I love walking around Costco to see how much of a specific product a company can package and sell. Why get a pack of four paper towels when you can get a 12 pack? The list goes on and on, but the one commonality throughout the store is simple — buying in bulk saves you money. The idea of buying in bulk is not lost on real estate either, specifically condominium conversion projects.
I had a potential client come into my office two weeks ago. The gentleman wanted to purchase a condominium project — the entire building — and run it as an apartment. He said he was getting a great deal, able to purchase the units for $350,000 each. The total purchase price for the 10 units was $3,500,000. He actually brought up the fact that he was getting a discount on the price because he was buying all the units from the developer at once.
The potential client was bewildered when I told him it appeared he would only be able to attain a 20 percent loan to value, approximately $700,000. Anger was the next emotion before the individual asked “why?” I explained in detail how commercial financing works and how condominium projects are valued differently than apartment buildings. After our cordial conversation, the man realized he was not getting a deal, but rather inheriting someone else’s problem. He laughed and realized that buying the project for the asking price was a losing venture. Obviously he decided to pass on the deal.
At the turn of the 21st century, what are known as condominium conversions became popular. The idea was to go through all of the city and county regulations and transform an apartment building into a condominium project. Broken up and sold per unit, condominiums of that day and era were extremely profitable.
Of course, condominium conversions became popular and sellers quickly began charging ludicrous amounts of money for apartment buildings. Apartment buildings were sold 20 percent to 50 percent above market value simply to be converted to condominiums. Even at a 50 percent increase in price, many condo conversion projects had enough profit to make it worthwhile for a developer.
The problem with a condo conversion is the market itself. A developer who pays a premium for an apartment just to do a conversion is gambling that the real estate market will increase or at the very least stabilize, and definitely not decrease.
Without getting into the specifics, many developers had to sell their projects at a loss or conversion projects went back to the lender. Now some lenders find themselves in the precarious position of having to deal with partially built, empty buildings.
For an investor who can complete a condo conversion and operate it as an apartment, this can be a very good thing. Some investors are moving full steam ahead and purchasing condominium projects for cents on the dollar. Mathematically some of these projects make sense. The beauty with buying a condominium project at a discount is that if an investor is able to run it as an apartment building until the real estate market turns around, then they can sell the units off one by one.
The irony is that by taking apartments offline to convert into condos, apartments in some areas became scarce, placing upward pressure on the existing units, which led to an increase in rents. The downside is those market rents have now plummeted due to multiple condo conversions being placed on the rent market at the same time.
One of the major differences between valuing an apartment and a condominium project is the method that is used. An apartment’s value is dictated primarily from its income. Variables such as capitalization rates, gross rent multipliers and price per square foot all factor into an apartment building valuation. A condominium project’s value is primarily determined by the price of the unit on a per square foot basis, based off of recent comparable sales. Income does not play a part in valuing a condominium project since the units are sold off individually. The difference between the two valuations can be significant.
For example, two identical side-by-side eight unit buildings are placed on the market for sale. The first property is an apartment building with an annual income of $115,200.
The other property is converted to condominiums. Each condo is placed on the market for $350,000 making the effective price of the condo project $2,800,000. This example is to show the difference in value between the two types of properties that are essentially the same minus some improvements.
Now developers and lenders are feeling the pain of aggressive lending, while some investors are getting fire sale prices on great properties. However, as with any important investment decision, understanding what you are buying and for how much are fundamentals that must not be forgotten. It may not be Costco, but buying in bulk can still save you money if you are an investor looking to buy a condominium conversion.
Mike Heayn is a Commercial Loan Consultant, specializing in Multi-Family Lending. He can be reached at (310) 428-1342, or e-mailed at firstname.lastname@example.org.