotel. Michael, Triyar is doing a project in Scottsdale— how did you select the site?

Mahoney: In the old days, when market research was not easily available, we relied on instinct to site a property. Today, you can find tons and tons of information about markets and it is foolish not to buy this research. Instinctively, Scottsdale is thought of as a resort and retirement community. But research shows that less than 17% of the population is retired, and the average age has come down from a high of 65 to under 40. Research confirmed that we still have to deal with the “seasonality” issue— hotel room vacancies rise and rates lower during the hot desert summers. But research also showed us that business travel is less affected by seasonality. We are developing our “W” hotel in Scottsdale with all these market conditions in mind.

Connolly: For the Mandarin Oriental Hotel and Residences in Chicago, site selection was easy. We knew we wanted to be on the east side of Chicago near Millennium Park, and there was only one empty lot in that area, so we bought it.

Janson: Michael, tell us how your project in Scottsdale addresses the market conditions you described.

Mahoney: We are developing an urban resort, within walking distance to all the shops in Scottsdale. We are including a third-party restaurant and a bar owned by a separate operator — both which will appeal to local clientele. We also knew we needed a brand that would provide the travel rewards that are so important to business travelers. We want to attract the business traveler who will spend an extra night or two at our hotel to get those rewards.

Janson: Is there a residential component to your Scottsdale project, Michael?

Mahoney: Yes, but it is not a condo hotel. We struggled with whether to have a rental program, but ultimately determined we didn’t have enough space to generate the kind of revenue that condo hotels should provide. We decided on building traditional hotel rooms and separate condo units that will not participate in a rental program. We think this is the right model for the property.

Janson: What about your Mandarin Oriental project, Peter? Is it being developed as a condo hotel?

Connolly: Yes, it is. Financing a building as a condo hotel project instead of a hotel is a very attractive way to go. With the condo hotel structure, we can replace equity or mezzanine debt with condo pre-sales. We are just starting pre-sales at the Mandarin Oriental in Chicago. We actually designed the building first and got the construction priced before we started pre-sales. We have forecast—with some level of comfort—the difference between our construction costs and sell-out numbers, and we are happy with where we are. My goal is to pre-sell 100% so the company can profit as much as possible.

Janson: Jim, what does your residential component look like for your Maui project?

Ratkovich: We are developing 98 condos next to the Grand Wailea Resort, and have contracted with Destination Resorts to manage them. We have an option for owners to put their condos in a rental program. We predict that one-third to one-half of the owners will participate in the rental program the first year and we will grow it from there. We will structure it similar to a condo hotel, with each owner contributing 25% in gross rent for expenses, and another 10% for management.

“State law dictates whether—and to what extent—developers can use deposits from buyers and whether those deposits are refundable.”

Janson: Are you pre-selling units? How does geography dictate pre-sales?

Ratkovich: Pre-sales are great for the Hawaiian market, because developers can use the revenue generated by pre sales. The beauty of doing business in Hawaii is that we can hand condo docs to buyers the minute they walk into the door, and we can take as big a deposit as we want. The buyer has a 30-day right of rescission. After that we can use the deposit for development.

Janson: Does your lender look at deposit monies as equity in the project from your side?

Ratkovich: Yes, essentially it is a mezz piece that is available to us—it’s up to us to be judicious about using it.

Mahoney: We are not pre-selling units in Scottsdale. Fortunately, we had enough of our own equity, so we didn’t need pre-sales to satisfy our lender. I like the “for sale” process and our lender likes the “for sale” process, too.

Ratkovich: We are looking for a lender for our Long Beach project that won’t make us go through a pre-sale. In California, it’s a one-way option for the buyer—you sell under a pink. I am concerned about how the pre-sales phenomenon can create false markets, like the one we’ve seen in San Diego where 30% – 40% of the market was investment-driven. With only a 3% deposit required, and seemingly minimal risk, why wouldn’t it be? But many of these buyers are left with units they can’t sell for the price they paid. This has had adverse affects on markets.

Janson: What about you, Robert? You are developing a project in Indian Wells—are you pre-selling units?

Haiman: State law dictates whether—and to what extent — developers can use deposits from buyers and whether those deposits are refundable. For our Indian Wells project, we have done something in between what Jim is doing in Hawaii and Michael is doing in Arizona: we are taking “reservations.” In California, reservations are fully refundable—either the seller or the buyer can opt out without penalty. However, to convert a reservation to a contract, the deposit is typically increased to 10% of the purchase price. Buyers can terminate a residential contract in California, with the maximum damages set at 3%.

