Condominium vs. Apartment Development Contrast
Over the years, a question has been whether the Tactica Multifamily Development Model will work for condominium development. I thought it would be worthwhile to tackle the difference between the two real estate classes and why they differ so much from a modeling perspective.
Condos vs. Apartments Contents
From 10,000 feet, condo and apartment units are very similar. If you were to drive by a high-rise development, you'd likely decipher it as a residential building. Without direct knowledge of the project, you couldn't tell whether the building was a condo development or multifamily new construction.
Both condo units and apartment units are residential dwellings. They're generally a part of a larger complex, possess common areas, and qualify as investment properties. Sometimes, condo owners lease out their units to renters to further muddy the waters between the two asset classes.
I can see why a perception exists that analyzing rentals vs. condos should be closely mirrored and interpreted under the same lens. However, some significant differences set multifamily and condo developments apart once you dig into the details.
The sale process is the most significant contrast between selling apartment buildings and condo complexes post-development.
For an apartment complex, pricing is a function of the NOI and residual cap rate. Rents, operations, capital markets, and sales comps play into projected pricing, but all units will sell together and are viewed "as a whole."
Example: A multifamily developer would forecast to sell their project at "$350,000 per unit." They wouldn't internalize the sale effort as "$200,000 for studio units, $275,000 for one-bedrooms, etc."
On the other hand, new condo buildings have a more complex sale process. Every unit sells individually, and in effect, there are many more moving parts tied to:
Pricing each unit individually
Sales timing
Condominium Complex Unit Adjustments
The most thorough condo unit mix analyses I've reviewed use sales comps (for condos or townhouses of similar quality) and estimate an approximate benchmark to set a baseline price per square foot (PSF) for the units. From there, each unit will have a detailed analysis that adjusts its pricing for things like:
Layout
Views/floor
Location within building
Balconies/decks
Extra bathrooms, bedrooms, and dens
Other unique unit features
Example: Studying relevant sales comps in the submarket, a condo developer sets her baseline price PSF at $375
Unit A: 1st level 1BR/1BA 900 SF unit with a walkout patio.
Target Sales Price = 900 * $375 = $337,500
However, the unit will be discounted by $7,000 for being on the first floor and lacking a nice view. It will gain $10,000 for the patio amenity.
Adjusted Target Sales Price = $337,500 - $7,000 +$10,000 = $340,500
Because each unit will appeal to buyers with varying preferences, forecasting sales proceeds is riskier. Therefore, the unit mix analysis is more grueling than a multifamily proforma.
Sale Timing
When a rental property sells, there is one closing date. When a condo complex sells, there is a closing date for each newly appointed unit owner. Ideally, most units will be pre-sold (many lenders will require this before lending). However, selling out new developments could take a broad spectrum of months/years.
I've heard from a few condo developers that profit doesn't usually hit the P&L until the last few units are sold. In other words, you could execute on selling 90% of the units and still not be profitable.
Sale timing could drastically impact time-sensitive return metrics like the IRR.
Financing for both condo and apartment developments starts similarly. The borrower receives a loan as a percentage of total construction costs. They're then on the hook to fill the funding gap with a cash downpayment. How the loan is repaid drastically differs between the two asset classes.
An apartment developer will refinance the construction loan once the project occupancy is stabilized or sell the asset (either action effectively pays off the construction loan).
The mortgage is paid down in a condo development as units are sold. Most lenders will specify a certain percentage of sale proceeds towards the mortgage paydown.
Example: A townhome sells for $600,000. There are $50,000 closing costs (realtor commission, taxes, and fees). The remaining $550,000 goes to paying down the mortgage.
The lender is paid back in full before the developer reaps project profits. From a financial modeling perspective, this makes a massive difference. Unlike the multifamily model, monthly debt service payments depend on the sales schedule. Fewer sales will equate to higher monthly interest payments.
In a multifamily development proforma, we put time and thought into the property management and operating expenses once the property stabilizes. Regarding condo living, an HOA will stipulate the monthly costs associated with grounds, landscaping, insurance, utilities, and service contracts, among other upkeep items.
The monthly HOA expense is tied to each unit. A condo developer fronts this monthly expense initially until they sell units and pass off the burden to the homebuyers. Therefore, the financial model must phase out the developer's HOA expense as units close in the proforma. Once the final unit is sold, the developer will have no more HOA expense burden.
As you're probably realizing, a condo development is intended to be a short-term investment. If it's not, the project likely struggled to garner attention and sell out promptly.
Given the short-term nature of condo development and all the moving pieces within that timeframe, I think a monthly cash flow would make much more sense than the annual cash flow used in the Multifamily Development Model. Major analysis components like condo sales, mortgage paydown, and HOA phase-out would be easier to follow on a month-to-month basis vs. annual.
Other differences between condos and rentals won't necessarily affect the underwriting techniques but should be considered.
Condos tend to have more stringent warranties than apartments and potentially more future litigation risk.
Condos' finish levels tend to be more "high-end" with a larger footprint.
There is also a severe need for a real estate agent on the team who is an expert on the condo/townhome housing market and sale processes.
Condo development will likely need investment in a "sales center," a space (often leased) that will provide interested suitors with all the information about units, finish levels, and amenities. I've heard of the sale center having kitchens and bathrooms built to spec into the space to show the interested parties exactly what homeownership will entail.
Summarizing Condominium Development
Condos and apartments appear to have many similarities. It isn't until you dive into the details that executing a condo development entails multiple components not prevalent in multifamily development. Different expertise is required given the "for-sale" aspect, financing, HOA, and the short-term nature of condo development.
Condominium investment is a unique asset class requiring a very different skill set than developing and managing multifamily rentals.