Bottom Line: Market Opportunities

Condo crash coming
In downtown Chicago and South Florida, experts aren’t asking if condominium prices will drop. They are asking when prices will drop.

By Bendix Anderson

While eager condominium buyers still line up outside sales offices, Jack McCabe wonders how long that’s going to last. McCabe is CEO of McCabe Research and Consulting, LLC, in Deerfield Beach, Fla.

He thinks the price of the average condominium in South Florida will drop 30% between 2006 and 2007.

But industry watchers don’t expect condominium prices to collapse in all markets – only in a few places where developers have incautiously been building more units than their markets can possibly absorb at once.

Workers are now hammering away at 142,769 new condominiums nationwide, including 25,888 units in South Florida markets such as Miami, Palm Beach and Fort Lauderdale. Workers have started another 15,013 units in Chicago, according to information from Torto Wheaton Research/Dodge Pipeline (Pipeline).

Unfortunately, many of these developers are building for real estate speculators. Local experts say that in both South Florida and Chicago more than 70% of condominiums are being bought by investors who never intend to live in their units.

In contrast, developers are building or converting about 9,600 condominiums in and around Washington, D.C., according to Pipeline. But condominiums are still moving quickly in that area: 7,000 condominiums sold in the first half of 2005, and experts think the area can absorb more. Even better, since an average condominium in the area costs considerably less than the price of an average single-family home, much of the demand for condominiums here is from homebuyers priced out of buying a house, not from speculators.

Analysts also aren’t too concerned about condominiums sprouting in
difficult-to-develop locations. “You have cities that have never accepted a high-rise,” said Gary McKitterick, a real estate lawyer with Allen Matkins Leck Gamble & Mallory, LLP, based in Orange County, just south of Los Angeles. McKitterick can count five new, mixed-use condominium towers rising from the ground outside his office window. But California’s liability laws and local officials make it so difficult to build condos that these new projects are unlikely to have much competition.

Speculators destabilize markets

In the markets where investors dominate, there is a risk of severe price fluctuations. The price of a dwelling gets much of its stability from the fact that a homeowner is unlikely to sell and move away into a more attractive investment. Even taking into account the fluctuations of overpriced trophy homes, the cost of the average house rarely drops by more than a few percentage points even in real estate downturns.

That stability vanishes when two-thirds of a building is owned by anonymous investors. The allure of condominiums to speculators is simple arithmetic. Someone who purchased a $500,000 condominium in South Florida two years ago might sell the unit today for as much as $800,000, McCabe said. If this hypothetical investor made a 10% downpayment, then that $50,000 investment will have earned a $300,000 return, or 600%, assuming rental income covers costs.

Unfortunately, in some markets prices may be growing higher than any homebuyer would be willing to pay, regardless of how much the potential buyer appreciates the condominium lifestyle. For example, while the average condominium in and around Palm Beach sold for $460,000 from mid-2004 to mid-2005, the average single-family home sold for just $445,000, according to information from the Palm Beach Board of Realtors.

Also, at these prices the monthly cost of ownership is often much higher than a speculator’s condominium can earn in rent, according to David Dweck, a real estate investor and founder of the Boca Real Estate Investment Club. Dweck recently lunched with a condominium speculator: a lawyer who was happily losing $400 a month on a condo that earned less in rental income than it cost in mortgage payments and fees. The lawyer still hopes to eventually sell the unit at a substantial profit, Dweck said.

But if speculators like Dweck’s acquaintance figure out that their properties are likely to drop in value, they may leave the market in a hurry.

Speculators might also be forced to sell their condos even if the market is weak if they purchased their properties with a mortgage that had a balloon payment due at the end of a short term. Buyers with floating-rate loans are already suffering as interest rates rise, and many don’t have the financial resources to keep paying their mortgages.

“Florida and Utah currently lead the nation in terms of fore-closures,” McCabe pointed out. “Florida is going to have that title for quite a few years.”

Also, few of these condominium investors have had any experience as landlords and they are likely to make mistakes. “There is a tremendous body of law that applies to them,” warned Judy Roettig, executive vice president of the Chicagoland Apartment Association.

For example, states like Illinois require landlords to place a tenant’s security deposit in an
interest-bearing savings account in a local state bank. The interest must be passed on to the tenant in a timely manner. If the landlord fails in any part of this responsibility, the tenant can sue for those few dollars of interest plus two months of rent – often thousands of dollars.

Lawyers smell blood, and some are already advertising their services to tenants, Roettig said.

Perhaps worst of all, the typical condominium investor holds onto a condominium for just three years. As the condominium boom enters its third year, the buyers that bought near the beginning are now preparing to sell just as a flood of new units begins to hit the market, peaking around 2007.

“I saw this last time,” Roettig said. “Everybody dumped their units after three years.” In late 1979, Roettig worked for a condominium converter handling Sandburg Village, a 5,000-unit project on Chicago’s Near North Side. It was one of the largest condominium conversions in the nation at the time.

Roettig remembers long nights when she brought her kids down to the office to sleep in sleeping bags while she worked through the night processing closing documents. “People would line up for blocks,” Roettig remembered. “Those were rock-and-roll times, and condo converters were the cowboys.”

Roettig also remembers what happened when the boom ended just as other new conversion projects came online and interest rates rose into the double digits: “Suddenly there are 50 units just like yours on the market,” she said. Prices dropped sharply.

