Daily Business Review
June 13, 2005
Condo Market Flipping Out
By Oscar Pedro Musibay
In the Roaring '20s, an Indianapolis newspaper lamented the exodus of thousands of Miami-bound fortune seekers who wanted their shot at the big time in the "land of oranges and speculators."
Throughout the nation, newspapers and magazines featured success stories of people who gambled on land in South Florida and not only won, but won big. Lavish marketing campaigns made publications thick with advertising that extolled investment opportunities to be had in fledgling Miami.
The investors included the so-called "binder boys," said historian Paul George. They were bottom-feeders who signed for property with only 10 percent down and quickly flipped their commitments to the next gambler before closing on the purchase.
The heat and hype are here again. Some industry experts fear that flipping activity, or the assigning of contracts, for condo units may lead to a drastic downturn in today's market.
"These assignments may establish a market that may not be real," cautioned Bob Green, executive vice president for residential lending at BankUnited.
Many of the same variables that fueled the boom and led to the eventual real estate crash in the 1920s are here again. The hype has been encouraged by a mutually beneficial compact between developers and speculators, which are estimated to constitute three-quarters of the buying market.
As in the mid-1920s, property prices have skyrocketed, and the 10-percenters are back, signing contracts in residential high-rises throughout South Florida with no intention of ever closing.
Speculators from all walks life, retirees and foreign nationals, hair dressers and doctors, are investing in condo projects. They all hope for quick, double-digit gains without ever having to plunk down more than a small deposit.
Condominium developers are encouraging speculation, because it attracts presales needed to qualify for construction loans, a project's lifeblood. And, less of their equity is tied up in a single project, allowing them to jump into the next high-rise more quickly and with fewer cash flow issues. Developers also make commissions and fees on assignments of units before they close.
Their accomplices are a combination of players, including buying groups, which purchase blocks of units at a discount in some projects before the sale office opens; friends and family lists of clients who buy pre-sales and follow developers from project to project; brokers, who increasingly are buying units in the buildings they represent as well as competitor projects; unsophisticated investors, who scrape together deposits through second mortgages, familial contributions and professional affiliations; and users, who are buying second-, third- and fourth-hand contracts for condominiums.
Further fueling the frenzy are lenders that peddle interest-only loans and adjustable rate mortgages to a market hungry for any credit line that can be leveraged to buy.
Is it any wonder that condominium projects sell out overnight?
By the time would-be buyers who camped out overnight walk into the sales center, more than half of the units have already been reserved and the real money has been made.
Estimates of the volume of speculation vary and it's impossible to get hard numbers because developers keep information about buyers close to their vests. And while sales information is made public after units close, it's impossible to tell what a buyer's intention is.
But convincing anecdotal evidence would suggest the speculator market is burgeoning, evidenced among other things by freshly delivered condo towers that are mostly dark at night because they are filled with unoccupied units.
A flipper's nightmare
The Jade at Brickell Bay is mentioned often by brokers as the first big example of speculation gone awry. While it was a huge success for the developer, Edgardo Defortuna, who set new price records for the Brickell condo market, the elegant waterfront tower has become a flipper's nightmare. Dozens of units are listed for resale, and that doesn't include what are probably dozens more not on the multiple listing service.
"If we experience two or three more Jades, this whole thing will slow down rapidly," said Craig Studnicky, principal of International Sales Group, a competitor to Defortuna's Fortune International Realty sales brokerage."The prognosticators that have been saying there is a bubble will have been right."
Even before the 340-unit Jade Brickell was ready to deliver units, as many as 100 units, or about a third of the project, had already been resold, Defortuna said.
Another 80 to 100 units are currently on the market, Defortuna said.
Some units at Jade have been sitting on the market for months at inflated prices as speculators, possibly third or fourth in a succession of investors, try to unload units.
Jade is an important project because it is one of the first significant residential condominium projects in the Brickell area to be completed during the boom, and its resale success or failure, observers said, would be a bellwether of the market's strength or weakness. The project is also significant because sellers have been getting $750 a square foot for resold units.
