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Condotel unit in Waikiki
By now there are millions of disappointed investors in these types of properties. The most important investment lesson learned is that these buildings are deteriorating assets that have ever increasing maintenance needs.
When timeshares and other forms of fractional vacation ownership became popular in the 1970s, the U.S. economy was experiencing a high rate of price inflation. Real estate was known to provide protection from inflation, because property values were increasing at a similar rate of return, and leveraged rates of return were even higher. In the early 1980s, condotels had also become the rage in Miami Beach.
My mother was a realtor in the 1980s, and she and her fellow agents were all directed by their broker to buy timeshare units at a resort in western North Carolina. They were told that they were fixing their vacation costs at 1980s prices while their investments would continue to appreciate in value as vacation travel would become more expensive in the future.
By 2007, my mother was retired and living on a limited fixed income. The maintenance fees on the timeshare had increased to $40 per month and she asked me to take over the deed and use the unit as I wanted. I never visited the actual unit, but since it was part of Club Wyndham, I exchanged my week for other places each year – Hawaii, San Francisco, New York, San Antonio and Mexico. My week only counted for 3 days, though, for a stay in Honolulu, San Francisco or New York.
Now the maintenance fees have increased to $139 per month, meaning that I would be paying $1668, or $556 per day, for annual 3-day stays in Honolulu, San Francisco or New York, which I could get for a lesser cost without any sort of vacation club ownership. Since 2007, these maintenance fees have increased at an 8.66% rate of annual inflation in a period in which the U.S. CPI has increased at only a 2.4% rate of annual inflation. But this is not fraud, it is the simple arithmetic of property depreciation.
It's the maintenance fees, Stupid!
This leads me to an important concept that gets forgotten in the real estate investment world, that buildings are deteriorating assets. Over time, income for a real estate asset will increase approximately at the rate of inflation, while expenses increase at the rate of inflation plus the rate of depreciation. Anyone who tells you differently, including Wall Street, is selling something, paid to sell something, and paid to deny arithmetic.
Hospitality assets deteriorate even faster than most other real estate assets because of the exacting standards of the hospitality industry, under constant pressure to renovate. This is why maintenance fees are always rising so much faster than consumer price inflation for timeshares and condotels and other fractional vacation interests. And you, the investor, will be contractually obligated to pay these increasing maintenance fees for the rest of your life and the lives of your heirs! Thanks, Mom.
Meanwhile, an excess of vacation properties was built between 2005 and 2008, and values plummeted after the Global Financial Crisis of 2008 and some have not yet recovered due to the oversupply.
As for condotels, I first witnessed them in the early 1980s, spurred by the 15-year Accelerated Cost Recovery System enacted by the Economic Recovery Tax Act of 1981, but the Tax Reform Act of 1986 took away these benefits, and the burgeoning oversupply of vacation units killed the condotel industry, a historical fact that keeps getting forgotten after each time this industry collapses.
Constant problems with condotel investments include 1) high maintenance fees, many more than $10 per square foot per year, 2) having to share 35 to 50% of revenue with management without any guarantee of occupancy, 3) having to compete for occupancy with other owners, 4) having to frequently buy new furniture packages to comply with the hotel franchise rules, 5) HOA dues, 6) housekeeping fees, 7) special assessments, and 8) elevated insurance costs. On top of that, this is an investment type that rarely experiences capital appreciation. If capital appreciation was reasonably expected, the developer would never have wanted to sell units prematurely, right?
Condotels continue to re-emerge as a brilliant new concept before crashing in flames yet again and then forgotten. Some friends of mine were just pitched by WorldMark this week for a condotel investment in the California Wine Country.
Industrywide failure to consider buildings as deteriorating assets
The real estate industry in the 1980s newly embraced a valuation method called “Discounted Cash Flow Analysis”, in which valuations were based on 10-year cash flow projections. The only problem was that most of the DCF practitioners inflated income and expense projections at the same identical rate of inflation, not acknowledging that buildings were deteriorating assets in which operating expenses increase faster than income over long term. Every DCF valuation thus became inflated, and hundreds of millions of dollars were lost in the collapse of the commercial real estate and savings and loan industries in the late 1980s and early 1990s.
As for Club Wyndham, I was satisfied with the exchange possibilities, but displeased with the high-pressure sales tactics used on me whenever I showed up to peacefully use my reserved unit.
Twice when I stayed in Manhattan, for instance, the unit was not ready on time, even if I arrived at 8:30 pm, and then I would be handed off to a high-pressure salesperson trying to convince me to buy more points or I would never be able to stay in New York City again.
There were also the mandatory Information Breakfast Meetings I was supposedly required to attend during every stay at any Club Wyndham property. The first time, in Hawaii in 2007, I showed up and was denied admission because I did not bring identification, which was fine with me. They must have thought I was a cheap tourist attempting to steal their orange juice and plastic-wrapped muffins.
In San Antonio, Texas, I attended their Information Meeting on a Sunday morning, to which I was bussed several blocks away to assure that I would not escape during the brutal Texas summer heat. The speaker casually chatted with me before the Meeting started, mentioning that he had been a flight attendant before entering the esteemed career of timeshare sales. I had orange juice and muffins and scrambled eggs.
When he started the Information presentation, the only information he provided for the first 15 minutes was about himself, in which he had elevated himself to the status of being a former airline pilot. Then he asked all of us to chant the phrase “Today is the Day!” I felt like I was trapped in an Amway sales rally and quietly left, walking several blocks back to a very nice unit on the San Antonio Riverwalk.
When I returned to my building, the doorman had already been alerted in advance of my escape. He asked me if there was a reason why I left the Information Meeting so suddenly. I just said, “Today is not the day.”
PS: See the film Glengarry Glen Ross. Watch this film about desperate timeshare salesmen even if only for the outstanding acting performances of the late Jack Lemmon, Al Pacino, Alec Baldwin, Alan Arkin, Kevin Spacey, Ed Harris, etc.
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