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Anyone who regularly engages the news media knows that the national residential real estate market is experiencing troubled times, a tempest caused by an oversupply of homes, the collapse of the subprime-lending market, inflationary pressures and indications of increasing softness in the U.S. economy, and an overall slowdown in consumer spending. In Florida, condominium towers in Orlando and Miami are partially filled while sales remain slow and lenders become increasingly nervous about the ability of their developer clients to weather the storm. Why, then, is the timeshare industry smiling in these gloomy times, and what alternatives does timesharing present for leisure developers? The good news about the timeshare industry is underscored by a recent Ernst & Young study, State of the Vacation Timeshare Industry: United States Study, 2007 Edition, commissioned by the American Resort Development Association, the U.S. timeshare trade association. According to that study, measuring the industry as of Jan. 1, there were 4.4 million U.S. households owning 6.1 million weeks of use in 1,615 U.S. timeshare resorts containing a total of 176,232 units. The study also reveals that U.S. timeshare sales volume in 2006 was in excess of $10 billion, a 16% increase from sales in 2005, and industry leaders are informally reporting that their 2007 sales are showing a similar percentage increase from 2006. It is axiomatic that profitability in leisure real estate is primarily measured by price, pace and cost. In order for a developer to maximize his profit, he must price his homes or condo units correctly for the market, sell them quickly enough to avoid holding a significant inventory and incur as little product and marketing/sales cost as he can. Unfortunately, many second-home, condominium and condominium hotel developers are now upside-down against this formula, holding large inventories in the face of diminishing prices, a reduced availability of financing and a concomitant increase in sales costs. This harsh reality is causing an increasing number of these developers to investigate offering timeshare or fractional plans in their inventory as an exit strategy because of something the timeshare industry has known for years: Sales of timeshare or fractional interests in leisure real estate can broaden the market of available and eligible customers, substantially increase gross prices and produce additional revenues from purchase-money financing and management operations. But the barriers to entry can be substantial, and developers considering such a strategy should carefully consider the attendant risks. How the two interests differ A few fundamentals: Timesharing is any prepaid, long-term use right created in leisure accommodations and related facilities or amenities, which may or may not be backed by real estate. Timeshares may take the form of a contractual use right; a condominium or cooperative regime; a trust, partnership or limited liability company arrangement; or a homeowners’ association. They may be stand-alone resorts or single-family homes with individual fixed or flexible use plans linked by a voluntary external exchange program, or they may be large vacation cooperatives comprising sister resorts linked by a mandatory central reservation system. Like hotels, timeshares may be branded or may be operated by local or regional managers. Timeshares may be found at a bargain price comparing favorably over time to multiple hotel rooms, or fractionals may cost hundreds of thousands of dollars or more as a reflection of the high cost of rare land, expensive improvements and furnishings, and a substantial level of service and amenities. Fractionals are considered timeshares under most state laws, but they differ significantly in scope, price and service levels. Timeshares are usually sold as a value vacation alternative, while fractionals are generally sold as real estate in markets where the price of whole ownership is out of the reach of even reasonably affluent consumers. Timeshares are usually offered by the week and, where deeded, are manifested in relatively small accommodation ownership increments (e.g., a 1/51st undivided interest for one week of annual use), while fractionals are typically offered in deeded multiweek packages commensurate with larger ownership increments (e.g., a 1/12th interest that yields four weeks of annual use, a 1/8th interest that yields six weeks of annual use, etc.). In keeping with their core value proposition, the annual maintenance costs of timeshares tend to focus on physical property upkeep and replacement, with many related services being deemed ancillary and priced on an �-la-carte basis, while fractionals tend to incorporate comprehensive high-end benefits like daily maid service directly into their annual dues. But perhaps the most significant difference between these two categories is that timeshare developers almost always originate the purchase-money financing for their customers as a major profit center, while most fractional developers arrange for independent third-party financing for their purchasers. This element of purchase-money financing is critical to an understanding of the timeshare industry. The typical timeshare developer arranges a line of credit with a lender or factor and receives advances against that line of credit based upon a variable percentage (usually 75% to 90%) of the face value of a qualifying consumer’s purchase-money note by hypothecating the note and its related security instruments to the factor. Since the typical timeshare transaction is financed at 90% of the purchase price, a well-established developer with a 90% advance rate can generate 81% of his sales price in borrowed cash at or before the closing of a qualifying contract, and he can make up to half of his total product profit over time in the process because of the usually significant spread between the developer’s cost of funds from the factor and the consumer’s often credit-card-level interest payments to the developer. The hypothecation loan proceeds for each consumer transaction, along with the consumer’s 10% cash down payment, are typically tailored to equal in the aggregate the developer’s point-of-closing expenses for product cost (partial release of mortgage), marketing and sales, and overhead. And a high-volume developer can securitize large