Fractured, not Broken: Finding Value in Fractured Condos

March 15, 2021

In recent quarters, a growing number of real estate investors have begun to pursue multifamily real estate investments, seeking yield in a resilient asset class. Among several emerging multifamily investing strategies, fractured condominium investments continue to garner interest from institutional real estate investors, as a growing number of middle-market real estate investors focus on acquiring fractured condominiums to realize their deep-value potentials.

What is a Fractured Condo?

A fractured condo refers to a condominium project in which only a portion of units were sold, while the remaining units operate as rentals due to a variety of reasons. A wave of fractured condo properties emerged following the condo boom in 2005-06 and the subsequent period of extended economic distress, when market values plummeted and demand for high-end condos dissipated. As the expansion halted and recession hit, condo sales drastically slowed while condo inventory continued to pile up. Developers then either voluntarily converted the unsold condos to rental units—rather than selling them at significantly reduced prices—or lost the units through foreclosures to the construction lenders, who then sold the units in bulk to multifamily buyers at a steep discount.

In markets where demand for rental housing exceeds that of for-sale housing, fractured condos have become excellent acquisition targets for value-driven multifamily investors due to remarkably discounted prices. Certain fractured condos possess the hallmarks of successful multifamily investments, considering their locations, amenities, sub-market dynamics, and overall property conditions. Upon successful reposition, fractured condo investments can help investors realize meaningful upside returns unrivaled by other traditional multifamily strategies, particularly during economic downturns.

The Challenge: Not Your Typical Multifamily

Like all deep-value opportunities, uncovering returns in fractured condo investments is often accompanied by obstacles. From properly identifying an ideal acquisition target to executing the conversion plan, these projects can involve numerous challenges and require experienced sponsors to do the “heavy lifting.” In what ways are fractured condos different from traditional multifamily investments? 

Financing  – When pursuing traditional multifamily investments, real estate investors are able to seek debt financing from a variety of conventional sources based on their experience, business plan, and project quality. The financing of fractured condos, due to the assets’ idiosyncratic nature, often faces additional challenges. Fractured condos have difficulty attracting stable, low-rate permanent financing from agency lenders like Fannie Mae or Freddie Mac and are overlooked by CMBS loans. However, regional banks and non-bank lenders with a penchant for high yield are often willing to provide bridge financing at a premium rate. 

Underwriting – A major difference between a fractured condo and a traditional apartment is the percentage of rental units. An apartment complex is comprised entirely of rental units whereas, in a fractured condo complex, the percentage of rental units can vary. Fractured condo assets trade at a discount to comparable multifamily assets, making apples-to-apples comparisons nearly impossible. As such, fractured condos trade a cap rate that has a premium over traditional multifamily, and precisely determining what the premium should be could become a challenge.

Homeowner’s Associations – Financing and underwriting aside, another major challenge for fractured condo investors is dealing with the homeowner’s association (HOA). The owner of the rental units and the homeowners may not always have the same priorities. When the business plan calls for renovations and lease-up, it is crucial to have the HOA onboard to pave the way for successful execution. The buyer, thus, is required to have a solid understanding of the legal documents governing the homeowners’ rights in the fractured condo, such as bylaws, Declaration of Covenants, Conditions and Restrictions, and other local laws and regulations. 

The Opportunity: Adding Value Through Scaling

A fractured condo investor needs to decide which direction to take when pursuing the repositioning of the assetconverting the units from rentals back to condos and profiting from the condo sales, or acquiring more units to increase the percentage of rental units in the condo complex and converting the fractured condo to apartments. In markets where demand for rental housing exceeds that of for-sale housing, the condo-to-apartments conversion is favored. 

In a condo-to-apartment conversion, investors seek to exploit the changing value dynamics between the rental units and for-sale condo units. As more condo units are converted to rental units, the value of each condo unit is expected to decrease while the value of multifamily units increases. The inverse relationship between the values of condos and rental units does not stay linear, but further accelerates once 50% of the units have been converted to rental units, giving the rental units owner-majority control over the condo complex. This dynamic allows the fractured condo investor to buy out remaining condo units at decreasing price, convert them to rental units, and achieve higher value on those units.  

Given the pricing dynamic, investors can look for fractured condo investments with different percentage ownership to align with their risk tolerance and return requirements. Acquiring fractured condo units whereby the majority of the units within the complex have already been converted to rental units is less risky given such investment implies control of the HOA and decreased uncertainty. Conversely, investing as a minority owner carries limited flexibility as far as navigating the business plan, but higher potential upside.

Pricing dynamic aside, consolidating rental assets within the fractured condo complex boosts operating efficiencies. A fractured condo complex may have multiple rental unit owners, each renting and managing the rental units on their own. In this case, each owner will fail to realize economies of scale in attracting tenants, providing maintenance requests, and performing other property management tasks. By acquiring all rental units and consolidating the property management needs, the rental owner can reduce the per-unit operating cost and improve the overall property management quality. 

Other Considerations

As cap rates in secondary and tertiary multifamily markets continue to trend downward, sourcing properties that offer consistent cash flow with ample room for value creation becomes increasingly challenging. Investing in fractured condos remains a niche investment strategy that can potentially deliver strong performance both from a current yield and total return perspective.

The investment should be compelling on a standalone basis. Acquiring more units and further expanding the rental units can create value as mentioned above; this is often a key part of the business plan that leads to value-add potential in a fractured condo investment. However, in addition to evaluating the acquisition of additional condo units, the investor must not ignore the fundamentals of multifamily investments—occupancy, collection rate, current rent in relation to the market rent, operating cost, overall asset condition, etc.—and ensure the investment is profitable on a standalone basis.

Remain flexible and adapt to the market when setting the exit strategy. With a fractured condo investment, there are different ways to profit and deliver return other than the condo-to-apartment conversion mentioned above. The rental units could potentially be worth more on an individual basis in certain primary markets that exhibit strong growth in homeownership rate. Securing long-term financing also becomes a possibility once a majority of the property is successfully converted and stabilized as rental units. Passive investors may seek to invest alongside sponsors who have built flexibility into their business plan.  

Finally, investors will need to be aware that there is a finite supply of fractured condos in the market. The condo becomes “fractured” and the supply of fractured condo investments mostly arises following a recessionary period. As transaction activity in multifamily rebounds, market participants searching for deep-value opportunities continue to target fractured condo complexes in good asset condition, driving down the available high-quality fractured condo supply. Timing of acquisition and execution is therefore crucial.

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