Second Homes 411

Guest Writer: Jon Pedersen - Loves nature… and vacationing…

Recently, I traveled to Yellowstone Park to visit a friend in some of the most inspiring environs in our naturally blessed country. My friend, who lives in a town outside the park, and in the early morning hours we drove up the valley behind his home into the mountains. On a county road running along a stream and through the valley we passed twenty-five impressive single-family vacation houses, with a dozen more in various stages of completion. He told me that work had been stopped on the houses because developers couldn’t sell them anymore.

The Turner Corporation, an industry recognized source for data on construction costs, reports that increases in residential construction expenses increased by 10.33% between 2005 and 2006. My friend estimated that the existing homes in the valley were empty 70% of the time and a third of them were for sale. This story is being told in many of America’s rarest air markets.

In an era when energy prices are rising and volatile, the environment is suffering from the use/depletion of natural resources and real estate values have jumped dramatically, there is a more economically, environmentally and socially responsible manner in which to own and utilize the valuable properties where we all want to spend our time. In The World Energy Outlook 2006 it is predicted that world energy needs will be 50% higher in 2030 with 60% of that increase in oil and gas use with the associated emissions and damage to the environment. The United States only accounts for 6% of the world population but uses 24% of world energy output. The cultural costs of over-consumer consumption can and should be examined.  The following report is not intended to discourage development, but to encourage the great American inventive spirit to develop more wisely, and to point out that there is progress being made in new ways today.

Through newly evolving ownership and property structures such as fractional interests, private residence clubs, timeshare, condominium hotels and mixed property type resort developments we can optimize the utilization of limited time and resources.

Most of these property ownership structures are fee simple, the purest, capitalist form of real estate interest. They can be transferred (through sale or inheritance), mortgaged (often with tax deductibility benefits) and rented or loaned in the same manner as traditional real estate ownership. Fractional ownership, a form of Tenants-in-Common, refers to the divided ownership of an individual property. In the case of the houses in the Montana valley, six families could enjoy the property for eight weeks a year, two weeks in each season. Each owner would be responsible for a proportionate share of the taxes and operating costs of the property. Each owner holds legal title to a fraction of the property. Amenities such as personal property storage, transportation and provisions can be supplied through the homeowner’s agreement of the condominium association established by property owners.

Many four and five star resort and urban center hotels are converting or developing all or  part of their properties to condominium hotel (the Plaza in New York, the Delano in South Beach, the Hard Rock in San Diego, the Ilikai on Wakiki beach). Under this structure, owners occupy their rooms for a limited number of days per year and the units are rented as part of the hotel rental pool when the owner is not in residence. Owners receive a portion (often about 50%) of the rental income. These properties, too, can be mortgaged and transferred. Businesses, snowbirds, real estate investors and lovers of fine hotels provide a strong source of demand for condominium hotels. Like any property, familiarity and history provide an ownership bond. There has been much media coverage of the economic benefits of condo hotel ownership for the consumer, and economic motives for the hotel developer; but there has been little to no attention to the ecological upside of fractional, condo hotel, and shared ownership schemes.

The ecological benefits are simple, and don’t make a compelling story maybe, but they need to be recognized. When one family purchases a single family vacation home or condominium in a rare-air destination, this property is seldom used and enjoyed, yet the development footprint, utility expense, infrastructure expense is borne by the environment without interruption. In a single instance, this use of resources in minimal, but lets consider the macro-economic effect.

One-third of all homes sold in 2005, a record year for real estate sales, were vacation homes. This means many hundreds of thousands of homes sit idle for 9+ months a year in America alone. Is there a better way to develop and share these destinations?

Although city-center destination do not seem like natural settings, the development of condo hotels and fractional projects in urban areas has a beneficial positive effect on the urban environment too. Fully utilizing the infrastructure in a city means that less suburban and rural development is required, and efficiencies can be maximized. The desire of America’s soon to retire baby boomer generation, 76 million strong, will stress the housing markets they seek, and leave a void in markets they exit. The strong surge in recent years in condominium sales has its roots in three factors. First, the rising cost of real estate, next the down-sizing and empty nesting of the boomer generation, and lastly the entrance of the boomer’s children into the housing market. The dots of these three dynamic forces are easily connected, and vacation property development trends are just as clear after consideration of these facts.