Studnicky said it's taking about six months for a Jade unit to sell. In comparison, it takes only 45 days for units to sell in Miami Beach, South Beach, Aventura and Sunny Isles Beach, a sign that Brickell is overbuilt, he said.
Studnicky said the talk about Jade has turned.
"Everybody is talking about Jade," Studnicky said. "Not everyone has a success story. That third or fourth buyer is left holding the bag."
And what that means for investors in projects yet to be delivered, such as Skyline at Mary Brickell Village and Axis, remains to be seen.
Defortuna said sales at Jade are taking a while because owners are timing their sales to maximize profit.
"It really is depending on how greedy the seller is," Defortuna said.
He added that Jade is not a bellwether of problems, but rather representative of the strength of the market.
"The reason they are putting the units on the market rather than using them or renting them is because the prices are so good that even if it takes six months to resell, they are still making a very, very substantial profit," he said.
Brokers and other industry insiders familiar with the developer and its sales strategy say the units have likely changed hands as many as four times at this point.
"The fact is that they bought at $400 or $450 a foot two or three years ago and now it's close to $700," Defortuna said. 'Even if you weren't an investor, the temptation of the profit being so big makes you very potentially eager to sell."
An attorney, who asked not to be identified because he represents developers, said developers typically don't care about speculators or how they affect the market. If anything they realize investors are fueling the market.
The only reason developers restrict assignments is because lenders require it. However, there is constant tension between lenders and developers, with the builders always pushing for ways to get more liberal resale programs.
Lenders have typically given in, especially when projects are close to selling out. Lenders yield to the developers because they hope the resales will eventually trade speculators for users, making the banks' loans more secure, the source said.
But in reality, there are tiers of investors, and contracts can get flipped three or four times.
"Lenders are freaked, but the developer has mostly prevailed on lenders to allow resale programs after a certain percentage of pre-sales, on a project-to-project basis," said the real estate attorney who asked not to be identified.
"Because the developer has been successful at convincing lenders to permit the resale program after a certain percentage of sales, 80 [percent] or 90 percent, and it's happened at project after project, borrowers and buyers don't believe the prohibition on assignments is real," said the real estate attorney. "They believe they will be permitted resales because they have been and are."
John Landrum, executive vice president and chief operating officer of the Miami-based Related Group of Florida, the state's largest condo developer, said about one-third of units in the company's projects are assigned prior to closing, as was the case at One Miami, the first high-rise residential condominium project launched in downtown Miami.
Landrum said the psychology of those seeking assignments is clear.
"They are profit motivated in every case," he said. "I think there are buyer/investor/speculators who come along early into the market and look for high-quality projects that they know are going to get built, and they invest in those. They get there early and get attractive pricing.'
A recent report by investment firm Raymond James & Associates estimates speculators in some Miami condos account for 75 percent of the buyers.
Buying groups that cluster money from multiple investors are helping accelerate the trend. These groups inject money into projects that might otherwise not get off the ground, potentially allowing projects with no real end users to get built. The groups target projects in less-desirable locations and developers with unestablished reputations who need help driving sales to meet lender requirements, some developers said.
Overall, speculator buying in South Florida probably accounts for some three-quarters of the condos, a staggering figure.
"It's much closer to the 70 percent than the 30 [percent] to 40 percent [that developers usually say]," said Brad Hunter, who is director of the South Florida region for real estate research firm MetroStudy. "Talking to sales people at various projects, when you really get them to drop their guard and tell you what they really think, it's a majority of [speculators] across probably all three counties."
The fear is that if speculators are forced to close on units they intended to flip, some will abandon deposits rather than buy. It would be a difficult choice, but carrying costs can mount quickly, and without an exit strategy, investors would likely opt to lose a deposit rather than sink hundreds of thousands of dollars into purchasing a unit.
"The thing I don't understand is what investors are thinking," said a professional who asked not to be identified because he arranges financing for developers. "From a buyer's point of view, this is not a good investment. From an economic standpoint, you can't rent them and cover your nut."
Experts say a $100,000 loss on a $500,000 unit could be much more attractive than carrying a $400,000 mortgage on a unit that may or may not be rented. It doesn't take long for the monthly costs, mortgage payments, condo maintenance fees and property taxes, to eliminate profit margins. The situation could become dire for those who leveraged their primary residences to put down deposits on multiple condo units.
