ZOM Development in Orlando is right at home under the Big Top. Since its start in 1977, ZOM has built approximately 15,000 apartments, along with office, residential, condominium, and retail spaces. Yet, ZOM has stopped building condos in the frenzied Miami market, the same city where it has constructed numerous apartments and The Hotel Victor.
Why not build in Miami at the moment? It's simple. ZOM President and CEO Steve Patterson doesn't trust the financial strength and commitment of the foreign investors in South Florida. "I've always been a little leery of Miami," Patterson says. "There's a lot of buyer activity that doesn't show up in local demographics and in job growth numbers because of people from other countries. You're relying on Third World economies."
Patterson isn't the only person alarmed by the number of investors–both foreign and domestic–in the condo market. Making this even worse is that many of these investors are just speculators looking to sell their unit for a quick buck. As any apartment executive can tell you, job growth and wage increases haven't climbed enough to explain the dramatic rise in condo prices in many parts of the country. (For more detail, please see "Topsy-Turvy" in Multifamily Executive, August 2005, page 49.) End users stretching their buying power with exotic mortgages and people moving to condo-saturated urban areas certainly figure in the boom, but it's the increasing presence of speculators that make developers like Patterson wary to spend exorbitant amounts of money on land to build.
In some areas of Florida, investors constitute 50 percent or more of the buying, according Raymond James & Associates, a St. Petersburg, Fla.-based investment firm. Even in a more stable market, such as Washington, investors constitute about 30 percent of condo buyers, says Delta Associates, an Alexandria, Va.-based research firm. Most everyone agrees that some of these investors will eventually leave the three-ring circus that the condo market has become, but no one really knows when. All the people in the multifamily crowd can do is keep a protective hand on their popcorn and watch carefully for the signs–an uptick in interest rates, a hot stock opportunity, or even a revitalized dollar–that will cause investors to pack up their sideshow and move onto the next investment attraction.
Packed House
Ask most people what caused the real estate boom of the past few years, and you're likely to get a three-word answer: low interest rates. And, they're right. With the cost of money at historically low levels, Americans have leveraged themselves to the hilt to purchase homes that were previously unattainable. But there are more sources of demand than that, specifically the large amount of capital chasing condos.
"A lot of this money came out of the stock market after the tech wreck," Patterson says. "They got out of the market and had money that they didn't know what to do with. Today there aren't a lot of viable alternatives for them in terms of investments." Fortunately, Patterson expects investors to be around for awhile. "Unless there's a new tech-type boom, I don't see the investors walking away," he says.
Those most likely to stick out a shift in interest rates or a new hot-investment sector are the long-term holders–people who want a steady stream of long-term, rental income before they cash out and enjoy their appreciation. "In some cases, during a downturn, your investor is a stronger buyer than the end user," says Richard Lamondin, president of Cornerstone Premier Communities, a condo developer in Coral Gables, Fla. "He has a longer-term horizon. If the market goes down in two or three years, he wasn't going to sell anyway."
But investors don't want to continue to operate rentals at a loss every month. And, this is what will happen to many who buy and leverage condos at current market prices and expect to make money at today's rent levels. "The investors aren't getting the rents they need to support their debt service," says Conrad Egan, president and CEO of the National Housing Conference.
In the long run, this could mean a number of condo units back up for-sale. "How much longer are they willing to do that [operate at a loss]?" Egan asks. "If the appreciation slows down, they're going to try to get out and it will be hard for them to get out."
In Miami, many of these investors are foreign. But these South Americans and Europeans aren't renting out their condos. They just want second homes when they visit the States and a spot for their money that's safe from the turmoil of their home markets. "We have a lot of off-shore investors looking for places to spread their risk and invest," says Kim Kirschner, CEO of Kirschner Realty Inter-national, a Hollywood, Fla.-based company that does third-party condo sales. "When the Argentine crisis happened, a lot of Argentines who had been using [their U.S. condos] as a second home suddenly became end users."
