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How Mixed Use Structuring Can Help Your Hotel Project Pencil Out

Once the mixed uses for a project have been determined, the next hurdle for a developer is how the different components of the project will be owned.

The nature of the current urban real estate economy is motivating hotel developers to structure large projects in a manner which utilizes every available profitable option. The rising cost of land puts further pressure on developers to maximize economic value and minimize risk. In many cases, especially in urban settings, buildings consisting of a single use are either too difficult to finance, or the economics of the project do not pencil out.

These issues incentivize developers to engage in creative solutions, often leading to the utilization of a mixed-use building structure. Depending on the project’s particular needs, a mixed-use development can combine several different types of uses.Examples include: (1) a hotel building with an apartment component (consisting of both owned and rental apartments); (2) a hotel with a commercial office component; or (3) a hotel with both commercial retail spaces and apartments for sale or for rent. This article will discuss the methods a developer can utilize to structure a mixed-use project, and the practical and legal implications to be considered (including financing benefits).

Once the mixed uses for a project have been determined, the next hurdle for a developer wishing to utilize a mixed-use structure is determining how the different components of the project will be owned. If the developer intends to own the various components after construction of the project is complete, the mixed- use structure is simple as the developer will maintain control over the entire project. However, what happens if the developer does not contemplate retaining all of the components of the mixed-use project following completion of development, or if a developer wants to lower its equity requirements?

Luckily, there are many ways to structure mixed-use projects. Traditionally, the condominium regime is the most recognized method to accomplish the vertical subdivision necessary for a mixed-use project to be owned by multiple owners. However, developers should be wary of condominium laws and the multitude of restrictions and requirements which vary from state to state, as the formation of a condominium requires filing a declaration of condominium and the formation of a condominium association, which must adhere to the laws of the state in which the project is located. The declaration will create a three-dimensional legal description, and through the creation of units, the project can be sold as-is or can be further subdivided. The condominium governing documents will also provide for how the condominium will be operated and managed, and how the expenses associated therewith will be allocated amongst owners.

While the condominium structure is the most common method for creating mixed-use projects, there are many downsides to be considered with utilizing this structure. The primary drawback is associated with the requirement of relinquishing control of the condominium owners’ association and the owner democracy and governance issues that may result. The requirements for turnover of control vary from state to state, and transfer of control of the association from the developer to the non-developer owners may be required regardless of whether the condominium is residential or commercial in nature. Further, state laws typically contain restrictions on how common expenses can be calculated, therefore leaving less room for creativity as to what percentage interest may be assigned to each unit. Some states require that these values be based on square footage, number of units, impact on use, value or a hybrid of these methods. There are also additional expenses to be considered by the developer in creating a condominium; examples include legal fees, obtaining plats and plans, increased insurance costs, regulatory costs, state filing requirements, etc. Given these additional costs and the restrictions imposed by the condominium regulatory scheme, a developer may find that using the condominium regime as the basis for structuring the project is more trouble than it is worth.

An alternative method to the condominium structure is to utilize three-dimensional platting. This method allows for the subdivision of a project into different parcels based on three-dimensional airspace. These parcels are platted on an air space subdivision map and filed with local agencies. This method is ideal as compared to creating a condominium because it allows for the platted parcels to be owned separately, but does not require the formation of an association and the inherent governance issues. Unfortunately, despite the convenience of three-dimensional platting, this method is not accepted in most jurisdictions. Very few cities expressly permit it, and other jurisdictions that have adopted the method generally lack clear codes and regulations.

While the three-dimensional platting method is convenient, it still requires that the developer tie the pieces of the project together. This is where a shared building agreement (sometimes known as a reciprocal easement agreement, or such provisions may be contained in a declaration of covenants, conditions, easements and restrictions) comes into play. A shared building agreement grants easements to the multiple owners of the project, which allow access to the parts of the project that will be used by or serve all parts of the project, often referred to as shared areas. Examples of shared areas include elevators, stairways, roofs, utility systems, parking and other structural components. The shared building agreement may also address limited shared areas, which are shared areas appurtenant to a particular parcel or group of parcels. For example, signage or an elevator serving only the residential portion(s) of the project would be a limited shared area to the particular parcel(s) which it serves. The shared building agreement will provide easements for maintenance of the shared areas and limited shared areas, designate the parties responsible for maintenance of each and how the maintenance costs are allocated amongst the various owners.

Utilizing a shared building agreement requires that the allocation of expenses associated with the shared areas be determined upfront. However, there are many methods to achieve an equitable allocation—certainly one to which all parties can agree. For example, equal costs per unit, pro rata based on square footage, pro rata based on current or projected usage or pro rata based on benefit received or burden created are all methods for allocating shared costs. Oftentimes, there is a blending to achieve the desired result. Further, the governing documents must detail mechanisms to enforce payment of these costs. Obligations to pay shared expenses are usually secured.

Using one of the three-dimensional platting methods identified above can be ideal for a developer from a financing perspective, because it allows a developer to finance the pieces of a mixed-use project without necessarily creating a condominium for the entire project (a developer may still need to create a condominium on those portions that are being conveyed). Should the developer choose to do so, the developer may convey one or more of the components and separately release it from the mortgage. Hotel developers specifically benefit from this arrangement as the ability to take out equity on certain portions of the project helps the project pencil out and offers an improved loan-to-value ratio, making financing or refinancing possible. Consumers also benefit when more parties contribute to the maintenance and replacement of shared areas, as this apportions more funds towards developing and maintaining nicer amenities.

Drafting the legal provisions of the shared building agreement requires a degree of experience and precision to ensure that the document covers all essential elements without unduly burdening owners. Despite the complexities described above, the shared building agreement still provides the greatest degree of flexibility and enables developers to develop a project that will attract purchasers and lenders. All it takes is a little bit of negotiation among the lenders and other future component owners on the front end, as well as the proper legal team to bring it all together.

Dan Bachrach is a partner with Foley & Lardner’s hospitality group. Laura Zampieri is a real estate associate at Foley & Lardner LLP and a member of the firm’s hospitality and leisure industry team.

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