By: Brandon Turner
A friend who happens to also be a business partner in one of my non-real estate ventures reached out this week with a question. He does this from time to time, seeing as I am such a big shot real estate expert and all…
This time, the text read: Hey, Ben – how about this condo…?
This was worth a telephone call. He needed to understand a few things!
Two Basic Reasons to Buy Real Estate
There are only two reasons to buy real estate – cash flow and capital gain. Cash flow accomplishes the objective of financial freedom, which is defined as capacity to generate income outside of W2/1099. Equity, on the other hand, builds the balance sheet, which makes us rich. No big, earth-shaking discoveries here…
Why Condos Are Problematic
Indeed, condos are problematic with respect to both of the stated objectives. First, by and large, condos don’t appreciate as much as free-standing single family residences. Also, the cash flow can be unpredictable…
While there are obviously exceptions to the rule, mostly this is true, and there is a good reason for this:
Condos have an extra cost of ownership, which most houses do not — the condo association fee. Let’s remember that a lot of what drives values of owner-occupied real estate is availability and affordability of credit, which is to say the more people can afford to borrow, the more they will pay. Consumerism galore.
Well, when qualifying folks for mortgage loans, banks underwrite two metrics: the Debt to Income Ratio (DTI) and the housing expense ratio. I haven’t looked at the exact percentages in a long time since they are not pertinent to my business model, but essentially you are permitted to spend only a certain percentage of your income on all of your combined expenses, not including the debt service on the mortgage loan that you are applying for. And that new mortgage payment can’t inflate your total DTI above a certain percentage more.
Therefore, since your income is what it is, the crux of the matter relative to how much you can borrow is a function of expenses. Obviously, anything that adds to the expenses has the effect of diminishing the amount of P&I that your DTI can absorb…
Condo association fee is an expense, is it not? If your DTI permits your total hosing expense to be $1,200/month, then without a condo association fee, you’d be able to borrow the full amount of mortgage, resulting in PITI of $1,200. However, if there is a $275/month association fee, then since your total housing expense has to remain at $1,200/month and since taxes and insurance are what they are, you now must compress the P&I to result in lower debt service by $275/month. Well, crap…
Such is the logic. There are caveats, exclusions and intricacies that apply. If interested, please do further research. But since prices are set by what ready and willing buyers can afford to pay, which in a lot of ways is a function of what they can borrow, hopefully this explains why valuations of condos are structurally compressed.
So What’s the Problem?
The problem is that we want two things in a real estate investment – cash flow and equity appreciation. The condo association fee compresses appreciation of equity, as we just discussed. And since rents on most condos are not higher than rents on SFRs, but there is this additional and often substantial expense, the cash flow objective is also problematic indeed.
We have many “wants” when it comes to our investments, but there is only one “must have” — control, and this is perhaps the biggest issue with condos. The association fee will go up in tandem with CapEx, and unless you have substantive vote on the committee, you won’t be able to avoid paying.
Importantly, as that fee goes up (while the building is aging), your rents will likely not keep up. There’ll be newer and better amenitized condos in the marketplace by then. Ouch.
So, these will get cheaper, and investors will start buying more and more of them… because investors often think that cheap is good. Guess what? When there are too many investors in a condo development, the banks lose appetite for providing mortgages to investors, which completes the spiral cycle, and when you are ready to refi and bridge the equity, you may not be able to.
There is but one strategy that works well with condos, but that’s beyond the scope of this article. All and all, there are some serious problems with condos. Be smart!