Editorial: Recent Changes in SEC Rules Creates Opportunities for Condo Hotel Developers

by Bilzin Sumberg

The real estate market is back and with it has come renewed interest in building condo hotels, especially in popular vacation destinations like Miami, Orlando and Las Vegas. Condo hotels were very popular among foreign investors in the last real estate cycle and there are signs that trend is about to repeat. A condo hotel is exactly what it sounds like—a condominium building that has hotel-type operations and amenities. Condo hotel units typically are sold to individual buyers and units are rented to visitors as hotel rooms, with unit owners receiving a portion of the rental revenues. Recent changes in Securities and Exchange Commission (SEC) rules make condo hotels easier to market and finance.

Developers often rely on down payments on unit sales to help finance their projects. For that reason, it is in developers’ interests to efficiently and as quickly as possible market and sell units with little complication. However, until recently, condo hotel developers have had to be extra cautious when selling units so as to avoid structuring the sale as if the developer was selling a security. This is because, if the sale of condo hotel units is deemed a sale of securities, the transaction is subject to registration requirements of the SEC and state regulators, a process than can be long and complex. In order to avoid these requirements, condo hotel developers have historically sought to structure their projects to not be deemed securities, which meant that units could not be marketed with any rental arrangement or any pooling (or sharing) of rental income among all units. If condominiums were offered and sold with no mention of potential economic benefits derived from managerial efforts of others, and a unit owner, after purchasing his or her unit, entered into a non-pooled rental arrangement, then the transaction was not typically deemed to involve a sale of securities -- so long as the rental arrangement was not offered in connection with the purchase. However, it significantly limited the marketability of condo hotel units as developers couldn’t market the rental arrangement.

Fortunately for developers, the laws have changed just in time for the real estate upswing. With the enactment of the Jumpstart Our Business Startups Act, or JOBS Act, and amendments to the SEC’s private placement rules mandated as part of the JOBS Act, there are new opportunities available to developers. Now, they can market condo hotel units for sale together with a rental arrangement (including one that has rental pooling or sharing among all units) without needing to register with the SEC or their state regulators. The SEC’s private placement rules, which set forth an important exemption from securities registration requirements, have until recently prohibited any form of general advertising of securities or general solicitation of investors. Under the amended rule, which became effective on September 23, 2013, the SEC lifted the ban on general advertising and general solicitation. Now, developers can use the Internet, television, newspaper and any other form of mainstream media, including social media, to advertise condo hotel units for sale to the public while emphasizing potential economic benefits derived from a rental arrangement. By using the Internet and social media, some real estate developers are starting to use crowdfunding to sell their projects. The only limits under the new rules are that all of the purchasers of units must qualify as “accredited investors” and the developer must take reasonable steps to verify their accredited investor status. Now that developers are able to freely advertise rental arrangements and provide interested persons with financial projections, it significantly increases the marketability of condo hotel projects.

Furthermore, the new rules now allow developers to require unit owners to participate in rental programs as a condition to purchasing a unit, as well as requiring rental pooling arrangements if so desired. Mandatory rental programs differ from mandatory rental pooling arrangements. Rental pooling typically involves the pooling of revenues and expenses that are shared ratably among unit owners, regardless of whether or not a particular owner’s unit was actually rented during (or for the same amount of time in) a given period. By implementing mandatory rental programs, condo hotels can have a more reliable source of rental income and improved ability to book rooms since they would have certainty of guest room inventory. Implementing rental pooling arrangements can help resolve various operational issues, such as the need to establish a fair rotation system for reservation of guest rooms in the rental program.

Perhaps the biggest hurdle for marketing condo hotels under the amended private placement rules is the laws governing the sales persons on the front line, mainly real estate brokers. If condo hotels are marketed with rental arrangements, the product is deemed to be a security. However, anyone in the business of selling securities must be registered as a broker-dealer with the SEC and relevant State securities regulators and must be a registered member of the Financial Industry Regulatory Authority (FINRA). SEC rules, and most state regulators, allow a developer’s officers, directors and employees to sell securities without registering. Yet, they cannot be compensated for services related to securities transactions. Also, they must primarily perform substantial duties after the securities offering other than in connection with the securities offering and they generally cannot participate in selling an offering of securities more than once every 12 months.

Apart from a developer’s officers, directors and employees in the situation described above, any sales professionals involved in selling condo hotel units that are deemed to be securities will have to be dually-licensed, both through a real estate broker and a securities broker-dealer. Companies can be dually-licensed as a real estate brokerage firm and as a securities brokerage firm. Similar to State real estate broker requirements, in order to be licensed as a securities broker-dealer, a company must be registered with the applicable authorities as previously described and the individual sales persons must be licensed and must be registered representatives of the securities broker-dealer firm. In the case of dually-licensed sales persons when there is not a single firm that is also dually-licensed, the SEC requires that, as between the licensed securities brokerage firm and the licensed real estate brokerage firm, there must be a clear separation between securities and non-securities real estate activities. For example, the real estate brokerage firm must not be involved in the offering of condo hotel units being sold as securities. At the same time, the real estate brokerage firm must not directly or indirectly receive any of the commissions or other compensation related to sales of those condo hotel units.

Real estate brokerage firms can, without being a licensed securities broker-dealer, require that their dually-licensed sales persons pay them a flat periodic fee under what is referred to as a "desk fee" arrangement to cover overhead and other expenses. In that case, the securities activities of the dually-licensed sales persons must not affect the amount of compensation received by the real estate brokerage firms -- since none of such sales person's compensation for securities activities can be paid directly or indirectly to the real estate brokerage firm. The same "desk fee" arrangement applies to real estate sales persons who are not dually-licensed and, thus, not involved in the offering of condo hotel units being sold as securities.

The JOBS Act and the SEC’s amended private placement rules adopted under the JOBS Act have created great opportunities for condo hotel developers, as well as for real estate brokers and securities broker-dealers. Because developers can now structure condo hotels in a way that makes them more attractive to buyers, they should have an easier time selling out their projects. Yet, they will likely need the services of sales persons who are dually-licensed with a real estate broker and a securities broker-dealer. This presents opportunities for real estate brokerage firms and securities brokerage firms interested in expanding their business in this new market if they become dually-licensed.

This article is reprinted with permission from Real Estate Finance Intelligence.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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