Slumping Condo Sales Spur Switch to Rentals
It is the real-estate equivalent of turning lemons into lemonade. Take a condo project that isn't selling and turn it into a successful rental-apartment property.
That is the strategy developers and lenders are aiming to use on billions of dollars of troubled condo complexes. "If there's a potential rainbow out there in the clouds, it's that some of these stalled condo projects work as rentals," says Roger Winston, an attorney at Ballard Spahr Andrews & Ingersoll LLP in Bethesda, Md., who advised owners on several so-called condo reversions.
And while a few reversions have succeeded, the obstacles to make the switch from condo to rental are high. Among the hurdles: lenders reluctant to lengthen loan terms because rental properties produce income more slowly than condos; irate condo owners who don't want to live with renters; crushing tax assessments based on old condo sales prices; and a rental market that is weak in some of the worst-hit condo markets, such as Florida and Arizona.
Yet many condo developers are desperate as they fall behind on their payments to banks for construction loans at a rapid clip. Delinquencies increased from 4.1% of loans outstanding in the second quarter to 5.9% in the third, or $2.5 billion of the $42.7 billion of loans outstanding, according to Foresight Analytics, an Oakland, Calif., research firm. Those numbers only cover banks regulated by the Federal Deposit Insurance Corp. and exclude other condo lenders, such as investment banks and private equity funds.
In percentage terms, condo delinquencies are higher than those affecting construction loans to single-family home builders, which rose to 4.3% in the third quarter from 3% in the second. But on a volume basis, banks own seven times as much in single-family construction loans, more than $303 billion worth, of which $13 billion are past due, according to the FDIC and Foresight Analytics.
In one reversion, Capital Properties, based in New York, this summer bought the 405 remaining unsold condo units in a 574-unit building called Vaughan Place, in an affluent Washington neighborhood. Individuals had already bought 169 units before the sales market stalled. The seller of the remaining units was private-equity firm Carlyle Group, an equity partner in the project, which aimed to upgrade the luxury apartments from rentals to condos.
For Capital Properties, financing the bulk buy wasn't straightforward. Fannie Mae, which is a major lender to apartment landlords, passed on the deal, says Richard Cohen, Capital Properties chief executive, because Fannie couldn't figure out how to classify the property. "Is it a dog or is it a cat? Is it a condo or is it an apartment?" he says.
A Fannie Mae spokesman declined to comment specifically about Vaughan Place. He said Fannie Mae in general is "interested in financing deals that meet its safe and prudent underwriting standards."
Capital Properties, which paid for 40% of the deal with its own equity, ended up with a mortgage for the remaining 60% from Lehman Brothers Holdings Inc. A Lehman spokesman confirmed the deal.
Of the 404 units it bought, Capital Properties has 150 left to rent out, on target with its business plan, says Mr. Cohen, who says the project works well because of what he calls "one of the best apartment locations in all of D.C.," aided by a local apartment market that favors landlords.
In some markets, the reversion strategy might not work. For example, in the Tampa, Fla., region, developers are "bailing in one shape or another" on 50 projects, says Darron Kattan, with brokerage Marcus & Millichap. Adding to the pain, the rental market there is weak, because of the oversupply of empty condos and single-family homes being rented out and a job market that relies heavily on real estate.
Another issue is taxes. Policies differ by jurisdiction, but in general, local tax authorities assess condominium units at a higher rate than rental units. That can make buying bulk condos to use as rentals unattractive. Mr. Kattan cites one building with empty units that would be assessed at $700 per unit annually as rentals but are instead assessed at $2,100 per unit as condos. "It crushes the value of the property," he says.
