Cuckoo for Condos!
Get in early! Get out fast! Sounds like the housing boom's version of dotcom stocks--and everyone knows how that party ended. Right? Right?
(MONEY Magazine) – Late May, early evening. Chris Cowen cools his heels in a Minneapolis restaurant, waiting for a table. His buddy Keith is 15 minutes late. Cell phone rings. It's Keith. Got a proposition for you, Chris: a one-bedroom condo under construction in Scottsdale, Ariz.--1,800 miles away--for $135,000. The catch: Only 60 seconds to decide. Sight unseen. Over the cell. "It was a no-brainer," recalls Cowen, 32, who owns 28 condos (solo or with partners) in various stages of completion. Two months after his impulse buy, Cowen figures the unit's ultrafast appreciation has covered his $3,500 cash down payment 10 times over. "I've already made $35,000," he crows.
Know this guy? If you don't, you probably will soon, because condos are to the real estate boom what Internet stocks were to the 1990s bull market. And like the Internet day-traders before them, the new condo flippers, with their talk of instant riches and easy money, are about to become the life of every cocktail party. And why not? Condo prices have soared 80% in the past five years, making the same period's 40% rise for single-family homes look almost pokey. Developers are constructing new condo units at nearly twice the pace they were in 1999, and investors are literally lining up to buy one, two, three or more. In Miami, as much as 75% of some condo towers are investor-owned. No cash? No problem. Banks, with their loosened lending standards, no-money-down loans and teaser mortgage rates, are making it easier than ever to be a mogul-in-training.
Chris Cowen is betting his retirement that the wonder years won't stop soon. He cashed out his 401(k) to put $246,000 into a highly leveraged condo portfolio that he thinks could sell for $6.2 million. Estimated equity so far: $868,000. Cowen is so bullish, he quit his corporate job at Siemens to develop his empire full time. "Even if you make six figures, you still work for someone else, paying 40% taxes and putting in 60 hours a week. What do you get for that?" he scoffs.
Mix it all together--rising prices, record levels of construction, fast-and-loose mortgages and swelling ranks of new investors--and you get a market more volatile than Tom Cruise. "To some degree, what's driving condo prices is sheer greed," says economist Gleb Nachayev of Torto Wheaton Research, which forecasts a relatively mild drop of as much as 3% for U.S. housing prices overall in the next year. "Condo prices have increased faster than single-family homes--and they will fall faster." As they did little more than a decade ago. Overbuilt and overconcentrated in city centers, the condo market collapsed in the early '90s, smashing overstretched owners in the process.
No one knows when history will repeat itself. But c'mon: The easy money has been made. The right time to invest is not after a record five-year run-up in prices. It's not when the supply of new product is set to nearly double. If you're really drawn to the market, you need a deeper understanding of what's driving prices up--and what can drive them down. Above all, don't confuse what's worked in the recent past with what will work over the long haul.
The Case for Boom
Condos still have plenty going for them--namely, 76 million baby boomers. You know the demographic drill by now: As they become empty-nesters and retirees, they'll sell their rambling homes in the burbs and move into yardwork-free condos (or at least purchase them as second homes). They're expected to continue flooding into aging-friendly locales like Arizona, Florida and Nevada, but they'll also be flocking to traditional city centers as downtowns become safer.
Don't forget the children of boomers, adds veteran condo investor and National Association of Realtors chief economist David Lareah. They'll need affordable places to get started, and many already see entry-level-priced condos and townhouses as a great way to build equity so that they can trade up. "It's hard to concoct a scenario where condo prices collapse in most markets," Lareah argues.
A good condo pick that's soundly financed can be about as hassle-free as real estate investing gets. Gary Eldred, author of Make Money with Condominiums, notes that association fees typically cover the standard repairs you'd have to oversee on a traditional house. "Condos," Eldred says, "are perfect for people who want a passive investment."
The Case for Doom
Even the best investments can get overvalued, however. Condo fans cheer the 15% average annual spike in prices these past four years, but fail to remember that number was about 2% in the '90s. Last year, for the first time, the median condo cost more than the median home--$9,500 more. Prices in some parts of the country look even more ridiculous when you compare them to the low rents that condos currently generate. In Minneapolis, for instance, the average downtown condo sells for just over $256,000, up 77% from mid-2000. But area apartments rent for a measly $915 average a month, down from $918 four years ago, according to Torto Wheaton Research. Even with a 20% down payment, a 30-year fixed-rate mortgage would cost $1,150 a month. This condo investor is $235 a month in the hole--even before paying association fees and taxes.
Growing fears of overbuilding are also cause for pause. With so many condos being built today, one has to wonder: Who's gonna rent them? Apartment vacancy rates have been rising. "My guess is construction is growing faster than demand in some markets," says Raphael Bostic of the University of Southern California's Lusk Center for Real Estate.
