Condo Conversions Return To Cities And For Investors

A decade ago, developers nationwide were busy snatching up apartment buildings and converting the units to condominiums to cash in on rapidly rising home prices supported by low interest rates and lax mortgage underwriting standards.

The strategy still stands as a testament to the fervent homeownership boom, which ended abruptly — and messily — amid the financial crisis, the bursting of the housing price bubble and the collapse of the condo mortgage industry. The fallout largely led to foreclosures and bankruptcies, as developers were unable to unload the units.

But now, with demand for residential ownership ratcheting up in major markets where the emphasis for years has been on apartment development, condo conversions are making a comeback.

Activity is emerging on the East Coast, where developers such as Magnum Real Estate Group, Related Cos. and others are targeting buildings for conversion in New York, Boston and Washington, D.C.

What's more, executives with apartment landlords Essex Property Trust (ESS), AvalonBay Communities (AVB) and UDR (UDR), which are real estate investment trusts (REITs), suggested during their respective second-quarter earnings calls this summer that West Coast markets such as San Francisco were on the cusp of starting condo conversion activity.

Owners Weigh Options

Condo conversions provide apartment owners with a potential exit strategy at the top of the market, either by converting the buildings themselves or by selling to a condo developer for a premium.

Arlington, Va.-based AvalonBay Communities, for example, is developing a 503-unit luxury apartment tower in downtown Boston, but has indicated that it could opt to turn the residences into condos, according to documents filed with the city.

All told, converters typically expect a return of at least 20% on their investment, which includes the acquisition of the building as well as improvements and administrative costs associated with the project, suggests Alan Mark, president and founding partner of San Francisco-based residential marketing and sales firm Mark Co.

"I think we're very near the horizon of seeing condo conversions," said Philip Lamere, an associate director in the Boston office of Institutional Property Advisors, the multifamily investment unit of property brokerage Marcus & Millichap. "Anybody looking for a condo in the city is having a hard time doing it because supply is at a historically low level — two to three months of inventory.

Meanwhile, the number of condo conversions is accelerating in New York, but to date developers have displayed more discipline than they did during the run-up to the financial crisis, says Shimon Shkury, founder and president of Ariel Property Advisors, a commercial real estate brokerage based in Manhattan.

"We're seeing condo conversions, but mainly in assets that are really conducive to it versus assets that make no sense," he said. "In the last cycle, pre-war walk-up buildings and other questionable candidates were looked upon as conversion plays more so than today.

Big Apple Is Conversion City

Among other recent transactions in New York City, locally based Magnum Real Estate this summer contracted to buy two apartment properties from Post Properties (PPS) for $270 million, with plans to convert the 337 units into luxury condos, a spokeswoman confirmed.

Magnum Real Estate also has partnered with Los Angeles-based CIM Group to convert the top 22 floors of a Verizon art deco office building at 140 West St. into condos. Sales of units in that Tribeca neighborhood building should begin this fall.

Among other notable projects in Manhattan, Related plans to convert Carnegie Park at 200 E. 94th St. into 339 condos, and Centurion Real Estate Partners is converting the 324-unit 22 River Terrace into condos, according to plans filed with the New York State Attorney General's office.

On a smaller scale, Itzhaki Acquisitions is converting a former office building at 391 Broadway into four units and has plans to turn a 27-unit apartment building at 225 E. 82nd St. into condos. The firm primarily focuses on conversions of buildings in Manhattan's Tribeca, Soho and Chelsea neighborhoods, says Erez Itzhaki, principal of the firm.

Not only is demand for housing outstripping supply, but also developers planning to convert office buildings into condos now are weighing the merits of keeping them as offices, as technology and creative companies have begun leasing up space, he adds. Subsequently, property prices have jumped.

"You could sell a condo in a converted building for $1,300 a square foot three years ago, but today it's $1,700 a sq. ft.," Itzhaki said. Similarly, he adds, he would likely pay $14 million for a building today that he paid $9 million for two years ago.

West Waits

The rush of conversion of activity hasn't made it to the West, but Mark suggests that condo conversions are long overdue.

Developers have added thousands of apartments in San Francisco, Los Angeles, San Diego and Denver but hardly any condominiums, he says.

In San Francisco, the average condo price of nearly $1,120 a square foot in August represented a year-over-year hike of 10%, according to the Mark Co. The firm also reported available condo supply at less than one month.

Plus, buyers are snapping up units in development: Of eight properties that began marketing 727 units this spring and summer, only 225 units remain for sale.

Nevertheless, most condo conversion developers focused on the West Coast are hesitant to pursue a project, given memories from the last craze's aftermath and complexities involved in the deals, Mark says.

In particular, condo converters may face lawsuits if a construction defect surfaces in a building for up to 10 years after its initial development, for example. The apartment developers may also be liable, which often makes them reluctant to sell to condo converters, Mark adds.

"The appetite for risk of taking over a 300-unit or 400-unit building and converting it to condos isn't quite there yet," he said. "But I think it's time — it's phenomenal where prices are now."