Condo conversions: a passing trend or new revolution?

An awful lot has been written lately about condominium conversion. With historic low short-term and long-term interest rates, rapidly escalating single-family home prices and a surplus of capital chasing fewer high-yielding investments, last year was in fact the perfect environment for conversion.

Today, with short-term interest rates up (LIBOR is now 5.3% vs. 3.3% in mid-2005), long-term interest rates creeping (10-year Treasury is now approaching 5.10% vs. 4.25% in the mid-2005) and the overheated single-family market cooling off, the consensus view is that this has come to an end.

But the real question is how much of this conversion activity has been driven by interest rates and how much of it has been driven by fundamental changes in the preferences and new requirements of the next generation of households? Have there been enough fundamental changes in lifestyle preferences among older and younger people to sustain the condominium craze? Here are some things to consider:

People stay single longer and stay married for a shorter period of time. More people like to be where the action is, rather than get away from it. More people have been conditioned to build wealth and own their own home. More people are buying investment properties. People are working longer hours and there are more married couples with both spouses working. They are looking for alternatives to driving and require more luxury amenities and less maintenance.

All of these factors have an impact on what the public demands in the form of housing units. All of these promote the idea that condominium demand is here to stay. But all of these do not support the viability of condominium conversion.

There are two very important rules of the game that still ring true. First, all things being equal, someone in the market for homeownership will buy a single family home over a condominium unit.

With escalating construction costs and stabilizing housing prices, some condos will be priced too high and will not be compelling enough for people who can afford a single-family home for the same price. The personal preference will be harder to justify if there are more alternatives. Entry-level condos at the right price should still sell as there is much deeper demand for this product. However, higher priced luxury units may be harder to sell because wealthy empty nesters will have so many potential housing options. In a stable pricing environment, investors will become nonexistent. All of this impacts the converter.

Second, all things being equal, the seller of an apartment building will sell to an income buyer over a condominium buyer. That's because it's an easier, smoother transaction that is more likely to close and requires less post-closing liability. Condominium converters are getting more competition from the income buyers, something they didn't have last year. This is because the rental market has strengthened and there are more institutional income buyers willing to purchase properties at initial yields that are below conventional interest rates betting on rental growth.

These institutional income buyers, after getting priced out in 2005, have started factoring in aggressive growth assumptions and low residual cap rates to compete and win deals. Most of these buyers are using little or no debt financing. Private equity with conventional debt cannot compete with these institutions since they will typically rely heavily on leverage to make their return targets.

Most condominium conversion lenders have now tightened their underwriting and are funding fewer conversions due to rising interest rates and negative media hype. With thinner margins for the converter and more perceived risk and competition from aggressive and well-capitalized income buyers, many converters are now being priced out of the market (if they haven't already chosen to exit it).

So even though there will still be significant demand for condominiums, at some point, the condominium conversion craze will end. That point has already occurred in some of the metro New York suburbs.

With that said, condominium conversion can and still works in prime urban locations but is mostly restricted to urban and prime suburban areas (i.e., within one hour of New York City) or in site constrained markets such as Washington D.C. and Boston, MA where severe barriers to entry exist.

Fortunately for any apartment building owner that is still considering a sale, there is still a deep bench of institutional income buyers that will pay historic low cap rates for these properties.

Selectively, converters will still outbid the pure income buyer. Earlier this year, for example, the New York Tri-State Investment Team sold Avalon Corners, 195-units in downtown Stamford to an income buyer for over $60 million. Of the over 25 offers received for the property, only a handful were from converters. The most aggressive offers from the institutional income buyers were marginally better than converter pricing. The top income buyers outbid the converters because they underwrote aggressive rent spikes for the next two to three years.

In the sale of Hastings Terraces/ Osborn Manor, two properties totaling 198 units in Hastings and Dobbs Ferry, NY for $26.2 million, although the locations of both assets were prime, the buildings were built in the 1940's, were regulated by EPTA and were in need of major capital improvement.

Due to the condition and age of the property and the onerous regulations protecting renters, a conversion of the project was expected to be both expensive and difficult. As a result, the best offers came from income buyers. The cap rate on that deal, based on the sellers trailing twelve month NOI was approximately 3.9%. Buyers all underwrote significant capital investment in the property to drive rents higher and create operating efficiencies.

On the conversion front, CB's Tri-State Investment Team recently sold River Hill Tower, a 262-unit high-rise building on the North Yonkers waterfront for $52.25 million. Built in 1972, the property was not subject to EPTA and comprised smaller units with phenomenal water views, on-site amenities, and train access. The property was marketed almost exclusively to condominium converters, and as a result of these compelling features, the property generated strong interest and sold to a converter at a 4.02% cap rate. Condominium units at the property should be very appealing to entry-level buyers, as demand at the lower end is still very strong.

Further support of that demand is CB Richard Ellis Inc.'s pending sale of the Dixon Mills property in Jersey City, NJ, a 467-unit converted pencil factory with a variety of different floor plans, distinctive architecture, and unique character.

The property's off-waterfront location was conducive to high occupancy as a rental property because it was always viewed as a good value. These same dynamics should attract many entry level condo buyers due to its affordable price point as compared higher priced luxury condos in the area.

Given these unique dynamics, converter interest was fairly strong and the sale price (the property is in contract to a converter) will equate to a cap rate of approximately 3.9% based on the trailing 12-month NOI. The price represents a premium to offers received from income buyers, since most of the rental buyer interest came from private equity buyers who were negatively impacted by the recent rise in interest rates.

So, although the conversion craze may be winding down, it is still an ideal time to be selling multi-family assets. Converter interest for the right properties and markets remains, although at somewhat less aggressive pricing, while the institutional income buyers are more aggressively seeking product. Pricing is still at an all-time high and the fundamentals for multi-family remain strong.