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Converting to Timeshare, a Follow up

Monday, December 24, 2012
Mr. Arthur O Spaulding , Jr.
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Cox, Castle & Nicholson LLP
Cox, Castle & Nicholson LLP
Real estate & hospitality law firm

I read with great interest your September 25th article entitled “More Money With Timeshare Conversions”. The essence of the article was that, incertain circumstances, the conversion of hotel rooms to timeshare makes dollarsand sense. The article recited a numberof factors to be considered in evaluating whether or not the conversion totimeshare of a portion of the rooms in a hotel might be an idea that couldboost the overall economics of a project. As a lawyer who has practiced in the hospitality world for parts of fivedecades with a special emphasis on timeshare and other forms of vacationownership, I think the concepts embodied in your article were valid and havebeen proven. There has even been acorollary that says that the development of resort projects will probably notpencil out if both hotel and timeshare products are not a part of the proformafrom the beginning. But as with anybroad statement, the devil will be in the details and there are certain factorsthat can inhibit or even prohibit a conversion. It is best to keep those inmind when considering the conversion topic.

The principal impediment to the conversion of all or even a portion of anexisting hotel to timeshare is the presence of real property secured debt onthe project. In most jurisdictions, thesale of timeshare interests in a property is going to be a regulated business,meaning that the developer/seller is going to have to comply with certainregulatory requirements in order to obtain a permit or right to sell timeshareinterests. Although certainjurisdictions will be more lenient or flexible about those requirements, one ofthe more universal regulatory restrictions brought about as part of thelegislative effort to protect consumers from fraudulent practices, is therequirement that the real estate that serves as the source of the timeshareowner’s use and enjoyment opportunity be free and clear of monetaryencumbrances, or, if not, the timeshare owners’ use rights are givensuperiority over the interests of the lienholder.

In the context, then, of a hotel that is encumbered by financing that issecured by a mortgage or deed of trust on the hotel, itself, conversion totimeshare is not going to be permitted unless the lender subordinates its debtto the interests of the timeshare owners and the timeshare program and the timeshareinterests are sold free and clear of that encumbrance. As you can imagine, the usual lender on ahotel is not going to be too keen to give up its security, and certainly won’tunless it is paid an appropriate release fee to do so. And, even assuming it is possible to convincethe lender to release its lien, there is the legal issue of how can that bedone where the hotel is simply a single building or group of buildings sittingon a single parcel of land? In otherwords, how does one make the timeshare portion of the hotel a separate legal parcel,group of parcels of other type of real estate interest that can be releasedfrom a mortgage that encumbers the entire hotel?

Although there are a number of ways to address the release issue, thesimplest would probably involve converting the hotel to a condominium form ofownership prior to attempting the timeshare conversion. If a conversion to a condominium structure ispossible, then the secured debt on the whole of the property can be released ona per unit basis to free the units up for inclusion in a timeshareprogram. From the lender’s point ofview, their security is not impaired if they receive a release payment witheach closing of a timeshare sale, or if the release price is calculated on a “perunit” basis, the timeshare closings for the unit are bundled and the releasesof the timeshares from the mortgage are effected simultaneously in order togenerate the total release price per unit. In some cases it may be necessary to prepay the first release fee inadvance of any timeshare sales in order to prime the sales pump with free andclear inventory.

Of course, converting a hotel to a condominium structure may require someconsiderable advance work at the permitting and entitlements level within thejurisdiction where the property is located, so it is well advised to check theplanning and zoning requirements of that jurisdiction before embarking on thispath. As an example, in a timeshareproject we handled for a client this year, the decision was made to convert thehotel to a condominium form of ownership for both timeshare phasing andmortgage release reasons. Although thecity treated timeshare use and hotel use as the same types of uses under theirzoning ordinance, it was still necessary to process a “condominium subdivisionmap” though the planning department before the condominium could becreated. That process, althoughstreamlined by an aggressive approach we utilized locally, still took abouteight months to complete, and that was without any opposition to theconversion.

In jurisdictions where condominium conversion is not possible, it mightbe possible to utilize the conveyance of the hotel into a trust designed toaccommodate both hotel and timeshare uses, as well as preserve the lender’ssecurity on the property. The end resulthere, however, is a timeshare interest that will be treated in mostjurisdictions within the U.S. as a right-to-use interest or timeshare use. This approach is especially useful fortimeshare programs that are referred to, generically, as “vacation clubs”,where a timeshare buyer receives a club membership rather than a deed to a realestate interest as evidence of the timeshare owned. In such a situation, the lender would receivea security interest in the developer/owner’s beneficial interest in the trust,in lieu of the lender’s former security interest in the land andimprovements. As you can imagine, forcertain classes of lenders that is likely to be a non-starter, but, for lendersthat are a bit more entrepreneurial, this is a distinct possibility.

Another concern that a hotel project lender may have in considering thepossibility of a conversion of a portion of the hotel to timesharing is the“mixed use” aspect. The lender will seethe building as a whole, and may be concerned about the management of theproject should the developer go bankrupt. In the context of a condominium conversion, the usual structure wouldinvolve a two tiered legal structure, with the condominium and its association ofowners at the foundational level, and the timeshare regime, with its ownowners’ association, existing as an overlying layer. At the condominium level, as the units arebrought into the timeshare program those units will remain subject to thecondominium regime but are further subjected to the timeshare regime. The lender would have its real propertysecurity interest in the unsold, unannexed units. If there were a project meltdown and thelender were required to step into the project, the lender would become theowner of the units that were not yet subjected to the timeshare regime, and thetimeshare owners or timeshare association would be the owners of the timeshareunits that are subject to the timeshare regime. In that scenario, the lender is probably going to want to be able totake over management of all of the condominiums, both those that are subject tothe timeshare regime and those that are not. If its foreclosure or deed-in-lieu has given it title to more than halfof the total number of units, it should be able to control the management ofthe common areas of the project, even though the timeshare association will beresponsible for the management of the interiors of the timeshare units.

There are numerous additional technical and regulatory considerationsthat would be involved in any decision to convert a hotel property totimeshare, but those identified above are probably the most significant for anyserious consideration of such a plan. Inother words, there may be very good and compelling reasons to explore the ideaof converting a hotel to timeshare, but there are also very significant legaland practical hurdles to be overcome to bring such a plan to fruition.

Arthur Spaulding Jr.    Mr. Arthur O Spaulding , Jr.
Cox, Castle & Nicholson LLP
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