Keeping the -Mates from Running the – Short and Long Term Concerns in Mixed-Use Developments Containing a Hotel

March, 2012

I. Introduction

The 1990s and early 2000s were a boom time for real estate and hotel in mixed-use projects were no exception. During those boom times, the development of mixed, multi-use projects which included hotel or residential components and regular hotel components took off. Developers realized that by selling off the hotel and/or residential units, they could “have their cake and eat it too”. Although hotel or residential condominium units were sold without the requirement that the purchasers of the units put the units back into a rental program, in fact, the vast majority of buyers did exactly that. Accordingly, developers of which were in a combined development containing condominiums were able to recoup a large portion of the cost of the project while still maintaining the ability to manage the hotel and derive the income from the hotel operations. Similarly, by including a residential condominium component in a hotel building, the developer could lower its per-room cost of the hotel component which it continued to own and operate. And indeed, without adding the residential component to the deal, including a hotel in a mixed use development could not be economically justified, as the cost of the required elements (separate elevators, lobby and back of house) added expense without offsetting revenue. This was especially true because the sales prices of the residential units in a “high-end” brand hotel building were much higher than in a “traditional” residential condominium.

A “Condo Hotel” is where the actual rooms of the hotel are sold to individual unit owners and are operated as part of the hotel on a regular basis. To be clear, we are not really discussing the problems with the “Condo Hotel” structure. While many of the issues discussed may apply if the Condo Hotel is part of a mixed use project, we are discussing what operational issues arise when a hotel is part of a larger mixed use project.

This article will discuss the operational issues we feel might not get the fullest attention when the lawyers are creating the structures employed. To aid in the discussion, we have attached a couple of examples from the public record of declarations which address these issues. Neither of these declarations were drafted by the authors, but are attached for reference to aid the discussion. We have collected additional examples from the public record and can make them available electronically for those interested. We also attach a form of management agreement for a hotel operator acting as the manager of the residential component of the mixed use development. This is an example of an agreement that was developed by referring to the agreements used by several major brand operators.

II. Structure of Condominiums which include a Hotel Component

The legal structure of mixed-use buildings containing a hotel is either (1) a vertical subdivision or (2) a condominium regime. Both structures may be used when the project contains various components in addition to the hotel, such as a residential component, retail, spa, restaurants, etc.

A vertical subdivision is not a condominium structure but rather is created by a declaration similar to a horizontal declaration in a homeowner association community, but in this case the “land division” is done vertically, dividing the property into its various components using three dimensional legal descriptions of air apace. There are some states (and in some cases, municipalities), that do not readily accept vertical subdivisions, in which case this slicing and dicing of real property as a practical matter won’t be used, and in those cases, the condominium solution will be employed. A hotel within a mixed use project can also be structured using a single condominium with the residences being individual units and the hotel component being either a single unit in the condominium if the rooms are not being sold separately, or a condominium within a condominium with a master declaration for the entire project with each “use” (residential, hotel, garage etc.) being a unit and the hotel/condo or residential units being established as another condominium if the rooms are to be sold separately as condominium units.

Whether done as a vertical subdivision or as a single condominium, the key to properly structuring these projects is to provide a method pursuant to which the developer retains control of all of the common area components of the building. In a vertical subdivision these areas are typically referred to as the “hotel lot.” In the condominium structure these areas are typically referred to as the “hotel unit.” The hotel lot or hotel unit is typically comprised of the exterior of the building, the roof, all the electrical and other utility components, the HVAC system, the elevators, the hallways, the lobbies, etc.; in other words, all of the areas which traditionally are common elements of the condominium. The only common element in the condominium is the ground below the building. As the developer continues to own the hotel lot or the hotel unit it needs the unit owners in the building to contribute to the maintenance of these areas. The developer grants an easement to the unit owners to use these facilities in return for which the unit owners agree to pay the cost of maintaining these areas. The developer retains the right to determine what maintenance is required and therefore sets the annual budget for the maintenance of these areas. Although there is a condominium association, the structure is designed to assure the condominium association has no say on how these areas are maintained, as these areas are not common elements of the condominium. In fact, most of these projects are structured so that even the balconies which are adjacent to the units are also part of the hotel lot or hotel unit with easement rights given to the adjacent unit owners to use the balconies. This way the

8211457.3 2 developer/hotel operator can control what is placed on the balconies in order to control the exterior appearance of the building.