One fact is that not every boomer can afford multiple homes, especially in highly desired vacation markets where competition for rare-air real estate has set prices-per-square to unexpectedly high levels ($500,$750,$1000+). The much touted ‘wealth transfer’ effect is real and measurable but will likely only serve to make already wealthy boomers more well-healed, while leaving the mass boomer generation with a less than $250,0001 net worth at retirement.

So without massive inheritance inflows, the boomer generation will be required to ‘reinvent’ a retirement housing solution. Condo hotels will appeal to environment/sharing motives of this generation as well as the economic reality that offsetting expenses with rental income will benefit the owner.

The media has beaten the proverbial ‘dead horse’ that condo hotel is not an ‘investment property’ but the reality is that neither is a traditional condominium in this sense under the same logic. The income from a condo hotel creates a passive offset of ownership expenses by renting the condo when the owner is not in residence. Its easier than a traditional condo and offers more amenities and lifestyle features.

To take a more professional investors view of the return on a condo hotel unit investment one can use the traditional commercial real estate measurement known as capitalization rate (cap rate). A cap rate takes the net operating income of a property and divides it by the sales price (investment). Net operating income is derived from the cash flow produced through the participation of the unit in the hotel rental pool. The split between the hotel management company and the unit owners is established by the rental pool agreement. Some of these rental pool agreements are complex, but most in place at this point return 40-50 % of the revenues are returned to the unit owner and often the association dues are paid by the hotel mgt company. Normally condo hotel rooms are financed with a 20% equity investment. Many analyses of the returns on these investments do not recognize the lower equity investment relative to a normal commercial real estate investment. Also underappreciated is the fact that interest paid on the financed portion of the investment is deductible for the unit owner. So, condo hotels offer a form of real estate ownership which is unique and possibly personally tax deductible on a quasi commercial property.

Many early adopters to the condo hotel trend are counting on the ‘future demand of buyers’, speculating that any loss in cash flow would be gained when values of these rare-air markets appreciate at rates that are higher than general inflation. In light of the 76 million baby boomer retirees, if the trend catches on, this gambit may be a very real market mover.

The homeowners association in most condohotels is controlled by the hotel operating company. This is because the hotel could not operate efficiently with the unit owners controlling the day to day operations of the hotel. In return for accepting  hotel management control of the HOA the unit owners should require equitable terms relating to the cost of unit maintenance, condominium interests and overall hotel operating costs. The agreement should give unit owners the ability to replace the hotel management company if specific realistic financial targets aren’t met. The quality of the unit owners/ hotel management relationship should be established in initial documents. Smart hotel mgt co’s will make this regime attractive to unit buyers as part of their marketing plan. Projected returns on condohotel unit investments cannot be used as part of the sales effort by the developer because of securities restrictions (if an outside manager’s performance is used as part of the sales effort, an investment will come under SEC regulation). So an independent understanding of all these factors is necessary to analyze these transactions.

A successful  early condo hotel project, and one of our case-studies, is The Raffaello in Chicago’s Gold coast. Many of the buyers we met have a connection with the city and desire a part-time resident in the property’s location. Many are snowbirds that have moved to the south and southwest but have family in Chicago and visit regularly. They stay in a great historic building within walking distance of world-class restaurants and shopping.

There are other forces coming to a confluence which will propel these ownership structures into the mainstream. Beside the U.S., in Europe and Japan baby boomer demographics are a huge social force and have an additional 213 million in the cohort. Beginning in 2008, the rate of retirement age boomers (65 years old) will begin to accelerate. At its peak, in 2016, 25 million people per year will be retiring throughout these regions. They are healthier and more mobile that any generation before. Their ability to finance these properties will improve the properties quality and stability. The post 9/11 desire for security and, we believe, a growing appreciation of community, is a more subtle contributing factor.  Radical change in the quantity and exchange of information through the internet makes all these changes possible. The relaxation of international barriers to cross border investment (NAFTA the European Union) creates a deep source of demand for these properties and ownership structures.

