Distressed Debt & Asset Update: From Condo to Multi-Family Rental

Financing remains a major hurdle for the condominium real estate market, so many developers have shifted some use to rental. By Steven Bandolik and Brian McMearty.

The economic downturn has rendered hundreds of condominium projects dormant, stalled or simply left for dead. Financing remains a major hurdle, and the condominium real estate market has been slow to recover. Lenders have been cautious and are requiring loans to be underwritten with a higher percentage of equity. In this environment, many developers and owners have become creative about how to change these condominium projects to create immediate revenue, with some shifting use from sale to rental. It appears market demands may be making these strategies successful.

Recent figures released by the FDIC suggest that the lenders’ conservative approach may be justified. In the second quarter of 2011, $172.5 billion in real estate loans, including residential mortgages, were in non-accrual status at all FDIC-insured institutions. Although this figure is down from a high of $222 billion in the first quarter of 2010, it is still far higher than the pre-recession days, when the quarterly average for the five-year period of 2003 through 2007 was $24 billion, according to FDIC figures.

Amid this doom and gloom, there are stalled projects that have temporarily changed their use to become revenue sources for owners. If a project has not started construction, some owners have changed the use to parking lots or retail, which generates cash flow and helps the owner to cover the carrying costs of the property while the lender waits for a future market rebound.

However, there are also recent examples of projects that have completely changed their use to meet a rising market demand. Many projects that were originally planned as condominiums have changed their use to rental apartments as the demand for rentals rises, resulting in lower vacancy rates and higher rents. The apartment sector is experiencing favorable demand-supply dynamics, with delivery of new supply at record lows. In the first quarter of 2011, net absorption was 23,203 units, while vacancy levels declined to 5.9 percent and effective rents increased by 2.5 percent, according to CBRE Econometric Advisors. Vacancy rates for the apartment rental market are expected to drop further on a national basis, to 4.7 percent in 2012 and 4.4 percent in 2013, according to the National Association of Realtors. Correspondingly, the growth in rent is expected to be at 3.2 percent in 2012 and 3.5 percent in 2013.

Condominium projects have recently morphed into multi-family rental units in Chicago, Oakland, Boston and other major markets. These three cities are all expected to turn in vacancy rates below the national average in the third quarter, as are Minneapolis, New York City, San Francisco and Pittsburgh. The Waterview Tower in Chicago was originally planned as a 90-story tower with 233 condominiums and a 200-room Shangri-La hotel. Work on the project stopped in 2008, and a 25-story concrete shell has been sitting dormant ever since. The Related Cos. recently purchased a controlling interest in the project and plans to build a 65-story, 500-unit luxury rental apartment building.

The former CityWalk project in Oakland, Calif., was originally designed as high-end condominiums. Work stopped in 2007, and the project was dormant for three years; it was recently resurrected as a 264-unit apartment building.

In Boston, the Herald reported that a number of developers at a Sept. 21, 2011, NAIOP real estate meeting indicated that they were switching their projects from condos to apartments.  This resurgence in demand for multi-family rentals appears to be driven by multiple factors, including:

  • Young adults who had not rented on their own between 2008 and 2010 entering the rental market in stronger numbers;
  • Reduced home values that have made prospective buyers very cautious;
  • Landlords regaining bargaining power, which may reasonably be expected to result in continued rent growth;
  • Tighter underwriting standards on residential mortgage loans continuing to favor renting and impact home-buying decisions; and
  • A large number of foreclosures that have forced previous homeowners to become renters instead.

As apartment rentals trend toward lower vacancies and higher rents, it appears that more stalled projects, especially condominiums, may change their use to rentals to meet the increased demand. This repurposing may not be consistent with the owner and developer’s original “vision” for the project; however, it is consistent with market trends, which will likely have an influence on lenders when evaluating options for the scarce capital that is necessary to complete these projects.

The market, of course, may eventually shift again, which begs the question, “Will future apartment projects morph back to condominiums when the market fully recovers and the demand for high-end condominiums increases?” The answer is, “We’ll just have to wait and see!”

Steven Bandolik is a director with Deloitte Financial Advisory Services L.L.P. and Brian Mc- Mearty is a senior manager with Deloitte Financial Advisory Services. This article contains general information only and is based on the experiences and research of the authors. Deloitte Financial Advisory Services L.L.P. is not, by means of this article, rendering professional advice or services.