Condo convulsion

Demand for condominiums is faltering across the US as speculators exit the market. Can private equity real estate firms pick up the pieces? By Alison Granito

In John D. MacDonald's Condominium, the writer known for his hardboiled Florida thrillers paints a fictional but familiar picture of the seedy undercurrent running below the surface of a Sunshine State high-rise. In MacDonald's novel, the hastily built tower and its inhabitants have a rough go weathering the storm bearing down on them.

In Florida and other areas of the US today, a rough ride may be on the horizon for some developers, investors and owners of condominiums, a sector cooling more rapidly than the rest of the US housing market.

“What we're seeing, especially in South Florida, is the story of two markets.”

In the booming markets of the past couple of years, it was no challenge for developers and converters to sell condos as fast as they could announce a new project, from high-end waterfront palaces and luxe desert oases to basic or moderate homes aimed at first-time buyers and those looking to downsize.

But, as most seasoned investors will emphasize, real estate is a cyclical business. By most accounts, the cycle has already turned in the condo sector, and distress may be on the way in some markets. Numbers released in mid-August by the National Association of Realtors show that median condo prices in metropolitan areas across the country have essentially flattened, falling 0.3 percent in the second quarter compared with the same period last year.

In some markets—particularly those in South Florida, Southern California and Las Vegas—that posted consistent double-digit price gains over the past few years, price appreciation has slowed considerably. Developers across the country are turning to incentives as diverse as shares in luxury yachts in Miami to the hottest Apple laptops in suburban Washington DC to entice buyers, without cutting their prices on paper.

Southern California and South Florida, areas that saw redhot growth throughout the boom, can act as bellwethers for the national real estate market, according to Celia Chen, director of housing economics at Moody's website. While San Diego slowed remarkably fast, South Florida was right on its heels, along with Boston. Other areas are likely to follow.

“Where the markets were extremely frothy, now things are beginning to ratchet back,” she says. “Inventories have risen to a level that is just too high for the amount of underlying demand. The overwhelming trend is going to be toward weaker condo sales and weaker price appreciation.”

While tight housing markets and traditional supply constraints have to some degree insulated cities like New York and Washington DC, those markets are also likely to get softer over the coming quarters because they lack the strong demand driven by the growth of areas like South Florida, according to Chen.

Others say that although a softening housing market is apparent, they see potential for distress elsewhere. “Right now I'd be more concerned for retail than I would for multi-family or industrial,” says Russell Appel, president of New York-based real estate investment firm The Praedium Group. “There is more pressure on the consumer with rising gas prices than there is on business right now. Business profits continue to be high and business investment continues to be strong.”

Despite cycling out of the prolonged boom, it may turn out to be a tale of two markets, according to economists, investors and industry observers. Most expect cancelled projects to reduce supply and many pending conversions of rentals not to go forward. Those who got in early, executed quickly and understood the true demand in their markets may still come out ahead. Those who got into the game too late, couldn't get the shovel in the ground fast enough and didn't control their costs are likely to feel distress.

“What we're seeing, especially in South Florida, is the story of two markets,” says Jon Halpern, managing director of New York-based Marathon Real Estate, the property investment arm of Marathon Asset Management. “The top professional organizations knew how to control their costs, had been through difficult cycles before, bought their land at reasonable prices, went in there and executed and can still come out on tighter margins.”

Other inexperienced developers sold their projects out at prices 20 to 30 percent below where the market is today and are now being squeezed by rising construction costs.

“They aren't well capitalized and they can't get the projects financed,” says Halpern. “That's where you are going to see some distress because these developers are saddled with the liabilities of these purchase contracts.”

For now, most developers are still selling or trying to sell those projects that were past the point of no return, sources say. However, brokerage firm Marcus & Millichap projects that in some markets up to 40 percent of condos currently under development or in the process of being converted could end up as rentals. That could be good news for private equity real estate investors, who may be able to scoop up assets, particularly land, on projects that fail or do not move forward.

When David Berson, the chief economist for mortgage giant Fannie Mae, was discussing mortgage and housing projections recently, he cited not only large chunks of Florida, but specifically pointed to San Diego as regions at risk for significant price corrections.

The reason, according to Berson, was investors and speculators were rapidly moving out of the housing market and in some cases putting their properties up for sale, adding to already bloated inventories. And investors probably represented a larger share of the buying market in places like San Diego.

