‘Broken condos’ new investment niche

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Multifamily properties moving from owner-occupied to rentals

It’s a new, if somewhat stigmatized, real estate investment category: “broken condos.”

Three or four years ago, during the height of the residential real estate boom, some buyers, drawn by the promise of a carefree lifestyle, gravitated to condominiums. Developers around the country stood ready to answer demand, building thousands of new high-rise and resort-style developments in Florida, Las Vegas and Denver.

Even RDS Corp. headed by developer Ray O’Sullivan, promoted construction of Cooper Tower, a downtown high-rise that would include hotel suites on several floors with the upper stories devoted to luxury condominiums.

In retrospect, few could have imagined that so many of these promising double-digit-return communities would end up abandoned or on the foreclosure rolls.

As a result, today, many investors, and lenders, whose portfolios carry their defaulted condominium projects, have been forced turned to Plan B: generate cash flow by turning unsold inventory into for-rent apartments.

The story got its start less than five years ago.

Following the easy-money heydays of 2005 and 2006, buyers now concerned about Wall Street’s financial services sector pretty much stopped buying condos.

As early as June 2007 in “Broken Condominiums Waiting to Be Reborn,” Apartment Finance Today highlighted investor Norman Radow’s hunt for “bloc(k)s of unsold condominiums at projects in serious trouble.”

Pointing to growing investor interest in such foreclosed or distressed condominium communities, Jack McCabe of Florida-based McCabe Research and Consulting predicted there would be “a lot of units sold on the courthouse steps.”

Fast forward to September 2009: It turns out McCabe’s prediction was pretty accurate. In fact, Entrepreneur.com, based on a San Fernando Valley Business Journal story, said that broken condo sales in the Los Angeles area had become a $4.5 billion foreclosure or default asset class.

And developers interested in building new condominium projects now have an additional hurdle: this summer Fannie Mae and Freddie Mac decided not to finance new development purchases unless at least 70 percent of all units are pre-sold.

So how is the investment market responding to the heavy financial damper applied by lenders and government agencies?

Seizing opportunity

Fortunately, it turns out, real estate can always lead to an entrepreneur’s Elysian Fields if deals are negotiated correctly. And it hasn’t taken long for investors to see potential in “broken condo” properties.

Take the Colorado-based MIMG XV Associates LLC, for example.

The multifamily investment group which owns the Aspen Townhomes at 4215 E. Pikes Peak Ave. and more than 4000 units nationwide bought the 89 unsold condominium units that are now leased as apartments in the 111-unit Esperanza Village complex.

The rental units were part of a bank-owned portfolio, never redeemed by the previous owners. The community contained 21 units which had sold for between $60,000 and $90,000.

“The prior owners — Esperanza Village Partners LLC — were a faith-based group I think,” said Colorado Equity and Investment broker Thayer Thomas, who represented the new buyer. “Originally they paid $6 million for it — and added another $1 million in improvements. Their goal was to create affordable housing for the area’s working poor, but the market dried up when subprime financing ended. The owners had also ‘high-graded’ the units beyond what they could recover in rent. It’s just sat there for the past few years.”

And, at a per unit price of $32,222, the new owners felt they could weather a short-term period of negative cash flow.

“My clients were interested because of this marketplace,” Thomas said, adding that the area’s relative stability, thanks to a large military population, and the property’s updated Class B-plus status made it a good investment.

Plans include offering new apartments at affordable rents with incentives such as a $99 move-in deposit and a month’s free rent.

The buyer also was able to find a partner willing to help finance the deal.

“That was key,” Thomas said. “They were motivated by the deeply discounted price, even though they knew at least 23 of the units will need major rehabilitation. Bottom line, they’ll make a lot of money on it.”

While Esperanza Village is one of the area’s most recent examples of a multifamily housing complex that has, like a leopard, changed its spots, it’s not the first to have earned “broken condo” status.

Some caveats

Rental units at the Cheyenne Creek complex at 115 W. Cheyenne Road, were bought as a package by Resort Living LLC for $8.5 million during 2005 from an owner who had tried to convert the community into condominiums.

With units priced from the mid-$100s, the project was not as successful as its owner had hoped. Today, 80 percent of the units are apartments and 20 percent are privately owned condominiums — mostly in a single building.

Multifamily investors only buy rental units, leaving condominium owners on their own when it comes to the resale market.

Prudential Real Estate broker Becky Gloriod was a listing broker for initial Cheyenne Creek condo sales during 2006 and 2007, prior to the financial industry meltdown. Today’s sellers in broken condo situations have some challenges, she said.

“Unless your buyer pays cash, it’s going to be tough,” she said. “Fannie Mae so far is not approving borrowers, even with 50 or 60 percent down. And the HOA’s (homeowner association’s) regulations require that at least 51 percent (of units) are owner-occupied.”

Likewise, Marsha Kromer of First Mortgage Co. said loan approvals for condominium buyers, in general, have become increasingly hard to get.

“Colorado Springs has never really been a condo city — we’re more interested in townhomes or single family,” she said. “I think you will see more situations like this where an owner is unable to sell condos and turns units back to rentals — and investors who see the opportunity will get very good deals.”

Cheyenne Creek is not currently for sale, but if it were, it too would be considered a “broken condo” property, Thomas said.

“There will be more broken condo and townhome developments here and elsewhere — including new construction,” he said. “The lenders will need a haircut. Depending on the type of lender involved, their reserve limits will force them to sell off properties — and it’s a good time for those who have the know-how and local market knowledge to take them over.”