Some of the mixed-use communities are done in separate buildings. When a building contains residential units only, it may make sense for that building to be structured as a more traditional condominium so that the unit owners can maintain the common areas of the building, but with the developer retaining an architectural approval right over the exterior of the building. The way in which the project is structured could result in landscaped areas being common elements of the condominium. This can also create an operational problem if the same contractor is not used on a project wide basis.

There are additional reasons to maintain “control”.

• So that hotel owner maintains voting control throughout development and after sale of all other components

• So that hotel owner can effectively delegate to a brand operator and provide a mechanism to assure the quality of service and physical plant

• If something goes “awry,” hotel owner is in control of the process to resolve all issues.

• To provide flexibility in the sale or financing of the separate components

• The hotel owner can effectuate an exit strategy – e.g. remove the project from the condominium regime.

As we will discuss later this control of maintenance of the hotel and the overall project is vital to the hotel owner’s ability to employ a major brand to operate the hotel – as without this control the operator’s brand standards cannot be maintained.

III. Operational Problems

The documents prepared by the developers’ lawyers for these mixed-use projects are complex and voluminous. Although such documents carefully set forth how these projects will operate and spell out the legal significance of the structure, many of the problems being raised by the residential and hotel unit owners occur because they never read and/or understood the documents. Many of the owners are shocked to find out that the building doesn’t operate as a “traditional” condominium and thus they have no voice in the budgeting process or in operations and management.

The main operational problem confronted by all of these projects is the way in which expenses are allocated among the various components of the building. The most prevalent complaint that the hotel operators hear about is that some of the expenses should be hotel

8211457.3 3 operation expenses and should not be charged as a shared expense to the hotel room unit owners or to the residential unit owners. A couple of examples of these types of expenses would be the expense of a concierge and the expense of having towels around the pool. Owners claim that the cost of these items should not be borne by them as they are strictly hotel operation items.

In structuring these projects, it may be important to exclude from the hotel lot or hotel unit which is owned by the developer, those areas of the building which are designed to generate a profit. For example, restaurants in the building should be created as separated condominium units and not as common areas (that is, not part of the hotel unit or hotel lot). Those restaurant units should contribute to the shared expenses of the building in the same manner as any other unit. This structure may not work if a lender or a brand require the restaurant to be part of the hotel even if it is ultimately operated by a third party. The lenders and the brand want to make sure that the entire hotel, including food and beverage, are profitable. Further, having the restaurant included in the hotel may be a requirement for the hotel's maintenance of a particular brand category (e.g., full service, luxury, etc.) The allocation of all shared expenses should be based upon what is common in the industry, and companies with experience in operating mixed- use projects such as these should be used as consultants in setting the budgets for these projects. Of course it would be best to clearly set forth the allocation of the expenses in the creating documents, but sometimes it is impossible to cover every single component and every single expense when preparing these documents in advance of the construction and operation of the property. But, what seems clear gets murky when you ask additional questions about each use. What about areas such as the pool deck? Is that a profit center since food and beverage service typically occurs around the pool area? Perhaps the areas around the pool at which there are tables should be excluded from the shared expense area and made part of the restaurant unit. But of course food and beverages are often served at the lounge chairs as well. Accordingly, it is imperative that flexibility be maintained in the documents to allow the hotel operator/developer to reallocate shared expenses based upon “fairness”. Of course, fairness is in the eyes of the beholder.

Particularly in hotel condominiums, the way in which expenses are shared is not necessarily reflective of the income to be derived by those unit owners who place their units in the rental program. Based upon experience, it is clear that the smaller units have a better cash flow than the larger units. Smaller hotel rooms get a higher rental price per square foot than do the larger units. Unfortunately, most documents are set up so that expenses are shared on a per square foot basis and, therefore, the net income derived by these units on a square footage basis goes down as the square footage of the unit goes up.

Experience has also shown that those unit owners who are in better financial condition have less complaints than unit owners who are not in as good a financial condition. The latter often have mortgages encumbering their units which, of course, reduces their net cash flow and

8211457.3 4 very often turns their net cash flow into a negative. The owners in a weaker financial situation are looking for villains. Disclosure documents inform the purchasers that there was no guarantee of return on their investment, but as stated above, most of the purchasers don’t read the disclosure documents.

