Here’s a question for you. When does a condo become a security?

The answer is when you try and sell it as an income producing property and make certain statements about the return an investor might expect. That’s an oversimplification but essentially how the SEC views it.

Why does it make any difference in the larger scheme of things? Probably because you’re going to see a lot of people trying to get out of a lot of real estate contracts by arguing that the contracts are null and void because the proper securities disclosures were not furnished.

The Wall Street Journal has a story on one part of the market where this is popping up:

Desperate to recoup money paid to acquire condominiums in hotels, buyers from California to Florida are trying to use the courts to get their money back, arguing that condo-hotel developers violated securities laws when selling the units.

A few years ago, condo-hotels seemed like a great idea. Hotel developers could offset construction costs by selling rooms to individual buyers, then share the rental income with the owners every time a room was booked. However, instead of the lucrative venture some buyers claim they were promised by developers, condo-hotels have turned out to be one of the worst investments in decades.

The industry is getting hit on two fronts: The condo crash has wiped out the value of many units, and the hotel bust means the rooms are being rented only infrequently and at much lower rates than anticipated.

Now, some buyers are arguing in court that purchasing a unit in a condo-hotel is similar to buying a stock, where the buyer is entirely reliant on the operational skills of management for any return. Therefore, they contend, the purchases should have been regulated by the Securities and Exchange Commission, which would force companies to issue a detailed prospectus and have agents licensed to sell both real estate and securities, a rare combination.

“These were not simple real-estate purchases,” said Jared Beck, an attorney in Miami who is working on dozens of suits against condo-hotel developers. “A hotel is a profit-making enterprise, and by purchasing a condo unit you are giving investment capital and you expect a return.” Moreover, Mr. Beck said, “When you look through these marketing materials, there’s no question that in the mind of a reasonable consumer you’re going to think it’s an investment.”

Don’t assume that this applies just to condo-hotel developments. It’s applicable to any real property that’s sold to an investor with representations of investment returns. I, frankly, was never aware of the distinction until about three years ago when I was in Florida working on the marketing plan for several fractional ownership projects.

What’s surprising is that there haven’t been more suits using this argument. My experience has been that developers and real estate agents are quite aggressive in furnishing prospective buyers with all manner of income and ROI projections that they can expect to realize from renting the prospective property. As the article points out the cardinal sin that most developers commit is distributing sales material with that contains that sort of information. But attorneys for developers say such cases represent little more than buyer’s remorse.

So keep your eyes open for more of this and if you happen to be in the business of selling real estate to investors, be very careful about what you commit to paper or get a securities license and write a nice prospectus.