Cost overruns. Construction defects. Conversions gone bad. While there are tremendous profits to be made in the center ring of the condo circus, the dangers lurk everywhere.
Just listen to Bill Donges, CEO of Lane Co., whose Atlanta-based company is concentrating on bringing thousands of units online in the next few years.
While Lane is an experienced builder, many of itscompetitors are not– and increasingly they have been coming to Lane for help on troubled projects where construction costs have outstripped the initial sales prices, forcing the developer to cancel the early reservations and raise sales prices to match the updated construction costs. "You get unbelievable bad will, lawsuits, fighting, and screaming," says Donges. "You have to reinvent yourself. The project becomes anathema. The brokers treat you like you have leprosy, and you will be marked as a failed project. It turns into a nightmare."
It's a different scenario than the jaw-droppingly fast sellouts, overnight campouts of hopeful buyers, and head-spinning opening parties that have garnered much of the headlines in recent months. But it's far more dramatic and for developers and converters, far more financially dangerous if they fail to limit their risk in the condo ring. These construction challenges and financial issues are like the lions at the circus: trainable, but ultimately wild, brutal, and uncontrollable if placed in the wrong hands.
As fast as condo prices have risen, so have construction costs. During the past few years, developers and builders have seen the price of raw materials and labor skyrocket. "Virtually every commodity, including all labor, has seen across-the-board increases," says Leonard Wood, director of Wood Partners in Marietta, Ga. "We were up over 10 percent last year and another 10 percent this year."
It's a very real problem, as soaring building materials prices and labor costs diminish a project's profits. Even worse, costs can outstrip the early sales prices, forcing a builder or developer to return buyers' reservations and potentially stigmatize a project.
To manage these costs, smart condo developers say they are tightening down the process. "You used to be able to estimate, and it's not really possible to do that today," says Wood, whose company expects to build 2,500 units in 2005. "You can't go off your historical results. You have to go off actuals. Get your plans done and get them bid out so you know where you stand."
But neither can developers afford to do these projects on the cheap. Once a company is involved in condos, "you've opened yourself up for a long-term scenario as far as the possibilities of construction defects and the condo owners coming back against you," Donges warns.
Converters are at even greater risk. While condo builders have some protection, thanks to right-to-repair laws recently passed in many states, converters don't. "If the original construction happened over 10 years ago [in California], the purchasers are not going to be able to sue the builder," says Greg Dillion, co-managing partner with Newmeyer & Dillion, a Newport Beach, Calif.-based law firm that represents large developers and converters. "They will be able to sue the converter."
To protect themselves, converters must do a thorough inspection of their property, documenting that examination with notes and photographs. "Don't just walk around the grounds," says Don Neff, president of La Jolla Pacific, an Irvine, Calif.-based construction consulting firm. "Get inside the building. Get inside the attics. Do inspections where people are living. If you find significant issues, you need to do investigative testing. If you have evidence of water intrusion, for example, you will need to open up drywall, look into stud bays, and see where water is coming from."
If something still goes wrong, there's yet another way to gird a company against the construction defect lions: a good customer service department. "If you smother your customers with kindness, you can avoid the litigious nature of the business," says Steve Patterson, president and CEO of ZOM Development, a developer and apartment owner in Miami.
Establishing such a department does take time– and it shouldn't just be an extension of an existing property management group. "The customer who is buying a home has different expectations and different entitlements than a person renting an apartment," says Tom Bozzuto, president and CEO of The Bozzuto Group in Greenbelt, Md., who has separate customer service programs for its property management business and its for-sale customers.
Some companies address the issue by initially funding a new condominium's reserve fund, which is money that the residents' condo association can use in the event of any unexpected or early problems. "When you transition the association to the control of the new homeowners, they are not immediately faced with increases or assessments," says Mark Randall, director of Wood Partners, which funds a new condo building's reserves in its first year of operation.
"They will have plenty of money to deal with the initial building maintenance issues that invariably come up. We believe doing so is the right thing to do and greatly reduces the risk that the owners will have a reason to make a claim against us as the developer."