Another operational problem with hotel condominiums is making certain that the building remains compliant with the Americans With Disabilities Act (ADA). The ADA requires that a certain percentage of the hotel rooms remain available for persons with disabilities. If all the hotel rooms are sold to buyers as condominium units, and the buyers are not obligated to place their units in the rental program, those buyers who own the ADA- compliant units may not place them in the rental program and therefore the building will not be in compliance with ADA. Accordingly, it is recommended that the developers not sell the ADA units but rather retain ownership of them and accordingly they remain in the rental program. A question arises as to how you determine the number of units that need to be ADA compliant. Should you remove from the calculation those rooms which are not in the rental program?

Another common problem in these mixed-use projects is the result of noise and odors coming from restaurants. The restaurants are typically open to the public and therefore the ability to control behavior is very limited. Of course, the documents disclose the potential for noise and odors, but that doesn’t stop the unit owners and other occupants, particularly of the residential units, from complaining. But a successful food and beverage operation and the “buzz” attached to a hip restaurant is key to a hotel’s success, so anticipating the location and its impact on the residential component will be important during the design phase. It is also important that the sales force accurately represents the components of the project. It is tough to balance disclosure and the material desire to sell units – but over promising always comes back to haunt the developer and the manager.

The parking areas within these mixed-use buildings are also typically income-generating areas which should primarily bear the expense of operation of same, and therefore the parking areas should be excluded from the shared facilities and kept as a separate unit similar to restaurants. However, putting one hundred percent of this use on the garage operator may also not be entirely fair as the garage space will have to permanently allocate space to certain units in order to meet zoning requirements. Depending on how spaces are allocated/sold to residential unit owners, sharing expenses for resurfacing and ramp maintenance at a minimum may be necessary. This unit frequently has separate ownership to facilitate the financing and sale of this operation. A review of the declarations attached as Exhibits A and B will provide a rough "checklist" of a host of other issues to be addressed. Some seem obvious, such as sharing expenses for maintenance of the exterior façade, but there are others which might require redundant physical equipment (e.g., plant systems/generators, elevators) or personnel (e.g.,

8211457.3 5 separate security for hotel and residential uses) and issues arise over whether it would be more cost effective to share but then if one part or the other doesn't feel it is getting adequate attention/use of the shared service, there will inevitably be discussions over reinstituting a redundancy. Lenders [and purchasers] have become more focused on these declarations and how they work as they have just come through a period of many projects under financial distress. They will focus on: Who controls essential physical plant functions (e.g., utilities, generators)? Are the allocations "fair" and if not will the borrower or purchaser be able to force a reallocation? Will a different brand be willing to operate this hotel given how the deal and expense allocations have been made?

IV. Integrating the Brand Operator’s Concerns.

Most owners and developers are not in the business of managing hotels and will plan on delegating this responsibility to a professional manager and generally one which is associated with a major hotel brand. Most operators will require that they manage the association if the residential component uses their brand to identify and market the units – and definitely require this if there are Condo Hotel units. The operators are more ambivalent about managing the residential component if it is merely a part of the overall project and not “branded”. In this case, the operator may well prefer to enter into only an agreement to provide hotel services to the residential unit owners rather than be the party responsible for setting budgets and being on the firing line with all unit owner problems and rule enforcement. The fee for such management and the duration of those contracts (limited to two years in some jurisdictions) do not align with their main business and can be a distraction. In these cases the operators prefer to leave these responsibilities with the hotel owner if they can as their hotel management contracts will require the hotel owner to maintain the overall project in accordance with the brand standards of the hotel.

There is also an inherent conflict between the developer/hotel lot owner and the management company. The management company’s remuneration is typically based upon a percentage of profit derived from the hotel operations. Accordingly, pushing expenses onto the room unit owners will result in a higher profit. The hotel lot owner/developer needs to be fair to the unit owners and avoid litigation. Accordingly, there is often tension between the developer/hotel lot owner and the management company. Care needs to be taken when deciding who will be the one to communicate with the unit owners and it will depend on what the agreement with the operator requires. There is the risk that the management company will “throw the developer under the bus” by blaming the developer for the allocation of expenses.

A similar problem arises with the collection of assessments. The manager doesn’t want to be the “bad guy” and force the collection of the shared expenses from the room unit owners, but the developer needs those funds in order to pay the management company. It is particularly

8211457.3 6 important that the management agreement provide for the manager to notify the hotel lot owner/developer when the unit owners are not paying their shared expenses. Hotel managers, if not experienced in handling these types of issues, can further exacerbate the problem.

