Fractured Condo – Today’s Pariah
Just saying the three dreaded words, “fractured condo project” to a lender is one of the fastest ways to cut a conversation short. Before you know it, you’re hearing dial tone. I know first hand because I recently went through the process of financing a fractured condo totaling 150 units. Only 113 were owned by the seller; the remaining 37 condos were owned by 23 other individuals. After reviewing the numbers and asking a lot of questions I decided to invest in it too. But to do so I had to get over the stigma of this property type.
You see, fractured condos are the modern day “pariah” of commercial real estate. And I don’t completely blame lenders for their unwillingness to lend on this property type. Historically there are many instances where lenders have been forced to foreclose on unsuccessful condominium developments.
Fractured Condo Defined
But let me start at the beginning by defining a fractured condominium. It is a condo development where some of the units go unsold, typically a large majority. In 2008, fractured condos became prevalent as developers, who were unable to sell their condos, opted to rent the unsold units. Eventually the developer’s construction loan came due. They were unable to pay it off causing the bank to foreclose.
Condo Conversion Project Defined
In the Portland market, we also had the condo conversion craze. These were properties that were originally built as apartments and then were converted to condominiums by starry-eyed developers thinking they could make a quick buck. And they did. Those early in the process found good candidates for conversion. They were located in good urban areas where condominiums make sense. But as the good properties in good locations were converted, developers over time had to find apartments in less affluent neighborhoods farther away from the downtown core. It was inevitable that some of these condo conversion projects would fail. And they did.
Opportunity for Good Return on Investment
Fast forward to today. These fractured condo properties, whether built originally as condos or condo conversions, are one of the last property types where an investor can make a good return on their investment. Where capitalization rates for other properties are in the “silly-stupid” range, fractured condos still represent an excellent buying opportunity. But they are without question in the “high risk, high reward” category. That said, there are several common-sense solutions for overcoming the issues associated with a fractured condo.
8 things you can do to mitigate risk
- Find a real estate sponsor who has experience with fractured condos. If you’ve never owned a fractured condominium project, DON’T DO THIS ON YOUR OWN. Find a sponsor with a good track record owning and converting a fractured condo project back into apartments. Let him be the managing member and you the passive investor riding on his coattails.
- Find a lender who will provide BOTH a bridge loan and a permanent loan. Fractured condos as a rule are in poor condition and typically need significant upgrades to get them to an acceptable condition. You don’t just want a short-term bridge loan of 2 or 3 years to renovate the property. You want the peace of mind of knowing that there is a permanent loan available once the renovation is complete.
- Carefully review the sponsor’s rehab budget for the property. Make sure there are sufficient funds available to do a thorough upgrade to the property. You don’t want to be found in the unenviable position of owning a fractured condo and not having the financial resources to make the necessary improvements.
- Make sure the sponsor has complete control over the Homeowner’s Association (HOA). The sponsor must not only have legal control through voting rights but the ability to manage and operate the property without interference from disgruntled condo owners. He must have the ability to approve a capital call from all condo owners for their fair share of exterior upgrades and common area improvements. He must also have the ability to increase HOA dues in order to have adequate replacement reserves when capital repairs are needed.
- Make sure the HOA documents can be amended to be in compliance with the lender’s loan documents. Specifically, the provisions in the HOA agreement regarding the use of insurance proceeds and condemnation procedures are consistent with the new loan documents. Also, the HOA documents need to allow the lender the right to cure any late HOA dues on behalf of the sponsor.
- I know it sounds obvious, but make sure you have clear title to the property. For the property I just invested in, garages, open parking spaces and storage lockers were the possession of specific condominiums. It took considerable effort by the title company to determine who owned what.
- Find an experienced property management company that understands the nuances of managing a fractured condominium development. Don’t employ the services of a property management company that has never managed a fractured condo.
- Review the exit strategy the sponsor is proposing. Are the assumptions about rental growth realistic? Does he use an above average interest rate on the permanent loan just in case interest rates are higher than they would be in today’s interest rate environment? Does the sponsor assume he will buy out all the condo owners in order to achieve his projected return on investment? Or is the ROI achieved regardless of whether all the condo owners eventually sell their units to your investor group?
Following these eight suggestions will go a long way in reducing the risk of buying a fractured condo project. Did I personally make a good investment? I hope so, but the verdict is still out. Ask me in three years.
Have you had experience with fractured condos? If so, have they worked out well for you?
Source: Fractured Condos: Broken Doesn’t Mean Busted, by Gabe Gonzalez, Metropolitan Capital Advisors, August 13, 2013.