There are projects in the Caribbean and Mexico underway which take these concepts to new levels. Because of the relative economics of land, labor and materials developers are devoting capital to international multi property type mega properties. For example, there is a 17,000 acre project breaking ground in the Dominican Republic which will feature a five star centerpiece condo hotel, fractional and whole ownership villas and condominiums, marina slips, an Arnold Palmer golf course and a private air strip. All owners (and renters) can utilize the amenities of the hotel (room service, linen service, pools, health facilities). Vacation Finance is one of the only U.S. lenders specializing in cross border mortgage loans on all these property types

Another variable contributing to the demand for condo hotels is that they allow buyers/investors to take advantage of the 1031 like-kind exchange tax treatment of capital gains.  The added bonus of the commercial valuations of hotel (during certain portions of the real estate cycle) versus residential rental properties is missed by most observers. Savvy investors have bought condo hotel units and avoided the sharp downturn in many residential real estate markets. We also lend on limited liability corporation purchases of condominium hotel units, allowing members to buy properties in a reduced liability, tax beneficial fashion.

There has been a disconnect between hotel valuations, which are near all time highs, and other real estate markets which are declining nationally. This has caused some disruptions in the condo hotel market as developers no longer have a clear economic incentive to sell rooms. Combined with a substantial decline in speculative real estate investment, this has resulted in a pause in  hotel conversions and a slowing in condo hotel unit sales. This will, in our opinion, be a temporary slowdown in a concept which will be stronger than ever as market valuations correct.

Return attribution on loans. Investors in pools of loans collateralized by condo hotel properties should be big winners as the market evolves. The average fico score of condo hotel applicants at Vacation Finance through May 2006 was between 740 and 750 with commensurate income, Debt to income ratios and levels of liquid reserves. Higher interest rates and yield spreads, combined with superior credit performance (fewer defaults, less property value volatility and better credit performance (lower defaults, cash flow to note holder in case of default). The returns on cross border transactions are far more compelling and where we are spending most of our resources. For a more detailed examination of investment returns on condo hotel loans see our website.

The condo hotel concept is in no way a new creation, The Illikai hotel in Honolulu has been operating, in part, as a condo hotel since the 1970’s. A recent change in ownership has brought another wave of rooms to market. Buyers from the west coast of the U.S.  and Asia are seizing the opportunity to own one of Hawaii’s most spectacular properties at a time when traditional ownership structures are priced out of the reach of all but the most wealthy. This choice to own a condo hotel that is shared and optimized through constant hotel-style rental management, is good for the consumer-investor, the hotel operator, the would-be guest, and the environment that is not developed because so many interests are served in this form of ownership.

Rare-air environments can be best utilized by market acceptance and knowledge of the condo hotel, fractional and evolving timeshare vacation real estate ownership products. The environment upside of this development needs to be recognized by government officials, environmentalists, media, developers and consumers.

Jon Pedersen
Vice President
Vacation Finance
America’s First Second-Home Lender
jp@vacation-finance.com

Jon Pedersen has a Bachelor’s Degree in Economics from The University of Michigan, has spent over 20 years in bond and mortgage trading, and is Vice President of Vacation Finance. Vacation Finance, America’s First Second-Home Lender, is a lender to condo hotel unit buyers and to a lesser degree condo hotel developers. We have arranged mezzanine financing hotel condominiums project development, and have partnerships with hedge funds, U.S. banks and Non-U.S. investment companies. We understand the condo hotel market better than lender. Bob Waun our CEO, is recognized nationally as an expert on second home ownership structures and has been interviewed or featured in articles in the Wall Street Journal, Crain’s Business, The Scotsman Guide, Forbes Magazine, The New York Times (www.vacation-finance.com).