To highlight the brand operator's concerns we can again employ the management agreement as a checklist for issues. The operator wants to be clear on the delegation of authority and responsibility under the declaration and other governing documents. Budget control may seem overbearing to some, but the operators need to make sure that the project is properly maintained so that the "brand" the residential buyers bought is sustainable. In order to have effective management, the operator will also require control on billing and collecting and on personnel decisions – this also can rankle residential owners as they may want a different doorman, etc. and feel they are entitled to demand the same. Finally, making sure the project as a whole is maintained and properly insured is vital to the operator's ability to deliver its "product." All of this can add cost to a residential unit in such a project versus one in a single purpose building – but that is the cost of being part of the different experience and amenity package provided in these developments.

V. Rental Programs

While not strictly a matter that arises out of the operation of a mixed use development as a whole, we would be remiss not to spend some discussion on rental programs and problems in a development which is designed to at least partially integrate the hotel and residential components. One of the most difficult issues should be classified as “rouge rentals”. In order not to run afoul of the securities laws, the hotel room units must be sold without any requirement that they participate in the rental program. Therefore the owners of those units can choose not to rent them at all or rent them through whatever agent they choose. This creates a competition for the developer’s management company and can result in under pricing of the room units. Typically, the hotel has a brand name, such as Hilton or Ritz Carlton, and the owners of those brands license their use. The individual room unit owners who are renting their room units on their own or through a separate management company, do not have a license to use the brand name in connection with the rental of their room units. But how is an owner to rent his room unit if he can’t identify the building? Also, the residential units in the mixed-use projects are sometimes used in a transient manner. Since the residential units are typically on different floors than the hotel room units, the other unit owners on the residential floor will be upset to see strangers using one of the residential units. The enforcement of such rental arrangements is very difficult.

When unit owners rent out the room units on their own, it is imperative that the occupants be registered at the front desk so that their presence in the building is known. Also, the occupants will want to charge for services being rendered, such as in the restaurant or spa, and an

8211457.3 7 arrangement needs to be established for them to check in at the front desk and leave a credit card for such charges. Although these rooms are in competition with the developer-controlled rooms, the developer may still want to obtain the income from the restaurant and spa for the use of those facilities by these other occupants.

In projects where the residential component is not “hotel” units, there is often a separate registration desk (and sometimes this is a required element of compliance with securities laws) where unit owner guests check in and they receive information on the amenities available to such guests and the charges for the same. It is important to recognize that in some situations not all hotel facilities and amenities are fully available to residential unit owners (as opposed to Condo Hotel unit owners which typically do have full access). If certain pools, spas, golf courses or concierge services are not fully available it is important to make sure the declaration or shared facilities agreement is clear on these points and that the sales force and then the manager is very clear on what is available at what cost, as lack of clarity and disclosure leads to disputes among the hotel owner, operator and the residential owners.

VI. Conclusion

As in many things, flexibility to deal with changed circumstances and good communication are key to keeping relationships between competing interests on an even keel. The competing interests of the owners of the mixed use development are no different. Very often in these mixed-use projects the residential owners feel they are entitled to be treated as “higher class citizens”. They often expect that seating areas around the pool be reserved specifically for them. They also may expect that the allocation of expenses be more favorable to them as compared to the hotel operations since they believe that their use of the shared facilities has less of an impact than the hotel guests. The project developer and hotel owner and their lenders want to make sure the hotel is self sustaining economically so they will want to make sure it doesn't bear costs in excess of what they believe is normal just to provide additional amenities to the residential component. All parties have to recognize that in a commercial ownership arrangement, compromises in documentation and in "living together" need to be made to avoid litigation.

The solutions to these problems are not always easy to determine. Whether you are dealing with the interpretation and enforcement of the contracts and easements in a mixed-use development that is a vertical subdivision or applying the general law of condominiums and interpreting the declaration, these issues will arise, be discussed and debated. The best any drafter can do is try to anticipate as many issues as possible and allow for flexibility to resolve those that arise in the future.

8211457.3 8 EXHIBITS

Exhibit A: Declaration of Covenants, Restrictions and Easements for Trump Grande Ocean and Residences (exclusive of exhibits)

Exhibit B: Declaration of Covenants, Restrictions and Easements for Carillon Hotel and Spa (exclusive of exhibits)

Exhibit C: Form of Management Agreement

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