There's also a purely economic driver behind foreign investment in American condos. With the dollar so weak against the euro, many Europeans are putting their money in American real estate. In fact, Tom Bozzuto, CEO of The Bozzuto Group, an apartment and condo developer in Greenbelt, Md., is surprised that some foreign investors haven't set their sights beyond South Florida. "America is on sale right now," he says. "If I were in Italy or Germany and could come to America and buy properties, I would."
But other people share Patterson's concerns about the dependability of some of these foreign investors. "A lot of the demand for condos in Southern California and South Florida is [due to] the weak dollar," says Christopher A. Wimmer, a chartered financial analyst and assistant vice president for real estate finance at Moody's. "If you have a strengthening dollar and increase in interest rates, you may have foreign investors pulling out of these markets."
The Flip Routine
Soaring real estate appreciation rates have attracted a new group of people to the condo circus: real estate buyers with a day-trading mentality. Just ask Charles Kirschner, who as director of Kirschner Realty International, has a number of good stories about today's condo flippers.
There was the young real estate agent who wanted to tie up a property for his client, excitedly reciting how much money his buyer would make if he flipped the unit or rented it out. There was just a small problem: The agent's numbers were all wrong. And Kirschner told him so. "This agent was putting him [the buyer] into a unit where he would have lost his butt," Kirschner says. "A lot of these people are neophytes who watch too many infomercials or see friends make 30 percent return on their investment."
The deal-making doesn't stop there among the flippers. A contract may be sold three or four times before the unit even closes. There's even a Web site, called condoflip.com (its motto: "Bubbles Are for Bathtubs."), which lets buyers of preconstruction condos resell or assign those condos to new buyers. "There's a whole game in New York right now where people are going to contract with nothing down and flipping it," says Marvin Meltzer, vice president of New York City-based Meltzer/Mandl Architects. "Instead of the stock market, you're now playing the real estate market. Let's say the property is selling for a million dollars. You can probably flip it in two or three months and make at least 10 [percent] to 15 percent on your money with nothing down."
This practice has led to some astronomical condo appreciations that make a unit impossible to operate profitably as a rental and sales price figures that have seasoned developers scratching their heads. "In some deals, I thought that to make a decent return as an investor, I would have to sell it for X," says Roberto Roche, executive vice president of The Related Group, a condo developer in Coral Gables, Fla. "And I didn't see people paying that kind of money. Well, guess what? It has done three times more than what I thought it would ever get to. And I'm in the business!"
Not surprisingly, apartment owners and developers alike are concerned about these buyers. "Builders are worried about speculation–how much there is and what it may lead to," says Dave Seiders, chief economist for the National Association of Home Builders. "But it's really difficult to measure true speculation."
Anecdotally, though, there is plenty of evidence of flippers in the market. In Florida, Charles and Kim Kirschner can recount the story of one of their buyers who waited in line two nights to buy a condo. The man, who was interviewed in the local news, said he queued up for so long because at every other opening, he was beaten out by investors. "He didn't even know the price," Kim Kirschner says. "He just wanted a place to live."
If these flip-oriented buyers get in financial trouble, it could lead to serious problems for condo developers. "Units could come back on the market if there's a hint of a price problem, and it could put downward pressure on the new stock coming on the market," Seiders says.
Folding the Big Tent
The last thing developers want to do is compete against their initial buyers as they close out a building.
"We have clauses in all of the contracts that say you can't market, advertise, list for sale, put on the [multiple listing service], or in any way promote without express written consent of the developer, which can be unreasonably withheld," says Lamondin of Cornerstone Premier Communities. "In some, if I'm out and I've sold, they can flip if they want. In others, we may have a second building we want to sell."
In all Related sales, Roche won't sell more than two units to any one person. And with the second unit, the Related executive makes a practice of personally investigating a buyer's banking and credit history to ensure he or she can close the deal. "I don't want to have a guy in my Related portfolio that doesn't have the financial means to close the transaction," Roche says. "He may be walking away from 10 deals."