And tax law also encourages flipping.
Tax attorneys recommend that clients sell their units after holding a contract for more than a year and prior to closing, or otherwise face a huge tax hit on capital gains. Miguel Farra, a partner with Morrison Brown Argiz & Farra, said tax law favors investors because a contract and a purchased unit are considered independent taxable assets.
So once an investor signs the contract, the clocks start ticking toward 12 months and a day, the threshold for a long-term capital gain. At that year-plus mark, the contract holder is eligible for a 15 percent long-term, capital gains tax on the profit. Whoever closes on the unit, whether it's the contract holder or a new buyer, must deal with a new clock and could end up paying a short-term capital gain tax of as much as 35 percent on the value of the unit, if they sell in less than a year.
It takes well more than a year to build a condo.
With investors making up the vast majority of buyers in many projects, if such a trend were to spark a panic, the market would undoubtedly suffer.
Banks saw the risk of a market overheated by speculators long ago. That's why they wrote clauses into construction loans that require developers to restrict assignments and flipping by buyers.
But developers and brokers have found a way around those restrictions.
Developers in their contracts prohibit the buyers from making assignments before closing to avoid units they've already sold from competing with the project, and so developers can better control the flow of sales and prices.
But banks don't typically prevent buyers from assigning contracts back to the developer, after reaching a certain threshold in pre-sales, who would then handle the resale in place of the buyer. A broker representing the Axis condo west of Brickell Avenue recently described such a possibility to a prospective buyer as the loophole that allows flipping.
And Axis isn't the only project using this loophole. The ability to assign contracts helps push prices up and generates more revenue for developers who charge fees and commissions for such transactions.
"They tell you that they are doing this because of the lender situation. Is that true? I don't think so. They all got greedy. I think they figured out that they could make money on the flip," said a broker who asked not to be identified because it might affect her developer relationships. "It used to be they sold the building and that's where they made their money. Now they sell the building once, twice, three times, and they make money on each flip."
The developer makes a commission on the sale and also gets an assignment, also known as a transfer fee, which developers say covers administrator fees.
The real estate boom has provided huge opportunities and returns to an assortment of people and companies. Thousands of jobs have been created directly and indirectly by the massive construction wave. Banks have reaped record profits. Law firms of all types have garnered huge fees. And contractors can barely keep up with demand.
Cities and counties have pinned their futures to this wave, trying to redevelop entire blighted areas with the help of developers looking for any viable spot for a condo or multiuse development. But no city has allied itself closer or bet bigger on the development wave than Miami.
City leaders promise the boom will breathe life into areas planners have failed to revitalize for decades, including downtown and the Biscayne Boulevard corridor.
The fortunes of the city itself ,-once ridiculed as a "banana republic", are riding on the real estate wave. Any downturn would likely be felt hardest in the areas of the city that its leaders are pushing the hardest to redevelop, downtown Miami, along the Miami River and on the Brickell.
More than 600 new condo projects are slated for South Florida east of Interstate 95, with more than $10.1 billion in construction loans, according to court and property records. And with these buildings come tax base increases and more revenue for parks, transportation, beautification projects and other needs. The city of Miami's estimated tax base for 2004 jumped 21 percent to $27.3 billion during the last 12 months, according to a preliminary report issued by the Miami-Dade County tax assessor's office this month. In 2003, the city?s tax base was $22.5 billion.
Miami-Dade County has the greatest number of condos under construction, 19,769, more than double what's being built in Broward and nearly four times the number under way in Palm Beach, according to research firm MetroStudy.
And the bulk of speculation, experts agreed, is concentrated in South Florida's largest county.
There is some concern that companies that pool buyers' funds to invest in multiple condo projects may be further accelerating any market correction by creating a false momentum for the market, like what the "binder boys" did to the market in the '20s. In other words, speculators are selling to speculators.
These investment groups typically get discounts from developers in exchange for putting contracts on huge chunks of units. Often these contracts are done in the names of multiple buyers to avoid setting off alarms at lending institutions that typically frown upon multiple unit sales to the same buyer.
