Avoiding the condo trap: with many of today's condo conversions potentially becoming tomorrow's competitors in the rental market, selling properties to condo converters might be setting a trap for down the road.

Thinking of selling an apartment community to a condo converter? Think again, especially if the seller plans to stay in the rental market. More than 140,000 condo units in new construction and conversions could potentially be delivered this year, a level not seen since the mid-1980s. With the fate of the housing market now largely tied to interest rates, condo conversion is a short-term play with supply risk facing not only the condo market, but potentially affecting the rental market as well.

The share of multifamily housing transactions accounted for by condo conversions since the beginning of this year is more than 40 percent--twice the 2004 average, according to Real Capital Analytics. More than 60,000 rental units were purchased last year with the intention of condo conversion, with more than half of this activity to take place in Southern California, South Florida, Northern Virginia, Las Vegas, Washington, D.C., and suburban Maryland.

Investors are not the only ones confident in the condo market; developers are as well. More than 100,000 condo units are targeted for completion in 2005 nationwide--the highest annual tally since 1984. Not surprisingly, the same regions and markets that lead in terms of conversions are also the markets leading in new construction.

Housing demand has remained strong since the late 1990s, with the homeownership segment, fueled by the economic boom and favorable demographics, remaining particularly strong. To satisfy demand, housing supply has been rising all along, yet accelerating new condo construction and conversion is a more recent phenomenon.

While demand for condos is clearly present, rising condo development has also been fueled by unprecedented home price appreciation (single-family and condo alike). In fact, growth in condo prices surpassed that of single-family for the first time last year. Since 2000, median prices for existing homes have more than doubled in metropolitan areas such as Los Angeles and San Diego, and have nearly doubled in Las Vegas, Miami and Washington, D.C. The bulk of these increases occurred during the past three years.

Risks of Oversupply 

Accelerating condo supply in the form of conversions and new construction carries two types of supply risk:

First, as mortgage rates continue to rise and the single-family housing market slows, so will condo sales, resulting in more properties being delivered as rentals than the market is anticipating. In fact, looking at the currently low ratio of the cost of renting to cost of homeownership, it is a wonder how much steam is left in the condo market. (See Industry Trends column on page 88).

Second, individual investors are buying an increasing share of condos for rental purposes, adding competitive pressure oil professionally managed rental properties. According to a recent survey of homebuyers conducted by the National Association of Realtors, a whopping quarter of all homes sold last year were purchased as investment properties. In some markets, according to local sources, as many as half of individual home purchases meet the definition of investment properties. There is limited information on how this share is divided among single-family homes and townhomes/condos, yet one may argue that condos are no less attractive investment vehicles compared to single-family homes from the individual buyer's perspective.

Las Vegas: A High-Risk Area?

These risks appear to be more pronounced in areas that recently have seen strong employment and population growth. Las Vegas is one such market. This metro saw the fastest employment, population and personal income growth in the nation in each of the past five years. Last year alone, its total employment grew by 5.5 percent and its population by 4.2 percent--more than four times the national rate.

Strong economic growth combined with historically low mortgage rates have prompted the median home price in Las Vegas to double during the past five years, pushing the implied yield (expressed as the ratio of rent to home price) from 6.4 percent in 2000 to 3.4 percent as of mid-March (with mortgage rates factored in, the change would be smaller but still substantial). In the language of Wall Street, it would be equivalent to an increase in a price-to-earnings (P/E) ratio from 15.6 to 29.4 (or more than 80 percent)--somewhat reminiscent of the change in stock market P/E ratios over a five-year period preceding their correction in 2000.

Despite the fact that the relative pricing pendulum has shifted dramatically in favor of renting in Las Vegas, single-family and condo development is only accelerating. Torto Wheaton Research/Dodge Pipeline indicates that while condo completions averaged 1,100 units per year between 2000 and 2003, more than 1,600 condo units were completed in 2004, and 1,800 are under construction to be completed this year. This is in addition to the 6,100 apartment units (17 communities) transacted in the market last year for imminent condo conversion.

Las Vegas is one of the markets where half of the homes purchased recently could be considered investment properties. Conservatively estimating, if only 5,000 condo units are actually delivered to the market this year, as many as 2,500 could end up on the rental market by 2006. If such a scenario materializes, it would more than double the amount of new rental supply, resulting in negative absorption and a vacancy rate increase of more than 100 basis points.

Risky Loans

Could apartment investors and operators selling properties to condo converters be setting up a trap for themselves or other rental apartment owners down the road? In markets where new condo construction is already high, it is more than just a rhetorical question. Many of today's condo conversions will become tomorrow's competitors in the rental market. Moreover, if the housing market weakens substantially, these new competitors may prove particularly hungry to fill their units to generate cash-flow. Mortgage issuers may also take notice of these risks and view condo-conversion loans as riskier than traditional mortgages and underwrite them accordingly.

Gleb Nechayev is a Senior Economist at Torto Wheaton Research, Boston. He can be reached at [e-mail]. Copyright[c]2004, Torto Wheaton Research, a business unit of CB Richard Ellis (TWR). All rights reserved.