Paul Vismara

Like miners panning for gold, apartment executives today are sifting through countless failed condo conversion deals in search of valuable nuggets of bargain real estate.

“We see an opportunity to acquire some unique assets,” says Dave Woodward, CEO and managing partner of Chicago-based Laramar Group. The firm's last four acquisitions have been broken condo properties.

Such possibilities abound, especially in markets where converters looking for a quick flip have instead found themselves trapped by a rapidly decelerating market. “There are a lot of busted deals,” says Jack McCabe of McCabe Research and Consulting in Deerfield Beach, Fla. Why? Inexperienced converters with impatient investors.

As a result, many would-be condos are being resurrected as apartments, which are more in demand today. “There's no question that [reversion] is a trend we are seeing in the areas that led the condo boom in 2005, such as Florida, Arizona, and Nevada,” says Dan Fasulo, managing director with Real Capital Analytics in New York City. He says approximately 9.5 percent of the 331,500 apartments purchased nationwide between 2004 and 2006 for conversion have returned to the market as rental properties.

But buying a failed conversion and reverting it to rentals is not a strategy for multifamily novices. Today's broken condo deals range from apartment buildings where the now-dropped conversion process had barely started to vacant complexes where every unit stands in a different state of renovation. Properties may be in foreclosure and involve multiple lenders. Separating real estate gold from the fool's variety in such deals requires careful due diligence, the ability to think creatively, and the discipline to limit the considerable risk of such deals.

GET CONTROL The first task in such a deal? Get control of the asset. Given the variety of broken condo situations in the market, this may involve negotiating with the converter, banks, or mezzanine lenders.

“These deals are very leveraged,” explains John Orehek, president and CEO of Security Properties in Seattle, which purchased a failed conversion in Scottsdale, Ariz., last fall. “The people [providing] the capital are not long-term [investors]. They want to get in and get out. When things don't go as planned, the banks get involved and force [the converter's] hand.”

Often, though, the control ultimately rests with the project's lender, which can be good for apartment firms. “Lenders don't want to own real estate,” says Woodward, whose firm acquired a broken property in Boca Raton, Fla., not by buying the property itself but the note for the property from the lender.

Marc Swerdlow, vice president and general counsel for Chicago-based Waterton Associates concurs. “There's a lot of opportunity on the debt side,” he says. “It adds a lot of complexity to deals when you buy the debt and eventually take over the property, but if you are able to control the asset, you are cleansing it of much of the risk associated with stepping into a condo.”

Like everything else surrounding fractured condos, pricing such an asset presents its own set of challenges. “You need to pay less than you would for a stabilized deal, but it's hard to put a cap rate on a property with no occupants,” explains Woodward, who relies more on price-per-door or internal rates of return in such transactions. “Cap rates just don't apply.”

In the absence of a useful cap rate, apartment executives must essentially back into a reasonable price for such a property. Factors to consider include market rents, the property's projected rents and occupancy rate, desired return, and the perceived risk of leasing up such a property, particularly if renovation has already begun—and stopped—at the community.

As a result, the discount can be considerable. “In [our] deal, we paid maybe 20 percent to 25 percent less than the prior buyer had paid and spent on renovations,” Orehek says.

But purchasers must also avoid being dazzled by the seemingly low prices of these assets. “Paying 50 percent to 60 percent of the hyper-inflated value from 2005 doesn't mean you're getting a great value,” McCabe cautions.

DETERMINE THE RISK Of all the risks involved in these transactions, working with individual unit owners is often the most unpredictable—and potentially the most threatening.

“There is always that worry that unit owners will band together and sue you,” admits Waterton's Swerdlow. The firm just purchased two failed conversions in the Washington, D.C., suburbs. “When you step into the shoes of a converter, you're stepping into the liability as well.”

There are other worries as well. Hold-outs can destroy a project's schedule and pro forma. Fractured ownership also can lead to difficult and inefficient operations at the property. “We would never take over a project that was more than 50 percent sold, because then you don't have control of the homeowners' association,” Woodward says.

Marc DeBaptiste, a broker with Apartment Realty Advisors in South Florida, agrees. “You need to really understand the underlying condominium documents,” he says. “Once a property goes beyond a certain number of units sold—a super majority level, which is usually one-third—control of the association resides with the association.”

Ironically, the converter may be able to help. In one Waterton deal, “the converter was still in control of the asset, so they had the best position to buy the units back,” Swerdlow says. “We were able to mitigate a lot of the risks of a broken condo deal because the converter still had control and a good relationship with the individual unit owners.”

Finally, if the seller hasn't already bought out individual unit owners, you must figure that into the equation. They usually insist on selling at their purchase price, even if their property values have fallen significantly. “You just put it into your underwriting, assume some sort of premium, and go negotiate,” Woodward says.

To avoid expensive holdouts, try the straight-talk express. In one takeover, Waterton offered to pay individual unit owners 100 cents on the dollar for their condos as long as everyone agreed to the arrangement and promised to rent their condo-turned-apartments back for above-market rents, which would essentially cover the cost of buying them out.

It worked. “We had underwrote the asset with [an 18-month buyout period],” Swerdlow says, “but within three-and-a-half months, we were able to buy back 100 percent of the units at cost.”

Alison Rice is a freelance writer in Arlington, Va.