Chicago’s Condo Deconversion Sales: Will the Trend Last?
- Nov 01, 2018
Multifamily development has been gaining momentum in Chicago. This summer, the city was sending strong signals that it was approaching a new cycle high in deliveries with more than 10,000 units slated for delivery by year-end, according to real estate data provider Yardi Matrix. This dynamic construction activity has been primarily bolstered by rent growth in the luxury segment and by the constant demand for high-end development in the city’s core areas.
But it’s not only new, cutting-edge residential developments that are defining Chicago’s real estate market, especially when it comes to investments. Value-adds are still attractive for most real estate investors. Interra Realty Managing Partner Patrick Kennelly talked with Multi-Housing News about his company’s most recent moves on the market, highlighting the opportunities behind condo buildings suitable for deconversion projects. Interra Realty closed a large number of such deals in the north part of the metro during the past quarters.
The trend reached its peak in 2017, but hasn’t winded down yet. Whether or not condo deconversion sales will continue in the next quarters depends mainly on the availability of this type of buildings on the market as well as investors’ willingness to overcome the delays that might arise in the process, such as getting the association’s approval.
How has condo deconversion to apartments impacted Chicago’s multifamily market?
Kennelly: I know more than 2,000 units which have gone from condo to rental over the past two years, with the majority of these deconversions happening in the north side of Chicago and inner ring suburban locations like Evanston and Oak Park. As for impact, it will definitely answer the strong demand for more rental units in these areas, though without an effect on rents. Although we have seen thousands of rental units come online in the past few years, we have not seen a major softening of rents in these areas yet.
Typically, buildings primed for a successful exit exhibit similar characteristics. Most properties have smaller units—studio and one-bedrooms—upcoming special assessments, high percentage of rental in the building and a trend of non-financed sales or cash purchases within a building.
What are the risks of such investments?
Kennelly: According to Illinois condo law, governed by Section 15, generally a deconversion sale requires that more than 75 percent of the ownership of the common elements approve the sale. The most obvious risk is the offer being sent to vote and not passing. The association incurs legal fees, stress of whether they are moving or not and undue cost of their time.
Additionally, from a buyer’s perspective, we have seen closings drawn out for months because of various issues and seller holdouts. We have recently dealt with a holdout in a deconversion sale that deferred the closing so much that the interest rates changed. It was enough to have a meaningful impact on the deal, so the buyer requested a credit for the additional costs.
How have changes in interest rates and tax legislation influenced multifamily investment in Chicago so far?
Kennelly: With rising interest rates and pricing remaining strong, investors are realized with a compression in their cash on cash returns. In turn, we are seeing some buyers exploring neighborhoods outside their core holdings to hit their desired returns.
As far as taxes go, many areas have recently been reassessed in Chicago and many owners were hit with big increases. This has caused some investors to look outside of the Chicago market in fear that taxes will continue to rise.
What are the challenges and opportunities for financing multifamily acquisitions in Chicago at this point?
Kennelly: Many buyers are aggressively shopping different banks to squeeze points as pricing is tight in today’s market. They are also opting for governmental programs like Fannie and Freddie Mac, which are offering competitive rates on a non-recourse basis.
With the recent deconversion trend, the biggest challenge in many of these deals is achieving an occupancy level that meets the bank’s standards. In most cases, banks are requiring between 85 to 90 percent occupancy to finance the deal.
What can you tell us about shifts in multifamily investment in Chicago going forward? Will we see less value-add deals?
Kennelly: The multifamily market remains strong and value-adds are still the go-to asset class for most real estate investors. Today, we are seeing less sophisticated and less experienced investors come into the market looking for an alternative investment. Although there are a few who prefer deals in which they can completely revamp the property from both physical and operational perspective, many turn towards deconversion sales.
Rather than having to physically transform the asset, most investors appreciate the operational changes that they can make to a building and still add value, such as branding the apartment building, raising rents to market and cutting expenses through their in-house operations.
Tell us a bit about Interra’s investment strategy, particularly in condo buildings which can be converted.
Kennelly: Since 2017, Interra has been involved in the sale of over 10 buildings and over 500 condo units. The main objective for us when looking at a potential deconversion is to help owners exit a property they are otherwise unable to sell. We often see an association stuck in a cycle where the units cannot be financed because of the large percentage of rental units and the only viable purchasers are investors or “cash” buyers. These investors are buying the units at an attractive basis. Over time, we see the building operate more like a rental building, with the majority of units owned by investors.
Our goal when deciding to take on a deconversion assignment is to achieve a market value premium of at least 25 percent higher than the average recent sales in the association.
Image courtesy of Interra Realty