CREJ - Multifamily Properties Quarterly - May 2016
Homeownership is the American Dream for many, but numerous would-be buyers in Denver are finding the dream to be very elusive. Stories from residential brokers and friends seeking to buy a home often sound more like a nightmare. Buyers often are faced with multiple competing offers on prospective homes, resulting in bidding wars that increase the price well over the asking price. Cash buyers or buyers willing to put up nonrefundable deposits are winning out, resulting in a frustrating and difficult home buying process. What is the challenge to buying a home? Simply put, there is an overall housing shortage. This has been a boost to the apartment market because it keeps renters in greater supply. However, with growing demand from homebuyers, lack of new condominium development and ever-rising rents, the market might be ripe for conversion, which could be an attractive alternative exit strategy for apartment owners. Housing Shortage After the downturn in 2009, residential real estate development fell to record-low levels. The chart demonstrates how wide the gap in residential deliveries is compared with historical construction trends and the expansive population growth. Exacerbating the shortage is the complete lack of for-sale condo and townhome development. The chart excludes most condo/townhome development, because it was difficult to find a consistent data source for deliveries; however, some residential experts pegged the number of condo and townhome units being delivered prior to 2007 generally in the range of 2,000 to 3,000 units per year. Since then, the number of deliveries has fallen into the hundreds of units per year. If you take 2,500 units a year for eight years, you can see the market is lacking at least 16,000 condo units for sale compared with the historical construction deliveries. With pent-up demand and a substantial drop in supply, why aren’t more condo projects in development? Mainly because there are barriers to new ground-up condo development stemming from construction defect litigation and cost to build, market timing, and financing by the development and buyer. The current construction defect laws make developers, contractors, architects and everyone on the development team nervous about building for-sale condos due to the high risk of being sued. Until there are substantive changes to these laws, it will be difficult to get many large-scale projects off of the ground. This difficulty is attributable to a development team being required to carry much more insurance, adding more cost to an already expensive development environment. Coupled with increasing land and construction costs, the end product will be expensive, effectively gearing properties toward more affluent buyers and creating a high barrier of entry for first-time buyers, as well as others in the entry-level housing market. If and when the defect litigation environment shifts in a more favorable builder direction, developers, insurers and lenders still will be sensitive to the risk and potential for future lawsuits. New developments can be a time consuming and risky endeavor. There is timing risk ranging from land planning and entitlement to construction delays. While demand from buyers for condos is high, waiting a year or two for finished product can change a buyer’s appetite or the economic environment can change, eroding buyer demand. Financing for the development of condos is scarce and will require strong presales, strong borrower liquidity and large equity down payments. When a developer can obtain construction debt and equity, selling to the condo buyer has significant lender underwriting hurdles that must be met. Most borrowers prefer financing provided by government sponsored enterprise lenders such as Department of Housing and Urban Development, Freddie Mac and Fannie Mae, because they have the most favorable rates and down-payment options. The government-sponsored enterprises have tightened lending requirements for borrowers in general and even more so on condo projects. Projects have to reach substantial presales or have a bank willing to hold loans on their balance sheet while preselling in order to meet specifications before a government-sponsored enterprise will agree to purchase condo loans. These financing constraints are additional barriers to growth in the condo market. Condo Conversion Much of the apartment supply being developed today will be ideal for condo conversions tomorrow. In every real estate cycle there is a point at which demand for entry-level housing exceeds supply and the government steps in to help increase liquidity. While condo conversions would face some of the same challenges that a new condo development would face, there will be a tipping point at which the regulations loosen or the economic opportunity outweighs the perceived risks. With an existing building and in place revenue, a bank might be more willing to finance such a project, allowing more flexibility to hit presales to achieve benchmarks acceptable to a GSE lender. A lender might perceive less risk with existing building versus new development, and liquidity might find its way to apartment condo conversion sooner than later. In respect to the construction defect litigation environment, converting an existing apartment community to condos has the potential to mitigate much of the new development risk. Apartment buildings that have been in existence for several years would have given the owner/developer the opportunity to correct construction defects prior to selling individual units. Additionally, depending on when the property was built, converting these units into condos might be outside of the time frame in which a homeowner or an homeowner association can bring forward a suit for some defects. An existing community also eliminates the development risk associated with ground-up development. Skip the land planning, zoning hearings, architectural review boards, and on and on. In Colorado, converting an apartment community to condos can be a fairly straightforward task and done reasonably quickly. This gives a condo converter a big head start – existing sellable units, in-place income from existing rents and, potentially, some captive buyers already living on site. Converting existing apartment stock to condos could be beneficial to apartment owners. Conversions would shrink the overall rental pool and stock of residents that would prefer ownership to renting. It would help keep the apartment market supply and demand in balance. Further, in the last few cycles, buyers intent on converting apartments to condos often drove pricing higher for investment sales and helped support values of apartment building sellers.