Mel S. Weinberger is a Partner based in our Washington office.
Fractionals have transformed the vacation ownership industry in recent years and are quickly emerging as preferred alternatives to wholly-owned vacation homes for many consumers. Typically, fractionals attract consumers who could easily afford a second home but can't justify the cost and inconvenience of whole ownership when their use of the property is usually limited to several weeks each year. This distinguishes fractionals from one-week timeshare interests that are usually sold as a hedge against rising vacation costs.
For developers confronting the incredibly tight credit market that currently prevails, coupled with decreased discretionary spending by the overwhelming majority of consumers, converting a whole ownership property, whether a detached single family home, townhome, hotel suite, or condominium unit, to fractional ownership might provide an effective exit strategy through the creation of a product that is far more affordable than whole ownership. There are many critical legal and practical considerations that generally confront developers and property owners considering the fractional option as a means of maximizing the net present value of their investment returns.
It is almost always less challenging from a legal, financing and design perspective to incorporate a fractional component into a real estate offering prior to the commencement of sales and, in particular, prior to the recordation of any condominium declaration or other private restrictions. However, sometimes, the adage "better late than never" makes sense.
Legal Considerations
The following key issues, among others, must be satisfactorily resolved before the economic benefits of a possible fractional conversion can be realized:
- Zoning
Is fractional ownership, which most often represents a specified percentage undivided fee simple interest as tenant in common in a particular property, permitted by the applicable zoning, subdivision, or similar ordinance? If not, how likely is it that the appropriate governmental entity will be willing to amend the ordinance to permit fractional ownership? This is obviously a threshold legal consideration. - Private Restrictions
Does the applicable condominium declaration and/or master covenants, conditions and restrictions allow fractional interests to be created and sold? For example, in Florida, if the property sought to be fractionalized is part of a condominium regime, unless the condominium declaration as originally recorded contains certain statutorily mandated language that expressly contemplates the creation of "timeshare" interests, fractional interests, which are almost always considered "timeshare" interests under state law, cannot legally be created and sold without the unanimous approval of all of the whole unit owners. In other states (and in Florida, even if the statutorily mandated language is included in the condominium declaration), the issue of whether the developer may unilaterally elect to create and sell fractional interests without any input or vote of the existing whole unit owners may still arise.
The provisions of the existing governing documents usually determine the precise underlying legal structure of the fractional regime. Sometimes, such existing documents can simply be amended to add all necessary provisions related to the fractional interests, especially if the developer is still in control of the relevant condominium or master association. In other cases, the fractional regime must be "overlaid" on top of the existing whole ownership regime. Both approaches can be equally effective, although the latter scenario is usually more complicated from a documentation perspective. - Use Of Resort Amenities
Will fractional owners be entitled to use and enjoy the resort's recreational and other facilities and amenities? Usually, such rights are assured via some form of recorded instrument (declaration, easement, etc.). In other situations, leases containing non-disturbance provisions are employed. It is sometimes necessary to overcome the objections of whole unit owners who are concerned with the possible overuse of the resort's amenities. The obvious explanation is that regardless of the number of fractions into which a particular property is divided, only one fractional owner (including family members and friends) can be in residence at a time. - Cost Allocation
How will operating, maintenance and reserve costs be allocated among fractional and whole unit owners? Fractional owners typically expect a higher level of services, including, in most cases, daily maid service and concierge and other hotel-like services for which whole unit owners should generally not be asked to contribute. Treating all owners fairly from a cost perspective is essential. - Use Plan
How should the use plan/reservation system be designed in order to fairly and equitably allocate occupancy privileges among all of the fractional owners? Will all available time be "floating," i.e., assigned each year pursuant to some type of reservation system, or will some annual weeks of usage be "fixed"? Purchasers are usually prepared to pay a significant price premium in order to ensure guaranteed occupancy rights during certain times of the year (e.g., Christmas/New Year's at a ski resort). Many use plans incorporate a hybrid structure that offers a good balance between predictability and flexibility each year.