pools of timeshare mortgages, usually in minimum traunches of $25 million, to even more effectively recover both his capital and his profit from timeshare sales. Hypothecation and securitization financing are not prevalent at the fractional end of the timeshare spectrum, and, as a result, the historic expansion of this segment has been relatively limited. This is because fractional purchase-money loans are for much larger amounts than are timeshare loans, resulting in a far greater borrower sensitivity to interest rates and a rate spread potential too negligible to induce most developers to assume hypothecation financing liability. Banks and other sources of second-home financing have traditionally been cool to fractional financing, because the typical parameters of an 80% loan-to-value residential real estate loan transaction simply do not apply to the purchase-money financing of interests in a fractional accommodation that may sell in the aggregate for as much as twice the price of a comparable whole-ownership accommodation. However, new sources of fractional financing have recently become available and are contributing to the current strong growth of this market segment. Condominium hotels have some characteristics in common with timeshares. Condominium hotels, or condotels, are condominiumized hotel properties that in theory allow a developer to sell his hotel to primarily consumer investors on a per-unit basis while retaining ownership or control over the related commercial and management facilities. Condominium hotels are subject to scrutiny under federal and state securities laws and may constitute regulated securities if rental is required or emphasized, if the developer or an affiliate is the sole authorized rental agent or if a rental pool is utilized to spread the revenues and expenses of the rental program across all participants regardless of whether their individual units are rented. Unit owner-use plans under some condotel rental management arrangements are becoming more and more exotic, in many cases offering investor/owners the right to exchange their units for the use of timeshare or fractional accommodations when they are not being rented. And an increasing number of condotel developers are considering the advantages of combining the condominium hotel with the more advantageous price point and broader market demographic afforded by fractional use, yielding a “fractional condotel” that has the potential to offer purchasers the best of both products. Destination clubs, or nonequity accommodations clubs, are timeshare plans that utilize a nonequity golf club membership platform. Destination clubs typically offer their members the right to use club accommodations for a 30-year term, restrict the transfer of memberships back to or through the club and promise members the refund of all or most of their purchase price or initiation fee at the end of the membership term, thereby allowing the developer to report the deposit as a loan for tax purposes. Destination club developers in theory make their money by recycling club memberships; by charging management fees and passing on club overhead to their members as annual dues; and by buying and selling club accommodations from time to time. Many destination clubs eschew compliance with state timeshare laws, risking recision of some or all of their membership sales if compliance is ultimately held to be required, but benefiting in the interim from a general laxity in regulatory enforcement. This product has enjoyed a great deal of popularity at the upper end of the timeshare market notwithstanding the recent bankruptcy of a large club, and many destination clubs have been taking advantage of the slow second-home market by acquiring club accommodations at bargain prices. Some potential risks Leisure developers interested in one or more of the foregoing products should carefully consider the risks in implementing any timeshare or fractional strategy. For example, Florida law prohibits the creation of timeshare estates in residential condominium units unless the declaration as originally recorded permits the creation of timeshare estates or unless an amendment permitting them is approved by all owners and all mortgagees in the condominium. This understandable but unfortunate public policy effectively precludes a timeshare exit strategy in many distressed Florida condominiums, even those that were originally sold as condotels where no purchaser intends to live in his unit and where nightly transient rentals are expressly permitted by the declaration and by applicable zoning. Developers should also be certain that timeshare is a permitted use for any residential accommodation, since most residential land covenants and zoning ordinances are not created with the specific objective of allowing timeshare use. Other areas of risk pertain to marketing and sales costs, hypothecation financing cash flow and the use of independent brokers to generate fractional sales. Marketing and sales costs for fractional and particularly timeshare plans, including regulatory compliance expenses, are usually substantially higher than those for other leisure real estate interests, in many cases exceeding 50% of the sales price of a timeshare interest. Negative cash flow is an inherent part of timeshare hypothecation financing; a developer generally does not start seeing positive cash flow from a hypothecated timeshare transaction until sometime in the fifth year of seven-year financing. And although fractional sales are similar in nature to real estate sales, independent brokers are often reluctant to refer prospective purchasers to fractional developers in exchange for a smaller fractional commission and the loss of a potential future whole ownership commission. Each of the foregoing risks can be reasonably addressed in a well-considered business plan with the advice of experienced consultants. So leisure developers who want to do more than sit and wait out the current storm should investigate the many alternative strategies presented by the timeshare and fractional industry. Robert J. Webb is the senior hospitality law partner in the Orlando, Fla., office of Baker Hostetler. He is board certified in real estate law by the Florida Bar and currently serves as the American Resort Development Association’s treasurer and legislative council chair.

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