To be, or not to be: that is the question:
Whether ’tis nobler in the mind to suffer
The slings and arrows of outrageous fortune,
Or to take arms against a sea of troubles,
And by opposing end them? To die: to sleep;
No more; and by a sleep to say we end
The heart-ache and the thousand natural shocks
That flesh is heir to, ’tis a consummation
Devoutly to be wish’d.
 -Hamlet, Act III, Scene I

There has been interest expressed among our multifamily investor colleagues for some time now in failed condo conversion projects around the country.  These potential bargains can be found almost anywhere, but many of them are clustered in the states that led the condo rush in 2005 and 2006 – Florida, Nevada, and Arizona. 

My wife and I attended a meeting in Orland just before Christmas in 2005, and while we were there the paper ran a headline story about the shortage of available apartment rental space given that so many complexes were being converted.  Ironically we were attending a conference in which the main theme was condo conversion analysis. 

Dan Fasulo, the managing director of Real Capital Analytics in New York City, estimated in May of this year that almost 10 percent (9.5% to be exact) of the 331,500 apartments purchased nationwide from 2004-2006 with the intent of conversion have come back to the market as rental properties.  Many of the experts in the field that we’ve interacted with in the past few months expect that number to double over the next year. 

The consensus opinion is that while the potential of finding a gem of a property is quite high, there can be a literal minefield of challenges to overcome.  These challenges include properties potentially in foreclosure (often with multiple lenders), properties with units in varying stages of renovation, and very high vacancy rates. 

We’ve done a bit of research in looking at a project like this ourselves in San Antonio; here’s a list of the advice we garnered from interviewing experts and doing a volume of reading along the way –

  • Make sure the market is sound.  Many of the these projects are located in markets that have taken a beating not only in terms of real estate, but in their general economy as well.  Job losses and slowing economic growth are contagions that have infected many of the condo rich markets in Florida, Nevada, California, and Arizona.  All of these issues can serve to lessen housing demand and weaken the market overall.  Are there exceptions?  Sure there are – Orlando for example continues with strong population and job growth despite the sour employment milieu noted in many other Florida markets these days. 
  • Get control of the asset.  You may be negotiating with the converter organization, primary lenders, mezzanine lenders, even investors left holding the bag.  We agree with those who have opined that lenders don’t want to hold these nonperforming assets, and lenders are easier to deal with than the other groups.  Options for creative approaches abound.
  • Pricing is key.  These are not stabilized assets, and it’s for the most part impossible to use cap rates to value a complex that is unoccupied or partially occupied.  Again there’s some potential for creativity here – but it will also required a very fundamentally sound appraisal of the property’s operational potentials.  You’ll be looking at eventual market rents, projected lease up and stabilized occupancies, completion of renovations / construction, and dealing with any current unit owners, as well as management considerations of a complex lease up / start up. 
  • An unexpected risk – individual unit owners.  We were quite surprised as we looked at the project in San Antonio to learn of the potential risks engendered when some of the units have sold already to individual owners.  This topic could take up a small monograph in terms of its complexity and contingencies; suffice it say that you must understand the condominium owners’ docs very well if units have sold, and the best advice we received was to be prepared to buy the units back at their purchase price, even if price have fallen.  Issues in this arena killed our San Antonio project as recalcitrant unit owners eventually filed a number of legal actions against the converter. 
  • Look for unexpected potentials.  As we negotiated our project in San Antonio we stumbled across the fact that the converter had pre-purchased a large amount of construction materials, and we were able to negotiate the materials into the equation at about 17 cents on the dollar.  The moral to this part of the story is not to leave any stone unturned. 

More and more of these types of projects may indeed become available; they’re not for the inexperience or weak of heart, but you just may find a gem among the rubble out there. 

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