Sunday, April 20, 2008

More Real Estate Trouble in the Condo Market

My neighborhood, the River North area of Chicago, has seen an explosion of condominium developments over the last decade. Loft buildings and business warehouses were the first to be converted, and then purpose-built high rise condominiums began to populate the neighborhood. While Chicago likely isn’t at the same frenzy level as South Beach in Florida, we certainly have a vast overhang of unsold and in-process condominiums on the market right now. Below you can see some of the recent construction (not all condominiums, a lot of it is office space) including the Trump Tower (on the left) as well as other developments. The "beige" building in front has a forlorn "Condos" sign at the top.

Today I was reading the Sunday Chicago Tribune real estate section when I noticed an article titled “Credit Getting Even Tighter for Condominium Buyers”. If you own a condominium and are interested in its value or are consider buying a condominium I strongly suggest that you research this issue in greater depth.

The first issue is regarding mortgage insurance or “PMI”. “PMI” is typically needed when buyers (or individuals refinancing their existing loans) don’t have 20% equity in the unit. According to the article:

“AIG United Guaranty… no longer will write coverage on condos in hundreds of ZIP Codes that it designates as “declining” markets. Applicants’ credit scores, assets or equity stakes don’t matter; Even in the healthiest real estate markets, United Guaranty will require buyers to put at least 10% down and will reject applications in buildings where more than 30% of the owners are investors.”

I don’t know how widespread this issue of not issuing PMI is across other insurers but it clearly is an important element in many markets; if other insurers follow this lead then many buyers will be effectively shut out of the market if they can’t put 20% down.

The second issue is that Fannie Mae, the government backed mortgage insurer (along with its cousin Freddie Mac) has issued new underwriting requirements that loan officers are required to verify before it will take the loans (i.e. without their approval they are non-conforming loans and command a higher interest rate, if you can get one at all). Per the article, loan officers will need to verify the following:

-Association operating budgets must have at least 10% of their dues going towards deferred maintenance or capital improvements

-The percentage of owners late on their payments

-The percentage of space allocated to commercial development

-The percentage of units owned by investors (who presumably rent out the units)

While all the criteria aren’t listed, it is safe to assume that there will be percentage measures for the above items and if these percentages are breached then the loans will not be considered confirming by Fannie Mae which is bad news for potential purchasers, since this drastically reduces the odds of getting a loan at all (much less one at a good rate). Per the article:

“Even if you had an 800 FICO score and put 50% equity down you still might not be able to get a condo loan” per one broker.

You can also see that Fannie Mae is trying to shift the underwriting and due diligence efforts back to the loan originators. They are required to legally stand behind their analysis and presumably will be subject to court action if the claims turn out to be false. At a minimum, this will result in much more paperwork as the loan officer will have to pore through condominium documents in order to do the analysis prior to going forward with the loan. I am only speculating but likely the loan officer won’t even bother unless there are enough units potentially for sale to make it worth his / her time – for example if you have a ten unit building why spend hours on analysis plus the legal risk when the same work would allow you to make loans on a 100+ unit building?

While these items will immediately impact those that are trying to refinance and those interested in buying a condominium in the near-term, there is a significant underlying impact on the owners of existing condominiums. Elementary supply and demand says that when demand is taken out of the market (buyers not able to qualify for loans), the price of the remaining supply will fall.

Beyond the "general" market impacts of this change, these items will likely impact the weakest developments the hardest. For example, if you are in a development with a high percentage of renters, you are likely to be banned from PMI and confirming Fannie Mae loans which will seriously impact your ability to sell your units, and for the developer to sell off their remaining units. At this point the project, which is likely teetering on the edge of bankruptcy anyways, falls over entirely and then you are stuck in a miserable process where an overworked bank tries to figure out what to do next. Do they finish the building? Do they sell it off as-is to another developer? If you are in a unit waiting on the developer that is a bad place to be, because you can't sell since no one in their right mind would buy from a bankrupt developer except at the most fire-sale of prices.

I don't want to sound too apocalyptic but this seems to be a terrible blow to the condo market, especially in the hardest hit areas which are already teetering on the edge of mass bankruptcies (which push units out into the market at fire sale prices, thus damaging everyone else's unit values in the process, and causing more marginal borrowers to fail).

Also note that this is your government at work - Fannie Mae and Freddie Mac, the government sponsored entities that are supposed to promote home ownership (especially in times of crisis, like now) are pulling up the rug on a whole swath of projects and leaving everyone involved in dire straits, so that they can limit their losses and thus earn more profits.

Cross posted at Chicago Boyz

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