Editor’s note: In this three-part special report, Inman News examines the challenges and rewards of pursuing property conversions in today’s market, a case study of conversion-frenzy-gone-wrong, and marketing techniques developers and agents use to sell these properties. (Read Part 1, “Changing building’s use presents challenges and rewards,” and Part 3, “Marketing converted properties as stylish and practical.”)

Renters in South Florida have seen hard times lately, as one apartment building after another has been snapped up for condo conversion. In the three southeastern-most counties — Palm Beach, Broward and Miami/Dade — almost 250 major complexes have been taken out of the inventory since 2004, totaling almost 63,000 units. Their developers were no doubt hoping to continue capturing the large profits they’d recently enjoyed from similar conversions, creating condos in a high-stakes, high-demand market.

While regions around the country have suffered in varying amounts from speculation between 2000 and 2005, the apartment-to-condo conversion market in South Florida represents a “perfect storm” of wildcat investment that gave early movers extreme profits — and dealt later ones a particularly harsh blow. For those nationwide looking at purely capital-driven, no-development conversions, South Florida is a cautionary tale. And for all of us, it reminds us that sustainable profit comes from adding value, not fortuitous timing.

An independent survey found that as many as 80 percent of potential condo buyers in South Florida intended to quickly resell (“flip”) their purchases. In some cases, entire projects went to speculators. They demanded more, so converters bought apartment complexes at record prices. In Boca Raton, the 240-unit Mizner on the Green complex fetched $411,000 per unit in August 2005, while the 160-unit Oceanview-Lakeview Apartments across from the beach went for just over $350,000 per unit a few months later — prices rental income alone couldn’t justify.

Then in August 2005, speculators stopped buying and started selling, and potential converters were left on the hook with giant complexes priced above market value: The Oceanview-Lakeview property was foreclosed recently with $50 million owed on a loan of $60 million, while the nearby Belaire Boca is facing foreclosure on a $91 million loan by Wells Fargo.

These are the figures according to the Deerfield Beach, Fla., firm McCabe Research & Consulting, which tracks large multifamily and mixed-use developments with a focus on the Florida market. CEO Jack McCabe said that developers could have seen the signs of a speculation bubble if they’d paid attention, but that “even large public home builders developed an insulated self-assurance that their projects were going to be successful,” based on the level of boom-time profits.

How could they have known better? McCabe points to ancillary data: “You hear people say, ‘1,000 people a day are moving to Florida.’ We’re finding it’s a myth because the public school systems in South Florida are smaller than five years ago. And the moving van companies all say they have more households leaving Florida than moving in.”

According to McCabe, fewer than 11,000 new condos were built and absorbed in the period from 1995 to 2005, but that currently there are nearly 20,000 condo units due to become available before the end of 2008 — many of them from apartment conversions. “There’s currently a 31-month supply of condos and townhomes in the MLS,” he said, “and (that) doesn’t count the FSBOs.”

He believes that Florida, while perhaps extreme, is no isolated case. “Miami-Dade County is the poster child for the condo bubble, and a microcosm for what’ll happen in markets throughout the country — Orlando, Phoenix, San Diego, Las Vegas. The NAR (National Association of Realtors) keeps saying that all real estate markets are local, but you have to add an asterisk next to that statement: During boom-and-bust cycles when speculation runs rampant, many markets share the same variables that create artificial appreciation and future blood in the street.”

So how can one ensure success in a conversion project? The answer, as in any other resale, is to base purchases on less-volatile fundamentals such as cash flow. One developer that knows this well is Artspace, a nonprofit organization that creates live/work rental complexes for artists, and whose list of 17 completed and 13 in-progress projects is dominated by large conversions from buildings that were formerly hotels, offices and industrial spaces.

Artspace Vice President of Consulting and Resource Development Wendy Holmes points out that their model is, in effect, speculation-proof: The organization is less-affected than most developers because it’s able to purchase properties in lower-demand areas with a certain reliance on what Holmes called the “SoHo model,” where artists create value in their neighborhoods, acting as a catalyst for local economic development. Further, it doesn’t care whether the property appreciates or not, as long as rents and tenancy are stable. “Our properties increase in value, but we’re in business to keep rents affordable for artists and creative businesses,” Holmes said. “We’re not in the business of flipping — we don’t care about the final market value.”

But Kairos Development Corp.’s Director of Acquisitions and Brokerage Kevin Brangers warns that conversions are challenging even when one isn’t relying on appreciation. “On conversions, there are so many unknowns going in, because you don’t know what’s behind those walls you’re going to tear out. There will always be overruns; make sure that you have good contingency plans. It’s sort of like when you dig into land for new construction, you don’t know if there’s going to be rocks in there: You can do testing, but you never know 100 percent the results or accuracies of those tests until you put a shovel in the ground. That’s especially true for conversions where you’re doing a complete renovation.”

What if you get in over your head? As McCabe points out, conversions at least gave you the possibility of collecting rent on the existing structure until the numbers get better. “There’s tremendous interest in buying real estate assets at distressed prices in the next 24-36 months that will offer substantial returns as the markets correct and baby boomers retire. In the meantime, their buyers will continue to cashflow them. You can do that on a lot of the conversions, while for new construction it’ll be difficult to break even or cashflow them, even at reduced prices.”

Tom Geller is a freelance writer in San Francisco.

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