Once a heavy player in the traditional apartment sector, Montecito Property Co. LLC moved into the conversions with a Jacksonville, FL asset about three years ago and hasn't looked back. Initially the company was active in Southeastern coastal markets; today it operates in Arizona, California, Florida, Georgia and South Carolina as well.

"I don't know if we'll enter the rental market again," says the firm's Jacksonville, FL-based partner, Bruce Taylor. "If something comes along in an area where we've had proven successes before, of course, we may hold it as a rental until the market warrants a conversion. But we wouldn't buy it for the pure operational value."

Last year alone, Montecito closed more than $1 billion in deals, ranking it as the second-largest acquirer of conversion properties by dollar amount, according to Real Capital Analytics.

But even for the larger players, the market has gotten tougher. In the short time the company has been active in the conversion business, things have changed dramatically, Taylor says.

"Everyone's trying to do it now," he asserts, "and the biggest problem is that some people don't know how to write deals properly. They may underwrite at large margins, which thin as they get into the deal, based upon construction overrides, etc. Therefore, they lower prices. Now you have to compete with that, and it drags down the market as a whole."

Taylor isn't the only one with that opinion. Using a term popular with many in the industry, Duchman agrees that "condo cowboys" may pose a threat to the overall sector. "It's not as simple as people think. You have to manage the inventory properly and maintain the rent while you're doing the conversion. There are a lot of laws and they vary from state to state," he says. "There's certainly a science to doing a proper conversion."

On the other hand, those new and aggressive converters have allowed some players to cash in on the red-hot market in other ways. Crescent Heights has reportedly sold some assets rather than convert them. While it's not the firm's main business, says Duchman, "it does have some tax benefits."

Equity Residential, too, has flipped properties to competitors. About 20% of the product sold by the REIT last year went to converters, reveals Neithercut. "We looked at those assets and determined it was in our best interests to sell them to a third party because we didn't think the condo profit would have warranted doing it ourselves," he says.

Condo converters outspent all other buyer groups in 2005, according to Real Capital Analytics, accounting for about $30 billion, or 37%, of all multifamily property sales. That's up significantly from the $12 billion they picked up in 2004 and $2.7 billion in 2003. Many of last year's sales were to inexperienced converters, notes the New York City-based research firm: 105,000 of the 191,000 total units that changed hands were purchased by players with no record of conversions prior to 2005.

Traditional multifamily investors have decried converters for driving up competition to levels where they can't compete, and the numbers support that claim. "Converters are difficult to outbid," RCA notes. "On average, they are paying 98% of asking prices and almost double the average paid by other private buyers." At $152,559 per unit and cap rate of 5.2% on average, converters are far off of the $106,969 per unit price and 6% cap rate recorded for apartment sales as a whole. Further, the average cap rate for conversion deals has declined from 5.7% in '04 and 6.8% in 2003.

In a hot market like this, it's true that the cap rate is not the primary factor when it comes to conversions, says Duchman. "But that's starting to change," he suggests. "Over the past couple of months, brokers have started to call us up and ask whether or not we're going to bid on a deal. A year ago, you'd have to chase them down to find out the asking price. The seller controlled the market. Now, it's becoming a buyer's market, but it depends on the area."

Furthermore, converters aren't paying what they once did for properties, particularly since the pace of unit sales has slowed, notes Robert A. Kaplan, a senior managing director at Holliday Fenoglio Fowler LP in Coral Gables, FL. That, he says, will lead to a slowdown in the sale of multifamily assets. "We're almost at the point now in Florida where institutional buyers of multifamily and condo converters are paying about the same. That's a dramatic change from six months ago," he relates.

The Lenders:
Taking a Closer Look
The record-low interest rate environment has worked in condominium converters' favor. It not only allowed converters to obtain cheap capital and pursue properties aggressively, it also made it easier for consumers to take out mortgages on condo units, driving up sales and prices, and subsequently, converters' bottom lines.

Yet recently, industry insiders note that the financing market has tightened up, making it more difficult for condo players to get loans for acquisitions and conversions. While lenders are standing behind converters with proven track records, they've started to scrutinize newer or smaller players.

Gregory H. Leisch, chief executive officer of Alexandria, VA-based Delta Associates, says financing has definitely slowed. "We know that lenders are pushing back on conversions," he says. "We're already seeing fewer deals being underwritten."

Holliday Fenoglio Fowler's condo business has grown tremendously since 2002, says Kaplan, at an average of about 25% per year. In fact, the firm's Miami office alone handled around $2.4 billion in condominium-related financings last year. Yet in the past six months, the executive says the attitude of many lenders has shifted from aggressive to neutral, with some reducing the amount of leverage they're willing to provide and others pulling out of the sector entirely. However, there are a few new funding sources in the market filling the void, say the experts. Patrick Crandall, a New York City-based vice president and Northeast regional manager for Fremont Investment & Loan, says, "Some European banks that weren't even on the landscape two or three years ago have become pretty formidable competitors."