Others take a more case-by-case approach. J.I. Kislak, an apartment owner and condo converter based in Miami, will rehab a property, consult with building experts, and establish the reserve fund based on that information. "We had engineers and architects assess the condition of the property and tell us what needed to be done and what had a useful life of X years," says Tom Bartelmo, the company's president and CEO. "We built a budget for the condo association and we're trying to hand them a good product."
Finally, some skip the reserves altogether.
"We used to do it, and today we seldom do," says Louis Birdman, CEO of SunVest Communities in Hollywood, Fla. "If you spent money to update the building, why spend more money to fund reserves? I'd rather do what the building needs as opposed to put up the money that never gets used. Funding the reserves doesn't get you out of liability suits."
Beyond liability, what's the biggest fear among the audience (and star performers) in the greatest show in real estate? The collapse of the much-hyped housing bubble.
It's an unpredictable factor, but one that builders and developers must be prepared to address– quickly– or risk losing their shirt.
If sales slow at a condo project, "you need to get out and beat the streets," says Kim Kirschner, CEO of Kirschner Realty International, a Hollywood, Fla.-based company that does third-party condo sales. "Meet with brokers to familiarize them with the property. Get into the multiple listings. Move into the primary and secondary markets, whether it's the daily newspaper with the weekend real estate section or secondary advertising like radio, billboards, and buses."
The other response to an unexpectedly sluggish market: reduce your prices or provide upgrades such as nicer carpet or appliance packages to buyers. "If you perceive the market is slowing down, you want to start offering incentives to get your project out faster than your competitor's products, so at the end of the day you aren't holding the bag," says Jeff Stack, managing director and principal of the Sares-Regis Group in Irvine, Calif.
If sales don't pick up, there are other strategies that developers and builders can employ, from converting a property to, ironically, rental apartments or even selling condo units in bulk to a large-scale buyer or institution, such as a pension fund. Each can provide a quick exit strategy, but each also has its own pluses and minuses. "There's such a lack of product in some markets that institutions may come in and buy [unsold condo units] as rentals," Stack says. "The bottom line is, they won't be worth the prices they were as condos."
Or, developers could maintain ownership of the condos and rent them out, waiting to sell them when the market improves. For this to work, though, market rents need to be high and the property's product type must have been relatively inexpensive to build. Lane Co. likes this fall-back option. "All of our condos are wood-frame, four- or five-story buildings in reasonably good positions," Donges says. "If [the market] were to change, we could convert back to apartments."
The choices get much more limited for high-rise projects in infill locations.
"The ideal scenario is that you underwrite a condo as a rental project and hope it sells as a condo," Patterson says. "But, quite frankly, with land prices and construction costs where they are today, that's not feasible anymore."
For developers with highly leveraged projects, the options for a failing project are even slimmer. "If [unsold units are] in the market for awhile, you can accumulate marketing costs and interest costs that are so substantial that, [even] if you turn it back into a rental, the income from the rental is not even going to cover the debt service," says Stack of Sares-Regis. "Unless you're a well-capitalized developer, the properties will be foreclosed upon and end up back with the bank."
Given such scenarios, it's no wonder that when it comes to selling condos, there's a constant debate about how fast– or slow– to go.
Many prefer the quick sellout. "Some people think we sell too cheap," says Roberto Roche, executive vice president of The Related Group of Florida, based in Coral Gables, Fla. "People want to get the last five cents. If it takes them five years, they'll do it. But we prefer the velocity rather than the waiting game. ... I can go to the next job and get started immediately. I save money in the marketing. I don't have to advertise every day for the next year. The sooner you close, the sooner you make your money."
For others, slower is better. Richard Lamondin, president of Cornerstone Premier Communities in Coral Gables, says he will spend an extra $500,000 in advertising to make an extra $5 million in revenue. "If you sell out in five hours, you're leaving money on the table," he says. "My horizon is nine to 12 months. If I sell it sooner, I've left money on the table."
Who's right? It depends on which strategy fits the developer's risk tolerance best. But don't extend the show over and over again in search of ever-greater profit margins. "If it's gone too long, people perceive there are problems," cautions Kim Kirschner, CEO of Kirschner Realty International, a Hollywood, Fla., company that does third-party condo sales. "That's the death of a project."
After all, the circus can't stay in town forever.