Condo hotels offer private individuals the opportunity to purchase a condominium unit for personal use part of the year and for rent to the general public as part of a hotel when it is not in use by the owner. These projects provide a source of financing for developers, a seasonal vacation home for unit owners and the opportunity for unit owners to cover their costs of carrying their units so long as there is sufficient demand from renters. Condo hotels were popular in the early- to mid- 2000s until real estate values started declining in 2008. Historically, there have been strict limits on how condo hotel units could be structured and marketed for sale under the securities laws in the United States. However, two recent legal developments combined with increasing demand for real estate in South Florida may provide significant opportunity for these arrangements to flourish.
Under the U.S. securities laws, if someone purchases a condo hotel unit with the expectation of receiving profits from the rental pool arrangement, then the arrangement is tantamount to an investment contract and the offering of units has to be registered with the Securities and Exchange Commission (SEC) unless there is an available exemption. Until recently, exempt offerings of investment contracts (known as private placements) were strictly prohibited from being marketed to the general public, which required that condo hotels be structured (often with great uncertainty) so as not to be deemed an investment contract. Whether offering a condo hotel unit constitutes an offering of an investment contract generally turns on two key issues: first, the structure of any rental arrangement associated with the unit and, second, the representations that the developer or broker makes about the rental arrangement to a purchaser during the sales process. In 1973, the SEC published a release noting that a condo hotel might not be subject to the securities laws if units are offered or sold without an emphasis on the economic benefits to be derived from the efforts of a third party manager under a rental pool arrangement.
Salameh v. Tarsadia Hotel
In August 2013, the U.S. Court of Appeals for the Ninth Circuit held that the combination of selling condo hotel units in the Hard Rock Hotel San Diego and later entering into a rental management agreement did not constitute the offer or sale of an investment contract. (Salameh v. Tarsadia Hotel, No. 11-55479 (9th Cir. Aug. 13, 2013)). It was significant in the Salameh case that the hotel did not promote the rental management agreement at the time of sale of units and that purchasers were not told that there would be a forthcoming rental management agreement or that a rental management agreement would bring investment-like profits, although the Court noted that a time gap between purchasing a unit and signing a rental management agreement may not always be dispositive.
Offering Condo Hotels to the General Public
Separately, the SEC’s new private placement rules allow condo hotels the flexibility of being offered to the general public as an investment without incurring the significant time and expense of registering the offering and then being subject to ongoing reporting and other requirements associated with being a public company. The new rules, which became effective on September 23, 2013, allow companies to market investment contracts and other securities to the general public under a private placement exemption so long as they take reasonable steps to verify that all investors are accredited investors.
If condo hotel units are offered to the general public as an investment, the sponsor or developer of the project would likely need to involve a broker-dealer (which can be an affiliated company) that is registered with the SEC, FINRA (Financial Industry Regulatory Authority) and the states where units are offered, and whose authorized business includes private placements of securities, since the offering and sale of investment contracts and other securities generally can only be done by a licensed securities broker. The registered broker-dealer also would likely need a real estate broker license in order to sell the condo hotel units. In limited circumstances, the individual directors, officers and employees of an issuer of securities are able to offer securities on behalf of the issuer provided that their primary responsibilities for the issuer are not the offer or sale of securities and that they are not compensated based on securities transactions (and provided that certain other conditions are met).
Only time will tell whether sponsors or developers start offering condo hotel units for sale as securities under the SEC’s new rules allowing general solicitation and general advertising of private placement offerings. We have not yet seen market practices start to move in that direction.