Getting Sober in the New Economy

Are Rentals a Better Solution for Affordable Housing?

"The crux of (the) analysis is that the loose lending practices seen during the housing bubble allowed 5 million renters to become homeowners and the market is in the protracted process of evicting this group."

Sometime in the early sixties, a large California developer opened its first development of condominiums for sale. They were offered at rock bottom prices. A home for a single family that could be bought for $10,000.00 was big news even then. The desire for suburban housing that could be built in high densities and thus be affordable was apparent. Condos could be sold in volume which meant higher profits for home builders. Other developers followed suit, and condominiums became a ubiquitous part of the national real estate market. Those home buyers who could not afford a single family home on its own lot could still get in on the real estate ownership bandwagon. Low interest loans backed by the government gave many low and moderate-income wage earners the opportunity to purchase a home. Most people could buy with 5% or no money down. Veterans could buy a new home for nothing down. Condominiums, and their planned development cousins, became the darlings of the real estate industry and they were constructed by the carload.

A huge number of former renters became homeowners due to the massive availability of product and government-backed financing. In fact the decline in rentals was roughly equal to the increase in condo ownership during that period, meaning a lot of renters became owners. An industry, as well as a type of housing, was born. But multi-family developments were not new, even in the Sixties. For over a hundred years, rental apartments provided affordable housing for millions of people in urban areas. What was new was offering these units for sale. That's exactly what condominiums are - apartment units that are sold to individual owners. In every other respect, they are just like the apartment buildings that are familiar to everyone. The big difference is that the maintenance and repair of these condominiums is now the responsibility of the owners - there is no landlord to manage the repairs and foot the bill.

Until the mid-nineties, the flaws in the condominium model were largely unknown. Even though the occasional recession slowed things down for a year or two, the real estate market was hot and price appreciation, especially during the five years preceding 2008, was on fire. The huge real estate “bubble” encouraged more people to move from rentals into condos using low-cost financing. Developers could sell anything that could be built, as fast as they could build it. The real estate market was a party. Buyers were seduced by cheap financing and the promise of unrealistic rates of return. But the expectations and the euphoria went south as we eventually sobered up and found that a lot of those sometimes hastily-built condominiums were racked with not only construction defects, but also suffered from underfunded reserve budgets that left later owners to foot a large repair bill.

If that wasn’t bad enough, the recession that began in 2008 collapsed the condominium market along with the market for other types of housing. A lot of those former renters who were enticed into buying condominiums by low initial-rate financing had assumed a rapid increase in their equity and an easy, profitable, eventual transfer of their interest. Those buyers are now facing unaffordable mortgage payments. With no appreciation to borrow against, they are rapidly falling into foreclosure. “Short sale” has become a term of art. A recent article in Business Week bluntly summed it up this way: "The crux of (the) analysis is that the loose lending practices seen during the housing bubble allowed 5 million renters to become homeowners and the market is in the protracted process of evicting this group."

As we stated in the "Affordable Housing Myth," are we really doing families with moderate incomes any favors by encouraging them to buy housing that is poorly built, expensive to maintain, and very difficult to sell? What benefit is there to saddling low and moderate-income families with impossible maintenance burdens? When we sell housing with hidden defects and even normal maintenance costs that greatly exceed expectations, does the buyer really own anything? More likely, we have asked these families to assume a crushing liability. Given the realities of the economy and the shaky condominium economic model, is attached for-sale housing really the best solution for low-cost housing? Could rental apartment buildings be a better answer?

Young workers have to carefully consider where to invest their spare cash and buying a home may not be their best investment. In fact some writers contend that home appreciation has placed a poor second to stock market performance over the past 20 years. An editorial in the Wall Street Journal states: “Is it wise for coming generations to continue to view ownership as the cornerstone of personal finance? Young people planning for retirement increasingly face a choice between house payments and contributions to retirement accounts. They simply can't afford both.”

Rental housing carries few of these drawbacks. Maintenance and repair costs and the risk of loss in value are borne by the investors. Tenants acquire no equity, but when the impact of the economy and the costs of long-term maintenance and repair are factored in honestly much of the equity in owned housing disappears anyway. A tenant's "investment" in rental housing is liquid. Tenants are free to move out whenever the lease expires--they can't be trapped by a down market. Also the rent on an apartment is usually much less than the monthly outlay to own a similar condominium, when mortgage payments, taxes, insurance, and maintenance assessments are considered. The promise of appreciation is one of the few reasons to pay 10 or 20% down in cash and assume monthly payments that are 50% more than rent on an equivalent apartment. But if the economic forecasts prove correct and real estate appreciation is negligible (or negative) for a number of years, the incentive to purchase is greatly diminished.

For a long time cities preferred owned housing over rentals, especially in a state like California where new for-sale units produce more property tax revenue. But any problem with municipal resistance to rentals is being overcome with the growing realization that more affordable housing must be provided adjacent to transit and jobs. A Los Angeles Times article reports: “The state's population is also skewing younger, meaning there will be more demand for urban rental units and less demand for suburban cul-de-sacs, according to the quarterly economic forecast released Wednesday by UCLA's Anderson School of Business. ‘The incremental demand for housing is moving more into multifamily housing...many of the younger generation have been buffeted by the boom and bust in the housing market, and see value in living closer to work.’"

If all of this is true, what do we do with the existing condominium stock—especially as it ages? For one thing, we should immediately stop any further conversion of apartment buildings to condominiums. There is absolutely no justification for it now and never has been other than profits for converters and higher property tax revenue for municipalities. The only way an apartment building can generate sufficient cash flow for proper maintenance is by maintaining investor ownership valued on rental income. Once a converter has purchased the building and sold the individual units at prices heavily inflated over their value as rental stock they are no longer profitable as rentals, and they cannot generate sufficient cash flow for proper maintenance through individual owner assessments.

Older condominium projects which are less than 50% funded for known future maintenance and which are approaching 40 years old should be carefully evaluated for long-term sustainability. The scope of the typical reserve study as mandated by the California Civil Code and similar regulations in other states, does not account for surprise component repairs until it is too late. Many of these projects are already seriously underfunded, owners will not be able to pass the cost of deferred maintenance on to new buyers as they have done in the past, and lenders will look at high assessment delinquency rates and deny these older projects the palliative financing that has saved them in the past. Many conversions and older condominium buildings will be forced to develop an end strategy that could include reverse conversion or liquidation of the project. The sooner the board begins to understand the problem of sustainability the greater the chance of preserving some owner equity.

Urban apartments, on the other hand, will continue to be much in demand by young workers and professionals. More rental housing could be one of the fastest means to deal with the affordable housing crisis and also provide a new generation of workers the opportunity to live where they work. If they are built properly and in sufficient quantity, apartments could be the condos of the new millennium.