7 tips for mixed-use due diligence

Investors must take many different things into consideration when deciding whether to purchase a hotel within a mixed-use project. Photo credit: AJ_Watt/E+/Getty Images

Performing due diligence on a hotel that is a portion of a mixed-use resort requires a detailed understanding of the operative governance regime for the project, such as the condominium and property owners’ declarations and covenants and restrictions regulating the project. Like a freestanding hotel, a hotel within a mixed-use project must function in accordance with operating standards that impact some combination of positioning, operating profit and capital appreciation.

While a mixed-use hotel theoretically benefits from the synergies between different uses within the project, its development and operation are intertwined with the larger project in many respects that may have either a positive or negative impact. Each aspect of the combination of uses within the project and the design, development and operation of these various uses entails the prospect of either enhancing or diminishing the hotel component and each other component of the project.

A careful, perhaps prescient, balancing of the requirements of each element of the project at the outset will have a lasting impact on the success of each component. The following are some of the chief questions to be addressed by an investor in an existing, or even a partially completed, mixed-use project.

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The Combination of Uses

Consider whether some components of the project have an undue impact on other uses/stakeholders in any of a variety of ways, including parking requirements, noise and other potential nuisances, compatibility of guests and impacts on project infrastructure. Ideally the guests of one use will enhance the business of the others and will not confuse or diminish the positioning of the primary component of the project—for this purpose, the hotel. Also to be considered: some components present competition to others, such as restaurants, bars and spas.

Physical Requirements

Parking requirements and the design of major building systems present the possibility of cost-saving benefits or elements of incompatibility that must be considered. Physical aspects of the project, such as outdoor and indoor publicly accessible areas, beaches, swimming pools and saunas also require attention from the standpoint of the impact on guest experience, the ability to maintain brand standards, mitigation of potential premises liability, maintenance and capital costs.

What is Being Acquired?

The acquisition of a single component of a mixed-use project entails the property being acquired in fee simple (or by lease) as well as a basket of rights pertaining to use and occupancy of other components of the mixed-use project. Is title to some or all of the parking being acquired? Is it shared with other components of the project and their guests? Can hotel parking be physically and operationally separated from other elements of the project? How about green or developed open spaces, vehicular and pedestrian access routes, swimming pools, elevators and building systems? What about the very skin and rooftop of the hotel?

Ownership is not essential, but it is critical to understand what is owned and the rights to use and access, allocation of responsibility for maintenance, repairs, insurance, security and capital replacement. Which stakeholder or stakeholders have the power to set and enforce operating standards, access and the other issues mentioned? Does the owner of the hotel have the right to exercise self-help if appropriate actions are not taken and to pass on the costs to other components of the project? Will these financial obligations result in liens against the other components of the project that run with the land? Conversely, a hotel owner needs to be aware of the rights of other stakeholders and their invitees to utilize portions of the hotel as to which the hotel owner acquires legal title.

Governance Regime

Alluded to above and described in more detail below, complementing the physical design of a project is the legal structure that regulates its use and enjoyment by various stakeholders. This is commonly referred to as the "governance regime."

The governance regime typically is some combination of condominium and property owners’ declarations and other declarations of covenants and restrictions. These are merely recorded declarations of the rules and regulations for the development and operation of the mixed-use project and are prepared and imposed by a "declarant." The declarant, typically the developer of the project, maintains certain rights with regard to the project for itself and other stakeholders, i.e., owners or tenants within the project.

The rights of the declarant are often assigned to the owner of one or more of the most substantial components of the project, in this case the hotel owner. Just as the governance regime may impart to the hotel owner or other stakeholders’ rights of use and access to portions of the project that they do not have title to, the governance regime may allow other stakeholders within the project to use and access elements of the hotel.

Consider areas such as hotel lobbies, outdoor open space, restaurants, bars, spas and swimming pools. While this may make sense if properly structured, it would not be appropriate for other stakeholders to have access to guestroom floors and certain other elements of the hotel.

Moving beyond elements of the project that are owned by a specific party, there may be "common elements" of the project that are owned by a property owners association for the benefit of some or all of the stakeholders within the project. Here, consider open space, pedestrian access and enjoyment spaces, roads, building systems and other infrastructure.

Alternatively, title to some of what could be common elements may be vested in the declarant pursuant to the governance regime or in a primary stakeholder, for example the owner of the hotel. In these instances, those elements that would otherwise be thought of as common elements will nevertheless be subject to use and access of multiple stakeholders and the costs associated with use, access maintenance, insurance and capital replacement will be allocated among various stakeholders as provided within the governance regime. This mechanism may have the effect of enhancing the control over these shared elements of the project and, potentially, avoiding some of the restrictions imposed by legislation concerning condominiums and property owners’ associations.

