As bad as this recession will be for most hotels, it could be especially devastating for condo hotels, the rage of the industry just a few short years ago. Condo hotels are hotels – usually luxury properties in resort locations – where each hotel room is sold to an individual while the developer maintains ownership of the public spaces like the lobby, hallways and front desk. The hotel room owners then place their rooms into a rental program that allows them to share the revenue and costs with the developer each time a guest stays in one of their units. The condo hotel is managed just like any other hotel, often by a professional management company.
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Even though most condo-hotel rooms were not sold as investments because of securities laws, many buyers apparently purchased them as investments. However, even when the hotel industry was flourishing, the value of most condo hotel rooms did not appreciate much. Worse still, some condo hotels have not generated enough cash flow to cover the hotel room owner's mortgage, real estate taxes and assessments.
With a severe downturn now confronting the economy in general and the hotel industry in particular, condo hotels are facing unprecedented cash flow problems. When such problems confront a typical hotel, there are just a single owner and lender to battle it out. If the owner does not pay the mortgage, the lender can seek to foreclose and acquire ownership of the hotel. A bankruptcy may ensue, but the hotel in all likelihood will continue to operate as usual. In contrast, a condo hotel may have hundreds of owners of individual hotel rooms – all with their own lenders – as well as the developer who owns the public spaces and may have his or her own lender. These multiple complex relationships create challenges for the condo hotel's future when it faces large cash shortfalls due to falling occupancies and room rates.
If a hotel room owner fails to fund any regular or special assessments, the condo association likely can seek to foreclose on his unit. However, if the hotel room owner has failed to pay his assessments, he probably has also failed to pay the mortgage on his unit, in which case his lender can foreclose on his unit. The problem for the condo hotel in that instance is that a lender is less likely to place its units in the hotel’s rental program, but usually will just list its units for sale with a real-estate broker. The fewer the units in the rental program, the less revenue to sustain the hotel, making a bad situation worse.
If the developer fails to fund shortfalls for which it is responsible, the condo hotel faces even more dire consequences. Even though the developer can pass along to each hotel room owner most costs to operate the condo hotel that are not covered by the hotel’s operating revenues, the developer remains obligated to fund any shortfall if that money doesn’t come in. If the developer fails to do so, the condo association can foreclose on the areas of the hotel owned by the developer. However, if that happens, the condo association then becomes obligated to pay all such shortfalls. It is not hard to imagine situations where the hotel room owners will resist funding the hotel’s shortfalls by having to step into the developer’s shoes. This is especially true where lenders have taken back units and are not participating in the rental program.
Of course, at the same time that the condo hotel is facing financial distress, vendors likely are not being paid current and guest service may be suffering. This situation puts the hotel’s management company in a precarious position as it may be dealing with vendors looking to the management company as the party ultimately responsible for their bills. Also, the hotel may be delinquent in paying its management fees. Of even greater concern is the possibility that the hotel may close, leaving the management company exposed to substantial damages where it employs the hotel’s workers.
If neither the developer nor the hotel-room owner funds the cash shortfalls, it is likely that the hotel management company will terminate the management agreement and leave. In the absence of anyone stepping up to retain a new management company (which will require an assurance of adequate working capital), there will be no one to operate the property as a hotel. As a result, the property likely will revert to a pure condominium, causing even further financial distress to the many unit owners who bought their units primarily as investments.
David M. Neff is co-chair of the Hotel & Leisure Group at Perkins Coie in Chicago, Illinois. David can be reached at (312) 324-8689 or dneff@perkinscoie.com.