In South Florida, things have gotten so heated that people are forming limited liability corporations to purchase units. In many cases, real estate agents will come to an opening with a specific strategy to tie up the best units first. "The [real estate agents] will get buyers to pay commission and get powers of attorney and they'll write up [the contract] first," Kirschner CEO Kim Kirschner says. "We don't let someone come in with 20 powers of attorney and mobilize 20 of our contract writers. If we don't give the end users a chance to buy on the first list and get ahead of the investors who are cherry-picking the best units, the end users are priced out."
Another way to try to close the investor door is to ask for a down payment of 20 percent or more. "If the deposit is strong enough, I don't think you'll have a lot of investors walking away for a 20 percent deposit," Patterson says. "These are optimistic people, but they'll definitely walk away from a 5 percent deposit."
Others include provisions that prohibit the investor from flipping a condo contract for a premium to a new buyer before the original investor has even closed or that require an investor interested in selling a unit to give the first right of refusal to the project's developer.
But William Rich, vice president of Delta Associates, questions how much some developers really want to enforce these provisions after his own experience buying a condo in the Washington metro area. "The developer had language in the contract to discourage people from flipping too early," he says. "But I was finding newspaper ads in the Washington Post and other places for units for sale [in his building] when they're not supposed to do that. They do have the language in there, but sometimes the developers don't enforce their own rules."
Swallowing the Sword
In a sense, investors are a double-edged sword to developers and condo converters. Without investors driving up prices the past couple of years, the condo business wouldn't have been nearly as profitable. But what happens if new investing opportunities, higher interest rates, or a stronger dollar draw these buyers away?
Many think the condo market will survive just fine. "There will be times where there is a leveling off and a decline because prices ran up too quickly, and people can't afford those prices," Jeff Stack, managing director and principal of The Sares?Regis Group in Irvine, Calif. "But long-term, there will be strength in condo markets. There's a whole group of people, both younger and empty-nesters, wanting to move back to the city and be closer to things and not have to drive to get everywhere."
NAHB's Seiders expects a "flat" landing for condos, where demographics keep prices from collapsing. "The markets [with condo appreciation] are in parts of the country where people insist on being," he says. "We're putting demand pressure on these areas and there are significant supply constraints."
But in many of these markets, there are a number of units opening in 2006 and 2007. In the next two years, 2,500 condos will be brought on-line by Lane Co. alone, according to Bill Donges, CEO of the Atlanta-based multifamily firm. But when you have a waiting list of 8,000 people for 200 new condos, as Lane had in July, building condos sounds like a smart business strategy.
Others think the fallout will only occur in certain markets. Equity Residential, a REIT in Chicago, is focusing on starter condos instead of the high-priced waterfront product because company executives believe those higher-end condos are more prone to bust. "The market is much deeper at the price point where we're offering very competitive, moderately priced starter homes to a very strong demographic," says David Neithercut, president of Equity.
However, if investors flee and developers continue delivering new condos, the more fortunate metro markets could slow down to 2 percent or 3 percent real estate appreciation, or worse. Gleb Nechayev, vice president and senior economist with Torto Wheaton Research and Investment Strategy Services in Boston, predicts traditionally strong markets like Washington, D.C., and San Diego will actually depreciate in 2007. "We're in the eighth inning in regard to the housing market," Nechayev says. "Our forecasts of home prices indicate you will see a slowdown in many markets, and you may see declines in home prices over the next five or six years."
For developers who can recall the condo busts of the 1980s and 1990s, such a projection is no surprise. "We believe the condo market is a very sensitive one and is correlated to interest rates," says Jack Callison, senior vice president of national operations for Archstone-Smith, an apartment REIT in Englewood, Colo. "We've seen this movie before, and it typically ends pretty ugly."
