Homeowners Associations

Aug 222012

The Condo Hotel: The Worst of Both Markets

I stayed in a condo hotel this past weekend which you do not hear too much about anymore. Condo hotels tend to mainly be found near beach and mountain destinations. In Tennessee, they are primarily found near the Smoky Mountains in towns such as Gatlinburg, Pigeon Forge, and Sevierville.

In 2002, the Securities and Exchange Commission (SEC) issued a “no-action letter” which contained specific guidelines, or “safe harbors,” for how to market and sell a condo hotel product without engaging in the sale of a security under U.S. securities laws. Many developers viewed the letter as SEC guidelines on how to develop condo hotels and the result was an immediate boom in the industry. However, the condo hotel sector took a beating in the financial downturn (“the Pets.com of the real-estate bubble”) and it has been dormant ever since.

At first glance a condo hotel appears to represent the best of both the residential and commercial real estate markets. A buyer owns the specific condo unit and pays the property taxes, insurance, and maintenance fees for it, while a management company rents out the rooms and splits the revenue with the owners (typically around fifty percent). Even though the buyer owns the condo unit, they are limited on how often they can use the unit. With taxes, insurance, maintenance fees, tough financing, and rental market fluctuations, condo hotels are actually one of the more dangerous investments. Thus, many condo hotels were unable to close on unit sales when the real estate bubble burst and prospective buyers were faced with these tough economic challenges.

Although not specifically addressed by the Tennessee Condominium Act of 2008, the formation of a condo hotel is similar to that of a standard condominium regime. They are created by a Declaration and normally accompanied by a set of bylaws. They typically also require the approval of a shared facilities agreement, a rental management agreement, and a unit maintenance agreement. The structure of the agreements, and the advertisements and representations made in the sales process, are important because at some point the buyer is no longer just purchasing real estate but is instead investing in a business enterprise triggering U.S. securities laws.