Monday, March 14, 2005

Suburban Condos: A Good Opportunity . . . for Somebody Else

In my town (Bellevue, WA) a new multi-family listing just hit the market: 12 one-bedroom condo units being sold as a package for $1.032 million. These units are sprinkled throughout a 240-unit condominium complex built in 1978 that happens to be located right across the street from the Microsoft campus. The units are 680 sq. ft. each, which is the perfect size for an aspiring, young software engineer who works long hours and must live close to the office. At $86,000 per unit, or $126 per rentable sq. ft., these suburban condos look extremely cheap when compared to $200 per sq. ft. for other condos of similar age and $400 per sq. ft. for new downtown condos.

I have seen suburban condos in this and surrounding complexes near the Microsoft campus come on the market over the past few years. Beyond their cheapness compared to downtown condos, what surprises me is how suburban condos have been lagging the detached house market, with the condos appreciating just 5% per year compared to 10% for detached houses:

Property: Price in 2001 vs. Price Today

Surburban Condo: $71,000 vs. $86,000
Typical Detached House: $300,000 vs. $440,000
Prce Ratio: 1-to-4.2 vs. 1-to-5.1

Because I believe it inevitable that the surburban condo market will "catch up" (and most likely sooner rather than later) with the rest of the residential real estate market, I think the upside over the next few years is very good for an investment in the 12 units now on the market. These particular suburban condos are the least expensive for-sale units in the local housing market and are priced far below replacement cost. The downside is that rising interest rates could lead to a softening of the entire residential market, possibly impacting first-time condo buyers the most (but this could also drive first-time homebuyers back into rentals, pushing rents up and producing better cash flow for condo owners who rent their units out). Balancing limited supply against potentially softening demand, I think that upward price pressure will win out, producing healthy returns for the investor who ends up buying the condo package.

Despite this excellent opportunity to invest in the condos, two factors prevent me from moving ahead to buy the package:

1. Very low cash flow: Priced at a 4% advertised cap rate (or 3% after taking reserves for capital expenditures and running numbers more realistically), the condos will conservatively support only about 50% loan-to-value and provide very little cash flow;

2. Better alternative investment opportunity: On a leveraged basis with 10% price appreciation, a 20% ROI can result from the condo investment. As attractive as this might be, I believe that better returns are available from wise investment choices in the stock market. I provide an example below.

Since an investor would need to operate the condos as rentals while waiting for them to appreciate in value, let's compare the condo investment to one of the large apartment REITs, Apartment Investment and Management Co. (Aimco, ticker: AIV):

Investment: Suburban Condos vs. REIT (Aimco)

Price: $1.032 mil. (list price) vs. $10.4 bil. (enterprise value)
Revenue: $84,000 (rent) vs. $1.47 bil. (total income)
Price-to-Revenue Ratio: 12.3 (GRM) vs. 7.1 (EV/total income)

Net Operating Income: $42,000 (pro forma) vs. $700 mil. (2004)
Cap Rate: 4.1% vs. 6.7%

Loans: $671,000 (assume 65% LTV) vs. $6.8 bil. (loans + pref.)
Interest Expense: $40,000 (6.0%) vs. $385 mil. (5.7%)

Net Income: $2,000 vs. $315 mil.
Equity: $361,000 vs. $3.6 bil. (market capitalization)
Current ROE (before deprec.): 0.5% vs. 8.7%

Est. 5-yr. Income Growth: 3% to 5% (rent inflation) vs. 4.7% (consensus)

As the numbers indicate, the REIT opportunity wins out as an income property investment:

* Better top-line income multiplier (GRM)
* Better bottom-line earnings ratio (cap rate)
* Better cash flow (current return)
* Similar earnings growth prospects

Where the condo investment should excel is in higher asset price appreciation. Let's assume that the condos appreciate at 10% per year over the next 5 years, and that the apartments in Aimco's portfolio see just half of this appreciation. We can then compare pro forma investment performance:

Annual NOI Increase: 4% for both condos and REIT
5-Yr. Asset Price Appreciation: 10% (condos) vs. 5% (REIT)
Round-Trip Expenses: 8% of exit price (condos) vs. nil (REIT)
Leverage: 65% LTV for both condos and REIT

Equity Investment ROI: 20% (condos) vs. 21% (REIT)

The higher asset price appreciation for the condo investment is largely offset by the better underlying cash flow the REIT investment offers. When the expenses (broker's commissions and transfer tax) involved in selling the condos are factored in, the pro forma ROI for the REIT investment ends up slightly ahead, 20% vs. 21%.

When I also consider the better liquidity that the REIT investment offers and the substantial amount of management time that I would have to expend buying, operating and later selling all of the condos (I speak from experience, having owned and managed apartment buildings over the years), I decide against pursuing the condo package. I need to see significantly higher expected returns from direct ownership of real property than are avaliable in the stock market before I become a landlord again.


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