Daredevil Act
Investors aren't the only ones driving the condo craze. In many major cities, aggressive mortgage bankers and brokers are enticing buyers to interest-only and adjustable-rate mortgages (ARMs). As the number of ARMs and interest-only loans grew to an astounding 63 percent of mortgage originations in the second half of 2004, according to the Mortgage Bankers Association, everyone from the national media to Alan Greenspan raised red flags.
After all, when Fannie Mae began offering interest-only loans, the housing finance giant didn't intend them for twenty-somethings trying to stretch into their first condo. "We had it targeted it at the financially sophisticated borrower," says Jef Kinney, vice president for business and product development at Fannie Mae in Washington, D.C. "This was [for] the person who saw the mortgage as one part in the overall financial management plan."
But many of the borrowers utilizing these loans could hardly be called financially sophisticated. "The mortgage bankers are rationalizing this by saying they're lending to people with a high FICO scores," says Phillip Kibel, a senior vice president with Moody's, referring to Fair Isaac Corp.'s commonly used credit scoring system. "But a student out of college who has never bought anything on a credit card and just got a new job will have a high FICO score."
These young buyers also want to live in urban areas, where condos predominate and so do these lower-payment, more financially unpredictable loans. "ARMs appear to be much more popular in high-cost, high-appreciation areas," Kinney says.
Some might say that makes sense. When home and condo prices are high, adjustable-rate and interest-only loans are more popular, because the monthly payment is lower. But others question the order of this particular cause and effect, charging that loans are what's behind much of the dramatic real estate appreciation rates in recent years. "There seems to be no question that the mortgage lending industry is contributing to the escalation in price with the introduction of mortgage products that we haven't seen 15 or 20 years that are designed specifically to address affordability and are inherently more risky," says Rick T. Murray, an equity research analyst for home building and REITs for Raymond James & Associates.
If interest rates jump at the same time as appreciation slows or even declines, countless condo buyers could be in trouble. "If people are stretching to afford a home at a certain payment and that payment has the risk of going up, and income and wage growth is not all that great, the payment will go up much more than the wage growth," says Kinney of Fannie Mae.
But he won't place bets on how many units will eventually be forced back on the market because of interest-only loans and ARMs. "People will be paying more, but I can't tell you how many people it will push over the edge to where they have to change their plan," Kinney says.
Lurking In the Shadows
Many condominiums are poised to reappear as rentals. When investment rating agency Moody's studies how the condo craze affects REITs and other apartment operators, it isn't interested in how much money these apartment firms made on the properties they sold to converters. Instead, Moody's wants to know how many of these converted units will eventually reemerge as rentals.
"If the music stops and all of this condo product gets started and there's no one at the end to buy it, the fear is the condo converters will have 2,000 to 5,000 units coming on-line that you didn't think [were] going to compete with rental product," says Christopher A. Wimmer, a chartered financial analyst and assistant vice president for real estate finance at Moody's. "When that happens, you end with someone who is desperately trying to fill their building and leasing them at any rate. If you're a REIT, you have to compete with that."
But many people think the shadow rental market already exists. With the high number of investors buying properties, many units pop up on the multiple listing service as rentals. "In markets that are overheating, the condos will end up as rentals," says Gleb Nechayev, vice president and senior economist with Torto Wheaton Research and Investment Strategy Services in Boston. "But there is a debate over how it can undermine the rental market."
Tom Bartelmo, president and CEO of J.I. Kislak, an apartment owner and operator in Miami Lakes, Fla., isn't worried about the shadow market because he thinks his rentals will be better managed. "If you bought a condo and want to rent it out, it's probably more difficult for you to put it in the paper, show it, and fix things that are broken than someone with an apartment office," he says.
Bartelmo wouldn't be surprised to see a cottage industry of small, local third party managers develop to fill this need. "I think there's a nice market for small managers," he says. "I doubt it will be a big market where someone will have thousands of units."