Q&A: D.C. Multi-Family Market Suffers Glut of Fractured Condos, Declining Values
- Jan 02, 2008
Like much of the country, Washington, D.C.’s over-supplied condominium market is under a great deal of strain. Particularly, the number of investors saddled with fractured condo deals has ramped up. CPN associate editor Amanda Marsh spoke with Matthew Texler (pictured), vice president of Bethesda, Md.-based Meridian Capital Group, on why this has been happening and who has been hardest hit.CPN: The D.C. market has seen an increase in fractured condos, with owners struggling to find financing. When did this begin to happen, and what is fueling the trend? Texler: The current D.C. condo market is stagnant. It has followed the rest of the nation’s residential market generally, and condo market specifically. When we were at the height of the market back in 2005, the majority of the rationale for a “D.C. perpetual growth” model was based on anticipated population growth. Demand for units was estimated to exceed supply for years to come, based on projected population influx.But first we had rising interest rates in 2006 curtail the record increase in prices, which scared off all of the condo flipper/third-party investors. And then the credit crunch of 2007 restricted access to acquisition capital for the first-time buyer, spelling the end of any chance that D.C. would miss the residential meltdown. Even with interest rates coming back down in 2007, the credit crunch has been so dramatic that demand has fallen off the charts for condos. Remember, there were three main demand generators for these units: investors looking to turn quick profits, and first-time yuppie owners looking to buy a place in the new hot Downtown. But the third demand segment was the Baby Boomers who were selling suburban homes and moving back into the city after years of raising families in the suburbs. This spigot of demand was turned off when these people couldn’t sell their houses in a declining suburban residential market. (A recent) USA Today cover story shows how the downturn in the residential market is having an effect on population movement in the country. All of these factors contributed to a 7 percent decline in home process in the D.C. area. And the last paragraph of the article highlights that the “perpetual D.C. growth” fairy tale is over. And so all of this has created a situation where so many condo projects in D.C. now sit fractured with partially sold units, and owners of unsold units struggling to find financing. The most common proposed solution is, of course, converting back to a rental. But that presents economic as well as legal hurdles. Economically, the construction costs of most of these projects were not justified from an IRR perspective based on a rental income scenario. They only worked with a condo exit strategy. And legally, the condo regime presents risks to lenders in the event they need to foreclose later on. It’s amazing that most people know the proverb that “if we forget history, we are destined to repeat it.” Yet, it’s eternally true, since we can’t help ourselves in the boom times from continually falling into the same sense of belief that “this” time we won’t repeat the mistakes of the past.CPN: Are there specific markets this has been happening in within the D.C. metropolitan region? == Texler: The increase in fractured condo deals, I believe, will happen in every market and sub-market where there was an increase in condo deals. The downturn in the residential market has been so pervasive that this decline has to be happening everywhere. As with most booms, they work like a pyramid scheme—the people that started developing condos in 2002-2003 made out like bandits; 2004, if they came on-line in 2005, even better. But to start in 2005, coming on-line in 2006-2007—the story was not a good one.CPN: Has there been any interest in financing these fractured properties? Texler: We haven’t actually seen a demand to finance these properties. The legal and economic hurdles are pretty strong. Prior to the boom, condo deals were traditionally financed with a downside analysis that the maximum construction loan was sized based on a 100 percent loan-to-value, where the value was calculated as if the property were a multi-family rental. This provided assurances that if the condo didn’t work out, the property could be sold as a rental, with little or no financial loss. During the boom, that LTV constraint continually increased to the high 100s, say 170-180 percent rental LTV. Simple math says that even if these properties can be sold, the construction lender is going to take a large loss if they foreclose and sell, adding legal costs for the foreclosure, on top of closing costs and sales price related to loan balance. And because many of these loans were done non-recourse—failure to sell units because demand dried up not being a recourse exception to the loan—it’s the lenders, not the borrowers, (who) will take the beating. The lucky lenders that find new buyers will require those new owners to come in with significantly more equity to insure limited losses going forward. And that equity requirement considerably reduces the available pool of potential buyers.CPN: Overall, who has been the hardest hit? Texler: In the end, the prevalence of non-recourse financing resulted in lenders and, more significantly, owners of units in fractured condo properties holding the bill, while many developers walked away unscathed. The owners of the units get punished by declining unit values (due to) the glut of supply and the current illiquid unit sales market. There are plenty of developers who took a hit and lost their initial equity by not being able to sell the projects in full; the economics of condo deals for many projects required the initial sales of units first to go to pay down the construction loan, with sponsors only getting equity returned and after that deal profit as unit sales surpassed break-even. This meant that the profit in the total project for the developer was only achieved with the last sales. More savvy borrowers were able to negotiate partial return of equity on a percentage basis with each unit sale, but not all owners were able to negotiate these provisions. The lucky borrowers in this market are the ones that at least sold enough units to pay off the loan, and return their initial equity. Zero percent IRR is better than a negative IRR.