But on the whole, capital isn't as readily available to condo converters as it once was. "Lenders have been aggressive over the past four years and now might have overexposure issues in certain submarkets," Kaplan explains. "There's also the perception of a slowdown in condo unit sales and the overall concern about excess supply in certain markets. The inexperienced or the slightly experienced converters are having serious problems securing attractive financing."

Crandall agrees. Fremont, a non-recourse lender primarily of bridge and construction loans, does transactions solely with assets that are immediately available for conversion, such as vacant office or multifamily buildings. The firm was heavily involved in other property sectors, but in the past few years has shifted its focus; condo-related deals now comprise a significant amount of its business.

"We're generally not going to do a deal with someone who's never done a conversion before and doesn't have some significant financial wherewithal," he explains. When Fremont does work with a new converter, he says, "we're going to structure the transaction accordingly—we won't advance as many dollars, we want to see more equity, we're going to pad the budget and the timing, etc."

According to Crandall, it's only inevitable that the finance community is more cautious, which has led to a more level playing field. "The competitive landscape has changed a bit. There are fewer lenders clamoring to do those deals, and they're not as aggressive on the underwriting," he explains. "It used to be that you would push to try to get more proceeds for the borrower because otherwise, another lender would get the deal. Now, that other lender won't do it either." Consequently, equity requirements have increased. "The goal is always to maximize the senior debt piece, since that's the least expensive part of a capital stack," says Kaplan. "Most lenders providing senior debt have reduced their maximums from 80% or 85% loan-to-cost to 70% or 75%, triggering the need for more mezzanine financing or equity."

In light of the perceived new dynamics of the financing market, many borrowers are seeking to secure equity in lieu of mezzanine financing in order to reduce their risks, he says. Everyone from groups of high net-worth individuals and international banks to institutions such as opportunity funds and life insurance companies are ready to shell out cash for good conversion opportunities. "Equity is generally more patient than mezz, and for well-conceived projects with experienced sponsors, there is ample equity," Kaplan says.

The Markets:
Hot—And Not So Hot—Spots
Condo conversions are spurred by the same adage that drives all real estate deals: location, location, location. Any converter will tell you that the success of a product depends first and foremost on its location within a geographic market, followed by the quality of the asset.

Not surprisingly, there's a lot of competition for prime properties not only in the top-tier markets, but also in select secondary and tertiary ones. "Today, everyone that has an apartment complex thinks it's a conversion opportunity. It doesn't matter whether it's in Albany, GA or Albany, NY," says Taylor.

Montecito will continue to be active in its current markets, but the executive relates that the firm is considering some tertiary areas with strong demographics, such as Nashville and the Virginia coast, that may have been overlooked by larger players.

"We're looking for stellar deals, and they're hard to find," concurs Duchman. "We have acquisition teams on the road right now in specific markets where we feel we need to have a presence."

Areas with strong local economies are attractive to a company like Crescent Heights, he says. For instance, the resurgence in the technology industry should benefit tech-heavy markets. The firm also likes Hawaii, where it already has a few projects.

'Advance with caution' is the firm's motto, he says. "We like to buy low and we certainly like to buy right. We think the opportunities will be coming, and we're going to continue to grow." Though he won't disclose any specifics, Duchman adds that the firm is considering conversions in select global markets as well.

Here at home, the most desirable spots for condominiums continue to be South Florida, Las Vegas, Phoenix and Southern California, as well as Metro New York City and Greater Washington, DC. Those areas have attracted a good deal of conversion activity, so much so that it's made some players back away. "We'll go as far south as Ft. Lauderdale, FL, which is a great market, but probably wouldn't touch Miami," says Taylor. "And even though it's been booming, we probably wouldn't go to Las Vegas, either."

Some cities have gotten to a point where they are now deemed at risk of experiencing a bust. Those are also the markets that have experienced a surge of investment by speculators hoping to cash in on the condo boom by flipping individual units.

Speculators pose such a risk to the overall health of the market that condo sponsors have been attempting to limit or prevent them from purchasing units. Yet again, maintains Taylor, the level of investor activity really depends on the market. For instance, the firm recently delivered Estate at Westbury in Bluffton, SC. The 320-unit property nearly sold out in two days, says Taylor, and almost all of the buyers were end users.