To keep speculators out, many developers have raised the amount they demand for a deposit to 15% of the sale price. When developers pre-sell a project that is not yet finished, some write sales agreements so that a condominium cannot be “assigned” or resold between the pre-sale and the time
the unit is finished and the sale finally closes.

However, many developers still sell several condominium units at a time to individuals or limited partnerships, sometimes to get the high prices these buyers will pay and often because it is simply easier to sell apartments in bulk.

Pressure rises on new development

Rising construction costs have begun to eat deeply into the profits of condominium developers, just as development becomes more risky. The situation has gotten much worse since Hurricane Katrina, as contractors and materials are absorbed by the rebuilding of New Orleans. Many contractors now try to avoid guaranteeing their prices, so the increases in material costs after the bidding is through will be passed on to the developer.

At the same time, financing has become harder to find. “From a lender’s perspective, everyone is taking a step back,” said Mario Facella, senior vice president for Bank of America Corp. (BofA).

Many lenders are increasing their pricing and tightening their underwriting for loans to condominium projects. “Those institutions that would have flexed on terms a year and a half ago might not do that in this environment,” Facella said.

As a result, some smaller developers have decided to give up their sites rather than build the projects they planned. Other builders have had to joint-venture with larger, more experienced developers to win financing.

“We are being more selective,” Facella said. “As financial institutions get more cautious about who they deal with, they’re looking for people who can carry the weight.”

Lenders are also growing more cautious about the markets they make deals in. “Many, many lenders have backed out of the southeast Florida condominium market,” said one industry professional. “People are afraid of what’s going to happen in 2007.”

However, lenders like BofA don’t plan to make fewer deals – but they are fighting harder to win the best ones. “BofA’s volume has not dropped back,” Facella pointed out.

Financing is also still readily available for many conversion deals. Converting an existing building to condominiums is less risky than building a new condominium building. Because conversions take just six to 18 months to complete, compared to 24 to 36 months to construct a new building, there is less risk of the market changing around a conversion project. There is also less time for construction costs to rise. Also, because converted condominium units are relatively less expensive than new units, a converted condominium is affordable to more potential buyers.

But lenders are still skeptical. Approximately 10% of condo-conversion loans originated in 2005 will default, according to a grim report by Dina Treanor and Zanda Lynn, analysts for Fitch Ratings, Ltd. Fitch warns against overbuilding, inexperienced sponsors and the inflated prices these sponsors often pay for properties.

As prices rose, the average capitalization rate for sales of mid-rise and high-rise buildings dropped, to 5.9% in the second quarter of this year, down from 7.7% at the end of 2001, according to information from Real Capital Analytics, Inc. A cap rate represents a property’s net operating income as a percentage of the sale price.

Condominium converters often pay much more, exemplified by Tarragon South Development Corp.’s purchase in September of Whispering Oaks at Palm Aire in Sarasota, Fla., at a cap rate of 3.5%, or $141,129 per unit.

Nonetheless, there is still lots of financing available for conversion deals, said Tom Cohen, vice president for GMAC Commercial Mortgage Corp. (GMACCM).

When Vilas Development Corp. looked for financing to convert 222 Pearson, a project on Chicago’s Near North Side just down the street from Water Tower Place, GMACCM acted as an intermediary for the experienced local developer, putting together a financing package that covered 95% of the project’s cost. Vilas had to put up only 5% of the project’s cost in equity. The property came at a high price: The developer paid at a cap rate of less than 5%.

“Lenders wouldn’t do this with a guy doing his first deal,” Cohen said.

Condominiums will thrive in some markets

Even after prices crash in a few places, building cranes for condominium projects should continue to rise over America’s more expensive cities, giving people who want to buy a home a cheaper alternative to very pricey single-family houses.

“Condos just happen to solve the problem of housing affordability in some areas,” pointed out Kendra Todd, an owners’ representative for the Trump Organization.

Because land is so scarce, the price of the average single-family home may level off, but is unlikely to drop. The inventory of new homes for sale relative to the pace of home sales is near its lowest level ever. “Given this small backlog, new home sales would have to retreat by more than a third – and stay there for a year or more – to create anywhere near a buyer’s market,” according to the State of the Nation’s Housing 2005, a report by Harvard’s Joint Center for Housing Studies.

Living in a multifamily building on a busy urban street is also increasingly attractive, both to young professionals and to older couples whose children have moved out of the home. Drivers tired of fighting traffic can reduce their time behind the wheel by moving into an urban condominium.

Since 2001, sales of condominiums have increased almost 50%, according to Condo-Mania!, a report by Wachovia Securities. But even with this increase, the volume of condominium sales – $13.2 billion in the first quarter of this year – is very small compared to the volume of single-family home sales: $300 billion.

“That’s a very trivial percentage of the total sales of homes,” said Thomas Byrne, chief marketing officer for LoopNet, Inc. He and other experts expect the share of the sale market taken by condominiums to grow, even after the condominium bust has come and gone.

Meanwhile, in South Florida, smart money is still looking for a way to invest in condominiums: McCabe, diversifying his research business, has started an “opportunity fund” to invest in failed condominium investments, snatching individual units and whole buildings from the teeth of foreclosure. Vulture funds like McCabe’s plan to rent their properties at a profit, holding them for four to five years “until the oversupply is absorbed,” McCabe said.

McCabe is limiting investment in his limited liability company to just 35 experienced real estate investors. He’s already had more than 400 inquiries and plans to start buying property once the crash starts in earnest.