Conversion crazy!

You've got to spend money to make money. Even today the old adage continues to ring true--especially in reference to the current condo conversion trend. Interest rates may be slightly higher than in 2004, but they are still historically low. The combination of these low rates and the steady increase of land costs has launched a condo conversion craze the likes of which hasn't been seen in 20 years. Condo developers across the country are paying a premium for rental properties to convert them into condominiums.

This movement towards conversion can be attributed to a variety of factors. Due to stock market volatility, many investors are looking at real estate as a favored asset class, causing an influx of institutional money into the market. With the demand for real estate increasing and continuing to push prices up, cap rates for multifamily properties continue to decline. Also contributing to the rise in the costs of multifamily properties is the booming housing market that continues to exist. With land prices currently so high, the market is simply not conducive to building a rental property.

The high costs of land and construction make it easier to buy and convert than to build from the ground up. The risk involved in acquiring and upgrading a multifamily property is far less than constructing a new building. The developer can avoid the fluctuating prices of building materials and labor and the possibility of construction delays: Developers know that they can complete a conversion project faster than new construction--it may take three or four years to see profits from a newly constructed condominium, however by converting, a developer can be in and out within a year. This expedited process enables the developer to capitalize on the current strength of the condo market. Because of this, conversions are less subject to economic changes than ground up construction projects. As long as interest rates remain relatively low, the rent vs. own analysis will favor ownership. As such, the faster a condominium is completed, the more likely it will be able to take advantage of the benefits of current low interest rates.

The multifamily market is experiencing cap rate compression due in part to the condo conversion craze. While traditional multifamily investors are constrained by return on investment hurdles, those planning to convert rental units to condos are willing to pay more (in some cases up to 40% more) because their returns are not a function of the current property NOI. Bidding wars causing buildings to sell for far more than the listing price have often been the result of the competition among converters. They're prepared to spend more, as a converter is not focused on operating the apartments for a steady stream of income, but on trying to maximize their returns by selling the units at the highest price possible.

The lack of vacant land available for development in urban markets is another reason for the continuation of this conversion trend. Due to the supply and demand curve of these markets it is highly likely that real estate values will continue to appreciate; New York City and south Florida are prime examples. In fact, due to the laws governing tenants' rights as well as the lack of remaining coastal land to develop, Florida has become one of the reigning markets for condo conversions. Foreign investors and speculators further fuel the Florida condo boom. Likewise, in downtown Manhattan and Brooklyn, it is becoming more common to convert office buildings into residential buildings due to the lack of vacant ground. After 9/11, the downtown office market declined significantly and as a result developers have been able to buy cheap and convert. Other areas of the country, such as, California, Nevada, and Arizona they are all realizing particularly high conversion volumes, as well.

In general, there has been no shortage of buyers for these converted units. It is the American dream to own property and when low interest rates make it feasible for people to stop renting and start buying, they're going to seize that opportunity.

RONALD LEVINE, VICE PRESIDENT, CONSTRUCTION, MERIDIAN CAPITAL GROUP