Janson: Can you, as the developer, use the deposit monies for your project?

Haiman: In California, there are options to post a bond that will allow developers to use deposits, but it is cumbersome. We elected not to go that route. The units are designed and we are now trying to get our hands around construction costs. Until the costs are finalized, we are taking reservations only. The reservation is unit-specific or price-specific. This allows us to move with the market. The increase in construction costs are pretty much parallel to the increase in unit value. So, to lock into price right now doesn’t make sense. The factors we are dealing with are: who is buyer, what is the purchase price, and what state laws govern deposits.

Connolly: In Illinois, any deposit you take from a buyer has to be escrowed—the developer cannot use it. Further, contracts are rescindable until the final property report has been filed, and any contract is rescindable for two years following HUD approval. You have to keep in mind the federal HUD requirement before you pre-sell: if you hold a contract or deposit for more than 24 months, you must file with HUD.
If you are building a 65-story building like we are, you are dealing with a 39-month build-up time, and filing with HUD before pre-sales is required. The process can take six to nine months.

“Pre-sales are great for the Hawaiian market, because developers can use the revenue generated by pre-sales.”

Mahoney: One of the hard things about pre-sales is that it makes it difficult to deal with rising construction costs. Our construction costs have skyrocketed, but the cool thing is that the market is coming toward us on price. We are not going to attempt sales until we can put on hard hats, go up to the condo with the buyer and say “here’s the view, here’s the layout and here’s the price.” Deals can get extremely complicated in this market. If you don’t have to pre-sell your project, it makes things easier.

Janson: You mention construction costs—how do you talk to your lender about construction cost increases? You negotiate a loan when costs are at $500 a foot and now it’s at $1,000 a foot. This is very hard for underwriters like me to understand.

Mahoney: Well, before you go to your lender, you put your pads on your knees… But seriously, if you have the right lender you can work out a mechanism for increases. Fortunately, our lender is HSH Nordbank and they are very experienced in the hospitality arena. They follow markets and they were very clued into the “Katrina effect”. Once the government announced an $8.7 billion budget for reconstruction in the Gulf states, every contractor and sub we worked with bumped their prices 15% or more. Gypsum, concrete, steel, trucking—everything went up. This is all anticipation — there isn’t that level of construction going on yet in the Gulf. I expect we will see another bump in prices when things actually get moving down there.

Janson: In that kind of environment, how do you developers deal with change orders and price increases?

Connolly: For condo hotel projects, we experience the “change order du jour.” For every change, our automatic response is “no.” Some of it is legitimate, of course. You have to look at each change and make a determination. But time is our enemy. When you get down to it, the guy in the hard hat holding the hammer, and his supervisor, are the people who will make sure the project comes in on time. So we work with them.

Mahoney: It is important that you have a very good general contractor that is your advocate. This advocate has to say “prove it” to every sub-contractor that submits a change order.

Ito: As an architect, I would say that proper planning is essential. Understand where you want to place your money, so that you can deal with the changes. Do you want to spend it on design in the restaurant? Design in the spa? If you are clear on who your customer is, you can decide where to spend the money.

Connolly: Well, the advantage—and curse—of having a brand, is that they tell us where to spend the money. Fortunately for us, Mandarin is very good at what they do. For example, our project will include a 40,000 square foot spa. We know what Mandarin’s pro forma is for the spa, so this helps us to determine costs.

Janson: Let’s talk about brands. Where do they fit into the mixed-use landscape?

Look for the panelists’ responses to the question about brands in Part II of What Makes a Successful Mixed-Use Project? in the next issue of the Global Hospitality Advisor®. To purchase The Hotel Developers Conference™ Handbook and Directory, go to JMBM.com.

Jim Butler is a hotel lawyer and business advisor specializing in creating solutions for hotel owners, developers and lenders. Jim leads a team of 50 members of the Global Hospitality Group® of Jeffer Mangels Butler & Marmaro LLP where they have assisted clients with more than $50 billion of hotel transactions around the globe involving more than 1,250 properties. In the last five years alone, they have advised clients on more than 80 hotel-enhanced mixed-use projects, virtually all of which have included condo hotels and hotel condos. Jim can be reached at 310.201.3526 or jbutler@jmbm.com.