Executive Insight: Distressed Condos

One of the most obvious results of the economic downturn has been a significant increase in the number of distressed condominium projects. The excess supply of for-sale condo units in many areas, declining housing prices, the credit crisis and tightening lending standards—as well as consumer confidence levels at historic lows—have created many situations in which condominium projects must be kept afloat. Either the developer or another party must wait for the market for for-sale units to come back or restructure a condominium project—either finished or unfinished—as a long-term rental. MHN Editor-in-Chief Diana Mosher talks to Roger D. Winston, Esquire, Ballard Spahr Andrews & Ingersoll LLP, about opportunities in distressed real estate.

What are some of the different ways that the market defines distressed condos?

Some potential distressed condominium scenarios include:

1) A project that is partially complete, with portions still under construction. Some unit purchase contracts have been entered into, but the condominium has not yet been established, and no units have been conveyed to third-party purchasers.

2) A project that has been partially or totally completed and has been subjected to the condominium regime, and some unit settlements have taken place. The developer still retains a majority of the units and controlling interest in the condominium association.

3) A project that is a conversion from a rental apartment facility, and has been partially converted to a condominium with some units conveyed to purchasers. Unsold units, as well as units not subjected to the condominium, may be occupied by existing residents or may be vacant.

4) A project that has been entirely subjected to the condominium regime, and more than a majority of the units have been conveyed to unit purchasers. However, the developer retains multiple units that it intends to rent out or perhaps sell to a bulk purchaser until the market improves.

Who’s investing in distressed condos?

We’re primarily seeing developers and institutional investors. They’re coming in with much more stringent underwriting requirements. The developer or sponsor is expected to put in some of their own money—typically about 10 percent. There has been so much mezzanine money sitting on the sidelines, looking for prices to drop and looking for opportunities. Now this money appears to be coming off the sidelines. It seems like the returns that the equity people are looking for have moderated a bit. For the past year now, we’ve seen deals being done because the gap is closing a little bit.

We’ve had some transactions where REITs are buying distressed condos, not with the intention—at least in the immediate future—of doing anything on a for-sale basis, but to get rental inventory immediately without having to go through entitlements or construction loans. It can take two or three years for all of that to happen. Also, they can buy these existing projects for less than it would cost them to construct the project, because they’re distressed and the lender is liquidating.

A number of the transactions we’ve seen involve apartment developers who say, “here’s an opportunity to buy something that historically would cost much more.” The specifications for building a condominium project would typically be higher. The quality of the product tends to be better if you’re catering to a for-sale market. Often the units are larger because they’re sold on a square-foot basis.

Now you’re buying a Cadillac, but you’re paying a Chevrolet price because it was built out as a Cadillac—but it’s being liquidated at a Chevrolet price. The good news is that maybe you can rent it for a little more since it was built as a Cadillac.

The other people buying these things are condo investors who think there’s a market out there and will attempt to sell to individual homeowners looking for a deal on what was once a $500,000 product. They’ll purchase 100 distressed condominium units from the lender (who has taken them back) for $350,000 each and sell them
at $400,000.

Consumer confidence is improving. The job market still isn’t doing great—that will continue to affect the demand. But, increasingly, we’re seeing credit loosening a bit. We’re seeing a little more demand and seeing investment activity increase.

What do investors need to keep in mind to make this work?

Due diligence can decrease risk, so you [need to] do a good market analysis. For example, are there other condo products that have come online, and what are they reselling for? Investigate the other housing options and employment opportunities in the market. Here in the D.C. area, there has been a lot written in the past several weeks about how the federal government is driving the economy through job creation.

So, if the government is moving 2,000 new jobs to the area, and there’s a distressed condominium project down the street from these jobs, it might be a good opportunity to buy that distressed property because all these people will be moving into the area and will need housing.

What other pitfalls should be avoided?

There’s a long due diligence list we go over with clients when they’re buying a distressed condo property, either for rental or for-sale purposes. For example, we say you have to understand that if the prior developer sold units within this project to individual purchasers, then you don’t own this [entire] project—you own a portion of the project.

It’s almost like having a partnership. You have other people who are co-owners. And you have to be accountable to them even if you own a majority of the units. You can’t make all the decisions. You have a functioning condo association, which means you have to have meetings of the condo association [as well as] an elected board of directors. You also have to adopt a budget and collect assessments from everybody. And, you have to deal with the complaints about barking dogs and children.

Institutional apartment guys are used to thinking, “I own everything here.” They’re used to opening the pool when they want to, making decisions about landscaping, and putting new trees in. The other day I met with a client who is going to buy 120 units, 28 of which have already been sold. They’ve decided to buy the units back from the homeowners because they wanted a long-term hold and wanted to do that as a rental community.

In another market, it’s making more sense to keep the existing owners in place and  continue to sell the units.

To comment on this executive insight, email Diana Mosher at [email protected].