These are extremely important issues in the proper diligence of a mixed-use project or a component thereof. Understanding what the documents comprising the governance regime provide for is critical, as is the analysis of the enforceability of the various elements of the governance regime, some of which may violate public policy within the applicable jurisdiction and thereby become unenforceable in part. A carefully developed governance regime may not avoid every possible conflict with public policy but should incorporate a "plan B" that achieves an acceptable outcome in the event that an element of the governance regime is invalidated or is not enforceable.

An important aspect of the governance regime may be an operating standard for some or all elements of the project. An operating standard establishes a benchmark against which the declarant may require compliance and impose charges for maintenance of the standards as well as the cost of violations of the standards. Bear in mind that the operating standard for the project will not be the same as the operating standard for the hotel but should incorporate the concept of compatibility with the hotel.

Operational Control

From the point of view of a hotel investor, with some exceptions, that which is not owned should be controlled. This, of course, runs into conflict with the interests of other stakeholders having an interest in the use and enjoyment of these elements of the project. However, control is a relative concept, not an absolute.

To place the control issue in context, consider the decision that it is time to upgrade carpets, flooring, wall surfaces, lighting, signage, paving, landscaping, etc. How about building systems? The last thing that an investor wants is for these decisions to be subject to the decision-making process of an association of stakeholders (condominium board or property owners association board). This is where ownership by the declarant of what would otherwise be common elements is vitally important.

If ownership of these project elements cannot be achieved, it may be possible to arrange voting rights/control of an association in such a manner as to assure control by a dominant stakeholder, typically the owner of the hotel. This issue is heavily impacted by state legislation which may limit the ability of a project sponsor to maintain the control that it desires. This question of control is one of the most important legal drivers of the investment decision.

Cost and Expense Allocations

The allocation of costs and expenses within the mixed-use project is very important but does not generally raise legal issues of the same complexity as control issues. The cost side of this issue typically can be diligence in a relatively straightforward manner. Nevertheless, cost allocations are probably the most commonly litigated issues pertaining to a mixed-use project.

One typical subject of such litigation is the commonplace deviations between cost allocation practices and what is permitted pursuant to the governing regime. It is common for the project sponsor to agonize over fair and equitable cost allocations only to have project managers implement their own design for this important aspect of the project.

Another subject of frequent contention is a misalignment of cost allocations with benefits derived by the various stakeholders. Typically, there isn't room for judicial relief if the documents are clear regarding cost allocations but there are frequently instances in which one stakeholder derives financial benefit from a service that is not taken into account when allocating the costs of providing the service. An example of this would be a hotel profiting from the parking operation and allocating all of its third-party valet parking contract costs to various stakeholders within the project. This type of issue may be the result of inadvertence, rather than greed. Front-desk costs in the case of a condominium hotel may also fall into this category.

It is important to note that litigation within a complicated mixed-use project is both costly and frustrating in that resolution may entail reasoning with a renegade condominium association stoked by its own propaganda and dislike of the declarant, whoever that may be. Consequently, beyond ethical considerations, it is important that cost allocations be fair and reasonable, carefully documented and implemented.

When thinking about cost and expense allocations, recognize that this entails both operating costs and capital expenses that are both sizable and, frequently, unanticipated. The existence of reserves and sinking funds is an important consideration during due diligence. This needs to be considered both from a practical perspective of when the reserves will be necessary as well as the legal perspective of what may be statutorily required pursuant to condominium or POA legislation.

Liability

Liability considerations vary based on the specifics of the project and are many. Consider some of the following:

  • Responsibility for construction defects
  • In the case of "for sale" real estate, misrepresentations in the sales and marketing process
  • Violations of securities laws in the case of condominium units eligible for rental program participation
  • Voting and board representation in connection with condominium or property owners associations
  • Violations of local ordinances, including code enforcement
  • Failure to maintain required reserves
  • Violations of condominium and POA legislation including provisions regarding the use of deposits by the developer and the impact of amendments to a condominium declaration on rescission rights of the prospective purchaser
  • Violations of the Interstate Land Sales Full Disclosure Act
  • Cost allocation questions, including what may be an inadvertent violation.

Mixed-use projects that include residential components, be they pure residential or transient occupancy rental program units, require an intensive analysis of statutory liabilities including successor developer liability, special voting rules that restrict declarant control of the Association and restrictions on the ability to maintain long term control over the management of the Association. This last issue is of particular importance to hotel brands that frequently want to manage the condominium association so as to assure the maintenance of the brand standards as to those elements of the residences that impact hotel guest experience. Many jurisdictions grant the Association the right to terminate a developer-initiated association management contract following turnover.

As one can imagine, the foregoing merely provides a rough framework for the legal issues that arise in the context of performing due diligence for a hotel or other use within a mixed-use project.

Andrew S. Robins is co-chair of the Hospitality Sector Team at national law firm Akerman. He counsels hotel operators and other hospitality industry clients on a wide range of regulatory and operational matters, including development and structuring of mixed-use development projects. Robins can be reached at [email protected].

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