Will fractional owners be able to make last minute "space-available" or "bonus" reservations? How far in advance will normal reservations be required and when can such reservations be canceled without penalty? Are rentals permitted? Can occupancy be reserved in seven consecutive day increments only or can shorter stays be reserved well in advance? It's usually a great idea to maintain some flexibility in the legal documents to allow the developer or project manager to alter the use plan if deemed in the future to be in the collective best interests of the fractional owners. - Exchange Program
Should the resort be affiliated with one of the reciprocal exchange companies so that owners can elect to vacation at other resorts from time to time? These days, most fractional purchasers desire this option, although there are various costs associated with the privilege, including annual membership and exchange fees payable by the fractional owner and an up-front affiliation fee payable by the developer to the exchange company. - Existing Lender; Partial Releases Of Liens
Will the resort's blanket mortgagee or other lien holder be willing to grant partial releases of its lien upon the closing of each fractional interest sale? That's obviously the only way in which the developer can convey free and clear title to the fractional interest upon closing. Lenders that are unfamiliar with the concept of fractional ownership of real estate are frequently reluctant, at least initially, to agree to grant such partial releases, especially since upon a default by a mortgagor, the lender can foreclose upon only that mortgagor's fractional interest, not any other fractional interests in the same unit or home. Furthermore, a developer's existing lender must typically be willing to extend the loan's maturity to reflect the anticipated longer sell-out period of fractional interests as compared with whole ownership (since more individual sales are needed). - Increased Regulation
Is the developer prepared to comply with the numerous statutes and regulations that govern the marketing and sale of most forms of fractional interests, usually under state timeshare laws? A timeshare registration is required in most states in which offers will be made through any means, including telephone and email, i.e., not only the state in which the resort is located, unless the offering qualifies for a statutory exemption from such registration. Avoiding regulation as timeshare interests is generally desirable but not easy. In some cases, selling fewer than a particular number of fractional interests in a single property does not require registration. However, the availability of this exemption varies considerably from state to state. Can the developer advertise, and are non-binding "presales" of fractional interests legally permitted, prior to registration? How can the Internet be used to market fractional interests without running afoul of state timeshare and other laws? Contrary to popular belief, online marketing is regulated under both federal and state law.
In the event that the subject fractional interests do need to be registered under one or more states' timeshare statutes, the developer will generally need to disseminate to purchasers a detailed disclosure document, grant purchasers a rescission period (usually seven to 10 days), include specified provisions in the purchase agreement and other consumer documents, escrow deposits prior to closing and otherwise ensure that purchasers receive all benefits promised to them.
Also to be considered is whether the existing whole unit registration, if any, can merely be amended to permit the sale of fractional interests or whether an entirely new, more costly and time consuming timeshare registration is required. The fractional interests may also need to be registered under the federal Interstate Land Sales Full Disclosure Act, administered by HUD, unless the project is properly structured and the purchase agreement and other documents are carefully drafted.
Finally, there exist a myriad of other federal, state and local legal requirements, including securities, telemarketing, tax, environmental, real estate licensing and various consumer protection laws, with which any prospective seller of fractional interests should become familiar with guidance from an attorney experienced in the fractional area.
Practical Considerations
Beyond the foregoing legal considerations, there are numerous threshold practical factors that a prospective seller of fractional interests must consider, including:
- Location
Not every property fits the fractional mold. Is the property in a desirable location from a fractional perspective? Fractional projects are typically most successful in locations that attract repeat visitors and where the cost of whole ownership is prohibitively expensive for most prospective purchasers. - Type Of Resort
Is the property in a regional, primarily "drive-to" resort versus a destination resort, i.e., one to which most visitors fly? While fractional sales at both resort types can be tremendously successful, the distinction often greatly impacts the determination of what type of use plan/reservation system the developer elects to adopt. Some resorts fall into both categories (e.g., Vail is a regional resort for Denver residents but a destination resort for most others). Fractional projects have also proven highly successful in certain urban locations. - Fraction Size And Price
What size fractions will be offered and how will they be priced? Typically, smaller fractions, e.g., 1/12ths, are priced more aggressively as compared with whole ownership prices versus larger fractions, e.g., 1/4ths. Larger fractions typically appeal more to purchasers in "drive-to" markets who can travel to the resort relatively cheaply and on a more frequent basis, as compared with purchasers of fractionals in destination resorts, travel to which is more costly and generally requires greater advance planning. Depending upon how much "space-available" or "bonus" time is contemplated, the fraction sizes don't necessarily correlate to the number of guaranteed days and nights of annual usage. - Marketing And Sales
Who will handle the marketing and sales of the fractional interests? Fractionals are a very unique form of real estate that can most effectively be sold by those who completely understand the product and can adequately explain it to potential purchasers. Use of a dedicated sales team is usually far more successful than relying primarily on third-party brokers who would generally prefer to sell property with higher purchase prices in order to earn larger commissions. Additionally, many third-party brokers don't fully appreciate the numerous benefits of fractional ownership. - Financing
Is purchase money financing likely to be available to fractional purchasers? In the past, many individuals financed their fractional purchasers by tapping home equity lines of credit or borrowing against their stock portfolios. The current economic downturn has rendered each of these alternatives infeasible for most consumers. This has required many fractional developers to at least consider offering seller financing, not a particularly attractive option since doing so results in significantly less cash being generated upon closing to pay lenders, marketing and sales costs, etc. However, there remain a few specialized lenders that still seem willing to make purchase money loans to highly creditworthy fractional purchasers, with additional such lenders likely to enter the marketplace in the reasonably near future. - Management
Who will manage the fractional project, including any related rental program? Who will administer the fractional use plan/reservation system? These are critical decisions that often dictate whether a fractional project will be successful.
Conclusion
The decision to create and sell fractional interests in real estate requires a developer to carefully weigh the potential benefits to be realized, particularly the likelihood of an accelerated sell-out of an otherwise troubled project, against the numerous legal and practical issues involved as highlighted above. While a conversion to fractionals may not be the right answer for every project adversely affected by prevailing economic conditions, the sale of fractional interests is worthy of consideration.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
