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April 12, 2010

Miami Condo Market–No Bottom In Sight

I live on Miami Beach. It is the epicenter of the condo boom and then crash. For four years now, every hint of a bottom has been greeted with applause. Everyone wants to call the bottom—or at least hope that prices cannot go lower. Everywhere you look, people want to declare victory. I thought condo prices were silly as they went up. I think calling a bottom is just stupid. We are nowhere close. These condos are nowhere near a bottom. People don’t want to admit it, but most condos should never have been built. There’s little or no value to many of them as condos. I know it’s heresy to say this—but it’s a fact. Let’s look at why condos have not bottomed and why they won’t bottom any time soon.

What is the difference between a condo and an apartment building? This seems like a silly question. An apartment building has an owner who is responsible for the building, collecting rent and earning a return on his investment. A condo is a multi-unit building where various expenses are pooled and re-allocated to the unit owners. The unit owners own their units and can sell their ownership to other people. That’s where the problems start.

Most condos are just poorly run. It all comes down to the old parable about democracy being the worst system of governance—except all the others. An apartment owner is RESPONSIBLE for doing things right. Most condo associations just don’t have the ability to do things right. Often the people running them aren’t qualified. The boards have real jobs that take up most of their time. It’s a recipe for disaster.

When you don’t pay your rent at an apartment building, the owner eventually takes legal action and gets you evicted. This process is much more cumbersome when you look at a condo building. The result is that many condo associations are effectively bankrupt. It’s a domino effect. If 10% of the units are not paying fees, everyone just pays 10% more. When you have 25% of the people not paying, the association cannot survive. You have assessments. No one wants to pay an assessment when his neighbor is not paying his fees. Assessments lead to fewer people paying fees. Eventually, the association just implodes.

What’s a condo building with a bankrupt condo association? It’s a bankruptcy. The individual condos themselves have no real value in the end. If half the units in your building aren’t paying fees, your fee is doubled. Can you afford it? Would you want to? What choice do you have? Eventually, your condo becomes a liability. This is what’s happening now in Miami.

People are stuck in buildings that are imploding. You have units in various stages of foreclosure. You have units that just refuse to pay fees because their neighbors are not. You have the remaining units hit with multiple assessments. Finally, you have banks that don’t want to realize they now own units and owe fees. How do you cut expenses at a condo where people refuse to pay? You can fire the pool-boy. Maybe you can fire the valet? You cannot skimp on basic maintenance and security.

You may think this is an isolated circumstance in Miami. It is not. Many buildings have less than half the units paying dues. It’s a disaster. Would you buy into a building where the condo association is in freefall? If you buy only one defaulted unit, your maintenance fees could skyrocket if people do not pay fees in the future. You would need to buy a majority of the units to be assured that you do not get stuck with someone else’s liabilities. You would then be an investor. However, an investor demands a return on his investment. Right now, prices are still too high to make the math work. Eventually, you need lower prices so that investors decide to buy up the units and make things right. Unfortunately, you need MUCH lower prices.

I recently went looking at some condos as investments. Let me tell you about a typical unit. New building, great location and a fire-sale by the developer. The unit was originally on the market for $450,000. By the time I saw it, the price was lowered to $185,000. That’s more than half off. It’s for sale at less than replacement value. I could probably rent it for $1,500 a month after brokerage costs. That’s the revenue—that’s it. Now let’s look at expenses. Maintenance is $900 a month. Property taxes and insurance will be about $400 a month and you have to figure that there is some regular wear and tear on the unit over time. Basically, you get $1,500 a month in revenue and about the same in costs. So, the unit earns you nothing. Here’s the real problem, unless you are a cash buyer, you still have interest expenses. If you get a mortgage at 6%, even if it’s interest only, you’re looking at $1,100 in interest expense. This condo will cost you $1,100 a month just to own. It’s not an income producing asset. It’s a loss producer. It’s a bad investment at these prices. Just because the price of something has dropped in half, that does not mean it’s cheap.

Below I compare this condo as both an investment and as a home to live in
As An Investment As A Home
Rent $1,500 $0
Maitenance $900 $900
Taxes & Insurance $400 $400
Wear & Tear $100 $100
Total Expense $1,500 $1,500
Interest Expense $1,100 $1,100
Total Monthly Cash Expense $1,100 $2,600

This is the problem. Condos are often not income producing assets. They’re wasting assets. In fact, as the condo building ages, the value should decline. For a brief moment in time, people forgot that fact. As long as prices were going up ten or twenty percent a year, no one cared that they were constantly paying to own an asset that they shouldn’t own. They would have been much better off renting. $1,500 a month in rent expense sure beats paying $2,600 a month to own something that is a wasting asset. The difference is $1,100 a month or $13,200 a year. You would need your condo to go up in value by over 7% a year to make up the difference. Does anyone actually think that will happen? For this reason, it makes no sense to own when you can rent—at least until prices drop a good deal more.

Unfortunately, most condo units will be negative cash flow for an owner. For the cash flow to increase, you would either need rental rates to increase, or for maintenance expenses to drop. Rental rates will slowly increase over time. There isn’t much you can do to fix that. However, you can cut expenses, but only if you control the condo association. You would want to buy up the units and convert the building to an apartment complex. Unfortunately, there is no real mechanism to do that. You need to buy up units from dozens of banks and possibly hundreds of owners who are underwater. It’s impossible. As soon as people feel that there’s any hope, asking prices go up.

In the end, most of these condos will be turned into apartment buildings, but it will take time. It will take lower prices. It will take money. It will take more pain by the owners who cannot or will not pay maintenance while others in the building refuse to pay. It will happen eventually, but at lower prices.

Remember, many of the current condo owners are ‘stuck.’ They’re underwater on their investments. Fees are eating them alive. In many cases, even if they wanted to sell and take the loss, they cannot get a bank to lend to a potential buyer if the condo association is in trouble. Think of that a second. If the condo association is in trouble, you literally cannot sell unless the buyer is a cash buyer. There aren’t too many of those. You are stuck!

The current glut of new developer inventory is slowly being worked off. That was the first shoe to drop. The next one will be the wave of condo associations going bankrupt. That will further scare potential buyers and lenders. Finally, you get capitulation. We aren’t there yet—not even close. There is no bottom in sight.

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