Partners, Volume 15, Number 1, 2005

Condo Conversions: Gauging the Impact on Affordable Housing

Condominium conversions have emerged as a hot, new trend in high-priced, high-growth real estate markets.

Fueled by strong residential demand and relatively low interest rates, developers and investors across the country are in a frenzied search for rental properties they can purchase and transform into profitable condominiums. The downside is that speculative condo purchases are on the rise and renters are being displaced.

Deals attract both developers and property owners
For developers, condo conversions represent a low-cost, quick alternative to new construction. The developer makes an offer to the property owner based on an estimate of the market price of the finished units, minus the cost of necessary upgrades. Buildings with solid rental revenue can offer ongoing income as unit remodeling is phased in. Because conversion may take only half the time of new construction, units are on the market more quickly, before demand or absorption rates drop.

The prospect of conversion to condominiums is enticing to many multifamily property owners as well. They are able to sell when the market will support the highest price possible. For some, the sale is much more attractive than the continued flow of rental income.

Increasing land and construction costs drive conversions
In markets like Miami, where speculative land purchases have peaked, existing multifamily properties can be less expensive than vacant land. When the rising cost of construction is added to the equation—up 10 to 15 percent in the past two years—the argument for conversions becomes quite convincing.

Peter McDougal, with Citigroup’s Center for Community Development Enterprise, says conversions have caught on with developers who apply for Low Income Housing Tax Credits as well. Although he has not yet financed a low-income conversion project, he says they make sense for developers on tight budgets faced with increasing land and construction costs.

Conversions most common near pricier homes
Conversions are most common in neighborhoods where they offer an affordable alternative to higher-priced homes and luxury condos. Investors mostly seek Class A properties—buildings with higher-end units and amenities in neighborhoods with strong demand.

However, as more developers converge on these profitable markets, even Class B and Class C buildings are being targeted. In neighborhoods targeted for revitalization, a Class B conversion can enhance its marketability through the improved infrastructure and higher property values that accompany new construction projects.

Market indicators reveal a slow down in conversions
Some signs indicate that the conversion gold rush may be losing a bit of steam. According to Robert Von with Realvest Appraisal Services, developers that got in early on conversions made lots of money. But he says property owners are catching on now and setting higher selling prices, thus eating into the profits projected for the conversion. For the affordable housing developer, higher acquisition costs will increase funding needs and lessen conversion benefits.

New construction projects have become more competitive with conversions by improving amenities and adding upgrades, thereby forcing converters to invest more in each unit to maintain the project’s marketability.

Ultimately, better (and costlier) amenities are driving median home prices higher thus pushing the prices of condominiums beyond the reach of median income families.

Impact of conversions on housing affordability
The National Association of Realtors’ study on housing affordability for 2004 showed the lowest affordability rate in four years. Despite low mortgage rates, the average household needed 132.6 percent of its income to purchase a home. In high-priced markets the pressure on moderate-income families is even stronger.

While statistics show that 10 to 20 percent of existing renters will purchase converted units in their building, the remaining 80 percent will be displaced.

Tracy Peters, managing director with the Red Capital Group in Ohio, says that conversions do not seem to be directly affecting the affordable housing market yet, but he believes the impact will become more apparent as market dynamics change. Dan Hogan, also with Red Capital, says creating incentives and increasing subsidies that support the development of affordable housing stock, along with assisting low-income families to become homebuyers, can protect communities where housing prices continue to rise.

Affordable housing advocates propose strategies
Affordable housing advocates, already aware of the potential impact of conversions on housing stock, recommend strategies that would allow more rental tenants to become condo buyers. This approach would both increase homeownership and forestall the inconvenience and difficulties of displacement.

With regard to those not eligible for ownership, advocates underline the importance of protecting low-income families, seniors, and the disabled by ensuring that adequate housing alternatives are readily available.

Speculative investors drive housing prices higher
The high proportion of speculative investment now driving property sales in competitive markets is a cause for concern. Many are buying condominiums and homes with the intention of selling them immediately for a profit in energized markets. New construction contracts are often sold two or more times before the units are actually completed.

“Flipping” is highly speculative and leaves purchasers exposed to shifts in market demand. When these investment purchases stop trading hands, industry experts predict many of the units will end up as rental properties. The resulting flood of unplanned rental vacancies could affect municipal planning and market pricing in a community.

Balancing benefits and costs of conversion activity
Conversion activity is predicted to remain strong in 2005. The benefits of conversions, which will certainly attract more developers, can be used to persuade developers to consider more challenging properties in moderate-income communities. They also provide nonprofit developers with an alternative to high land and construction costs.

Questions remain about how well municipalities will manage the impact of rental property conversions. Industry experts seem to agree that helping more renters realize homeownership and protecting affordable rental stock must be considered as seriously as increasing the tax base and attracting private investment.

Careful consideration of both opportunities and concerns can help conversion projects become part of the solution to the affordability gap in competitive housing markets.

This article was written by Ana Cruz-Taura, regional community development director in the Atlanta Fed’s Miami Branch.


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