While median condo prices slowed in Miami, rising 3 percent in the second quarter compared with the same period last year, they have started to slip in San Diego—falling more than 3 percent, according to the National Association of Realtors. In Las Vegas, prices did not grow as quickly as they had before, but they still climbed 7 percent year-over-year in the second quarter.

But Las Vegas has already seen several high-profile projects with ties to famous investors unwind including Las Ramblas, a $3 billion development backed by movie star George Clooney; Aqua Blue, a $600 million project which counted basketball legend Michael Jordan as an investor; and Ivana, Las Vegas, which had ties to the ex-wife of mogul Donald Trump.

“We haven't seen the mass foreclosures yet [in South Florida], although it has happened in other cities like Atlanta and San Diego,” says Michael Cannon, managing director of Integra Realty Resources-South Florida. “The reason it hasn't happened here is that we are still enjoying good employment and people are still coming here. We're growing.”

Despite the high-profile, cancelled projects and increasing foreclosure rates in certain areas, some industry observers and investors seem to be taking a wait-and-see approach.

“I think sooner or later you are likely to see some distress,” says Gary Stevens, a partner in the real estate division of Connecticut-based secondary investor Landmark Partners. “The main question is, ‘When is that point?’”

Florida may arguably have been the center of the nation's housing boom, issuing more residential building permits last year than any other state, according to the National Home Builders Association. The bloated supply of condos projected in South Florida is no secret, but how that will present opportunities for distressed investors going forward is not well defined.

“I can't blanket the word distress because the distress is property specific,” says Integra Realty Resources' Cannon. “It is not as widespread as the media has stated. I don't see that massive crash. I'd call it a roll back.”

Observers say the glut on the market isn't going to be as bad as the projections show, because many projects will not go forward due to rising construction costs and rising interest rates that make financing projects more expensive. Of the 100,000 units projected for Miami-Dade County alone, Cannon estimates that only about one third of those will be completed.

“Many of those projects are just never going to get off the ground,” agrees Marathon Real Estate's Halpern.

Especially in South Florida, projects that were merely cookiecutter developments built specifically for investor purchasers, but didn't serve the actual underlying demand in the market, are in trouble, sources say, while savvier investors who sought out unique opportunities or stuck to their niche are still faring well.

“There is a lot of commodity product down there,” says Halpern. “And, I think that with some of that stuff, who knows where the bottom is.”

“What I wouldn't want to own right now in South Florida is an inland piece,” he adds. “If you own waterfront or something very unique or a great street corner, those properties are holding their value because there are very few of them around.” Halpern notes that the market “has to play out a bit more” for those properties to come anywhere near distress.

One of the areas observers are watching for distress are apartment buildings that either converted to condo or were headed that way.

“I think the biggest opportunities for the opportunistic players will be to look at the conversion deals,” says Appel.

Cannon says he expects to see more hybrid buildings, those that contain some condos for sale and some units that go back to being rentals. Appel takes a slightly different view.

“I think they'll be some units in some markets that may go that way over time but it's still a little early,” says Appel. “I don't think you're seeing that yet. People are still selling units or attempting to sell units.”

But most agree that while rising construction and financing costs are contributing to the distress of some projects, the price paid for what is underneath the project may count the most. Those that paid too much for their land are feeling the most pain.

“The scariest thing in South Florida right now is in land,” says Halpern. “Land is simply a proxy for profit margin. With demand softening, you have some projects that are starting to fail and they are going to need to sell the land to try and recoup some of their investment. At the same time, costs have inflated significantly squeezing margins. The rationale to pay the kind of prices that were being paid before for land just is not there any more.”

In Miami and some other cities, poor zoning codes that allowed high-rise residential towers in office districts are contributing to some distressed projects, according to Cannon. He expects to see some of those properties end up as traditional office buildings instead of residential or office condominiums.

“There is a demand for rental office space and developers are saying, ‘I can't pencil it out,’” he says. “It's not that they can't pencil it out, it's just that the profit margins look better on office space. It's very possible that some places where people paid condominium land prices, they are going to lose some money and someone will end up building offices on it.

“We're going through the beginning of a new cycle,” he adds. “There are going to be failures and there are going to be successes. It's going to take longer to sell and everyone is going to have to do more homework because of changing markets and rising costs.”