Perhaps most worrisome: The growth in condo-investing mythology. Here are three whoppers that need reality checks.
MYTH: Get in early and you'll be guaranteed a profit. Remember the lust for Internet IPOs? Ordinary investors bid up the stocks of hot little companies that hadn't even registered their first sale yet. Today's version is a preconstruction condo, where investors jockey to get into a project not yet built, certain the units will jump in value when completed.
But getting in early doesn't guarantee riches anymore. That's because developers have caught on to the demand and are now selling preconstruction properties at market prices, says Kimberly Kirschner, a Miami agent who specializes in new condos. Also, developers are requiring buyers to reserve their units earlier--as much as three years in advance. That's an awfully long time to assume a hot condo market will continue to boil.
So when it comes to preconstruction, skip that line. Instead, buy an existing unit. While preconstruction purchasers can wait up to three years with very little to show for it at the end, you can collect 36 months of rent to put toward paying off your mortgage and building equity. If prices continue to appreciate, great. But that's a cherry, not the whole sundae.
MYTH: Creative mortgages lower your payments and guarantee positive cash flow. New twists on adjustable-rate mortgages and interest-only loans can make condo investing seem like a lark. But some of these things could slaughter you if prices fall when you have to sell. The riskiest is called an option ARM, which features several payment choices each month, including a standard interest-and-principal payment, an interest-only payment and an interest-only minimum payment that's so low it doesn't cover the month's interest charge. The unpaid interest is rolled into the principal, meaning that--yes--you're charged interest on your unpaid interest.
Fort Lauderdale resident Bruce Palmer, 50, recently signed up for an option ARM that cuts his monthly payment on a $417,000 investment condo by $500. As a result, his two-bedroom in Fort Lauderdale should generate a profit of $350 a month. Palmer, a commercial pilot, says he sees the risk. Paying the interest-only bare minimum means his mortgage is growing, not shrinking. If local prices were to drop, his loan balance could exceed the condo's value. But Palmer is confident, building a war chest to snap up properties. "If I could leverage more," he says wistfully, "I would."
Author Gary Eldred worries about such sunny thinking. Most condo investors should avoid option ARMs, he says, and either put down more money to lower the monthly payment or consider buying--gasp--a less expensive unit.
Whatever your choice, Eldred says your expected rent should cover at least 70% of your total monthly costs. Tax write-offs on condo losses can help close some of that gap, he notes. (Up to $25,000 in losses, excluding mortgage-principal payments, can be charged against total income of less than $150,000.) And he argues that rising rents should over time cover the rest. (With condo prices soaring, Eldred predicts that condo rents will follow as would-be buyers get priced out and rent.) More cautious investors would want their rent to cover 100% of carrying costs or more.
MYTH: You should buy in your backyard, where you know the landscape. Too few condo investors recognize one of the best reasons to buy: It can help diversify your real estate holdings so that your portfolio doesn't rise and fall solely on hometown economics and events. (Even if property is a relative bargain in your area, buying wisely elsewhere can make more sense than buying too much property locally.)
New York City attorney Richard Savitt, 40, never thought about all this 18 months ago, when he abandoned hopes of investing in Big Apple condos and bought in Philadelphia instead. "We just thought New York prices were crazy," he explains. But it sure looks wise now. Savitt and four partners bought four one-bedroom condos, each around $300,000. Similar units now list for as much as $450,000.
To help you determine where to invest, take the average price at which units are selling in a city and divide it by the annual rent the average apartment there generates. That will produce a price-to-rent ratio. The lower the better. (See above for ratios in 20 markets.) Houston, Atlanta and Philadelphia, for instance, still look relatively good, while New York City and San Francisco do not.
In Minneapolis, Cowen and four other investors who've become pals gather at a bar for their fortnightly meeting. Jahn Dyvik, a 42-year-old engineer who sold his Porsche Boxster to help fund more condo buys, says lower prices in neighboring St. Paul make that city the better bet. The rest of the group is sticking with Minneapolis, where they think prices will rise faster. Two others have also sold their cars. All have home-equity loans.
Where are prices headed? Cowen's not sure. The long-term case for condos looks good, but all the building out there makes him nervous. "People have unrealistic profit expectations." Not him, of course: "No one has a crystal ball. But the condos I've bought are going to go up."
Like a P/E for a stock, a price-to-rent ratio can help point you to relative real estate bargains. Here are MONEY's ratios for 20 metro areas.
[This article contains a table. Please see hardcopy of magazine or PDF
NOTE: Metro-area condo prices and rents reflect transactions for the first half of 2005, except New York and Boston, for which only first-quarter data were available. SOURCES: DataQuick, Northeast Apartment Advisors, Torto Wheaton Research, Zip Realty.