Landrum and Defortuna said they don't cooperate with investment pools, but Related's chief operating officer did say that his company works with brokers who represent as many as 10 buyers at a time.
Defortuna said there is enough demand that the most credible developers with the best networks and the best properties don't need to work with investment groups. Additionally, groups typically ask for a 15 percent discount on units, which would unnecessarily cut into their sales.
He said some less-experienced developers, however, might need the help.
"Some developers, because of their reputation or because of some issues in financing, needed a quick sell in order to get the project going, and they rely on those [groups]," Defortuna said.
Developers often have a loyal following of investors who follow them from project to project.
And so-called friends and family lists also make up a small percentage of their sales. "There is such a thing as a "friends and family list" and that varies from project to project, the names on the list," Landrum said. "That may be 3 [percent] to 5 percent of the units you are selling, in our case. So I don't think that is a long list."
Although he expects the market to be strong for several years, Landrum said there will likely a correction, or a slight "flattening" of prices, in neighborhoods such as downtown Miami and Brickell, areas where a huge inventory of units will hit the market in the next three years. Related has three large projects under way in each area.
"What will likely happen is that we will have significant inventory introduced into the market in 2007-08, and there will be a flattening out of price increases," Landrum said. "Instead of it being a 15 [percent] to 20 percent per year [increase in prices], it will probably be a 5 percent to 7 percent increase, which may not be enough to fuel further speculation."
Oversupply looms as the biggest problem in a construction market fueled by speculation and few end-users.
With 61,000 units in the pipeline in Miami-Dade County alone absorption is going to be an issue, said Bruno Picasso, director of market research for Integra Realty Resources, a real estate consulting firm.
In 2003, there were 8,454 units built and 7,210 sold, according to Integra's research. At the end of the year, that left more than 8,557 units on the market. In 2004, another 9,715 units were built and 7,425 were sold, boosting inventory to 10,847.
With about nine times the number of units absorbed annually in the pipeline, it is unclear how the market will accommodate such a increase in inventory.
Hunter said the situation is worse than it appears because units counted as sold are really not. They are in the hands of speculators who intend to sell them, and they too will be on the market as the new units are built.
Developer Claudio Stivelman, who is partnering with Defortuna on two condominium projects in Aventura, predicted the market will see a slowdown in sales in some parts of the county if there is a correction, but he still has confidence in the overall market.
"If there is a correction in price, you can hold. You can rent. You can trade," said Stivelman, a principal of Shefaor, developer of the 216-unit Uptown Marina Loft and the 232-unit ArTech condominium. "In different ways, you have more options than in the stock market."
Landrum sees several positive indicators that the market will continue to be strong: interest rates remain low and inflation has not risen; baby boomers, who stand to inherit trillions from family in coming years, continue to see real estate as an attractive investment; the euro remains strong and the continued injection of Latin American dollars into South Florida real estate bodes well for the future. Developers also see continued population growth as a good indicator.
But there are signs of problems, according to MetroStudy.
In May, Hunter told those gathered at a client conference that PMI Mortgage Insurance Co. notified its lender network throughout the United States that borrowers who have more than four mortgages outstanding or who represent more than $350,000 worth of risk exposure to the company will not be issued new loans. Serious concerns about interest-only mortgages were also raised by underwriter MGIC. The groups are concerned about the negative effects of investors on the real estate market, he added.
Green said BankUnited limits to four the number, for a primary residence, a secondary and two investments, of loans that can be made to one borrower. He said rapid appreciation of properties can make it difficult to get credible comparable sales to justify lending.
"I don't know if it's a problem, but it's a general concern," Green said. "What has us worried is that I bought this property for $150,000 in December of '04 and eight months later it's appreciated 26 percent. We're concerned that the values are not sustainable, and they probably are not."
Lewis Goodkin, of real estate research firm Goodkin Consulting, points to the dearth of users as a problem. "Why aren't we having a lot more users in the market?" he asked. "It's because buyers are using it as an investment vehicle rather than a shelter. Who are they are going to sell them to?"