In other regions, however, the presence of speculators only feeds into the oversupply issue. Delta Associates' Leisch pinpoints Las Vegas, Miami and Phoenix as places to watch in the short term. "Those markets are more susceptible to a harder landing than others because they have low barriers to entry and high levels of speculator or investor activity," he explains. "So there's a lot of supply, and demand is being interrupted because investors are pulling out of the market. In fact, speculators have already pulled out of all three of those markets."

Most executives agree with Leisch's assessment, adding that some Southern California cities like San Diego may also be at risk of a crash for the same reasons. Additionally, those areas have high concentrations of luxury product, which has a more fickle customer base, experts agree. "In Las Vegas and Miami, there's a great deal of concern that the very high end of the market is oversaturated with product, even without a pullback by investors," says Leisch.

A retreat by speculators does impact sales of individual units, but the issue of oversupply may not be as great as it seems, observes Kaplan. "At this moment, there is concern of oversupply in certain areas, but this concern has been present for two or three years," he relates. "Most experienced converters are expecting moderate sales over the next six to 12 months, but are optimistic that their projects will sell. Overall, the slowdown is extremely healthy and it's providing a soft landing instead of a precipitous crash."

Unlike his counterparts, Kaplan believes lower-tier cities are in more danger of a collapse than the super-active ones. "In the tertiary markets, if it slows down, it will slow down for a decade. Those are the areas where converters went in and captured a market that didn't otherwise exist," he says. "There is zero risk of a crash in Florida."

The Bust:
Self-Fulfilling Prophecy?
There's little doubt that the condo-conversion business has likely reached its peak. In fact, Leisch believes the sector is "largely played out in this cycle. But due to strong structural fundamentals, we're likely to experience a soft landing in most major markets," he says. "That's in contrast to the '70s, '80s and early '90s, when condos really took it on the chin in all markets. There simply wasn't the underpinning of support that we have now for this type of living. This cycle will be different than the others."

So what's with all the talk about a bubble? According to most observers, it's a bunch of hot air. "The problem, in my opinion, is the general consumer media, which is hyping up the issue," says Taylor. "As a whole, I don't think condos are going anywhere. It's not going to be like the 1980s, when there was a big bust."

In terms of identifying trouble spots, Duchman says it's important to differentiate between individual geographic markets. "It's not our belief that there will be a general bust," he says. "Real estate has had its ups and down, but over the years, it's been a sound place for people to put their money."

Fremont's Crandall agrees that the consumer media's bubble blitz could be more to blame for the slowdown than anything else. "To a certain degree, everything you read in the press about the bubble bursting is kind of a self-fulfilling prophecy. People start to believe it, whether or not the fundamentals bear out that assumption," he explains.

That's not to say, however, that there aren't major problems in individual markets. Industry observers have described this phenomenon as "tiny bubbles," often pointing to the hyperactive markets of South Florida, Southern California, Las Vegas and Phoenix. Yet while those locations can be risky, in many others the demand for housing is greater than the supply, due to household formation and job and population growth. The bulk of that demand, stress executives, will be for starter homes, a segment of the marketplace targeted by a good number of condo companies.

"In the markets in which we're doing our conversions, there's enough of a spread between the price of our units and the starting prices of single-family homes that we feel confident this trend will be around for a while," says EQR's Neithercut. "The demographics and the growth of the echo boomers in this country suggests there will be strong demand by that segment for condominiums, as well as in the Sunbelt markets from the snowbirds, second-home investors and retirement-age baby boomers. We're not building condos on the beach in Florida and trying to sell them for $600 a foot.

"That being said, we don't expect, nor have we ever expected, that we'll see the weekend sellouts that we have in the past," he continues. "If we only sell eight, 10 or 12 units a month, that's very much within our pro forma."

The other converters, too, see better odds in the entry-level segment. While Crescent Heights does have a few projects selling for $3 million to $4 million a unit, it also has targeted a specific niche of the market, says Duchman. It dubs its condos as "rent-ready" units, affordable to first-time buyers who otherwise would have rented.

Montecito's game plan is to find the best value in higher-end neighborhoods. "We always like to be about 50% to 60% of the median home price in a given zip code," says Taylor. "We feel like there's more of a market for that."

That's the segment that will help the condo sector to stay afloat, even as the real estate climate cools, agree the experts. "After a five-year run-up in single-family housing prices, what's been underpinning the conversion market is that condos are an affordable housing option," asserts Leisch.

And if they can't sell all of their units, Leisch points out, converters have a great exit in the traditional multifamily sector, which has experienced diminished inventory as a result of conversions. "What's playing in converters' favor is that we have a very robust apartment market," he says. "Many buildings are now retrading to institutional investors in some markets at even higher numbers than they were to condo converters. We just don't see any hesitation in investors stepping up to buy this product to continue rental programs."