Reflections on a Crisis, or the Case Study of a Condo - Conversion Fallout

Just two or three years ago, some of the hot products that we could offer as affordable housing were these condo conversion communities, so popular in Miami and Broward counties.

There seemed the best deals available; the developers provided assistance by offering office space to loan officers from mortgage companies and banks, so they could directly assist their buyers in securing the loans.

These were the happy times of the 100% financing, with developers assuming all closing costs, countless "incentives" such as paying off the first six months or the first year of condo maintenance fees, "upgrading" the converted condos with stainless steel appliances, redoing the floors, the cabinets, you name it.

The condo conversions are basically rental properties with a few or hundreds of apartments, which are bought by a developer. Going through legal procedures, making some required physical work on the property, would allow the investors to change the legal status of the rental community from one property to many independently owned "condominium units".

Starting around 2000/2001, this was one of the hottest markets for builders and real estate investors. Properties bought at an average of $ 60,000 or $70,000 per unit, (this is just an example), would be sold at prices hovering in the $ 200,'s to $250's and even more. Commissions paid to real estate agents were attractive and everybody seemed quite happy with the situation.

Key elements were the organizations put together by the developers to market and sell their products, as well as the surprising complacency of the lenders.

Buyers seemed happy. Buyers signed the developers' contracts giving a small deposit, which often left no room for mortgage contingency after 30 days. But in general, everything moved smoothly and new homeowners were happily occupying these units by the thousands.

Everybody thought that it was a wonderful way of "accomplishing the American dream of home-ownership". This went on till about the end of 2006, dragging through the first months of 2007.

Fast forward to November 2008. I get a call from a prospective client who wants to be shown a condo. I review the listing and find out that it is situated in a condo conversion in Pembroke Pines, which was fairly popular at the height of the "bubble". In 2006, a two-bedroom unit at this community was selling at around $250,000.

The prospective buyer pointed out three more listings in the same complex. All four units are short sales or bank-owned foreclosures. I set up the showings and meet my client at the place. I notice immediately a profusion of signs on many units: mainly AUCTIONS posters, foreclosure notices, real estate "for sale" signs.

It looked like almost everything there was for sale. I show the condos and in many of them, close to the back doors, small ant's mounds were the sign of blight and abandon. Some of the units hadn't been occupied for months, as evidenced by the state of carpets and bathrooms.

The area is convenient; the general condition of the buildings is good. So what's wrong?

The actual asking prices varied between around $ 90,000 to $ 110,000. After talking to the listing agents, I have the impression that they hadn't received too many offers and my feeling is that these places could go for as low or even less than $ 80,000.

That's about a third of what they were selling a little more than two years ago. Unbelievable? Not quite. That's the point.

Who can afford these modest $80,000 homes? Traditionally, and as per the criteria of Fannie Mae, somebody whose family income hovers in the monthly gross $3,000. (No more than 28% of the gross income can be dedicated to pay for the monthly mortgage, insurance, taxes) When they were valued at $250,000, this monthly income should have been in the $7,000. Otherwise, buyers could have been in trouble sooner or later.

But nobody was paying attention, apparently

And this is the real problem.

People who can only afford $80,000 homes, living in $80,000 homes, but having to pay $250,000 mortgages.

Consequences? Many choose to run away. Not only because they feel cheated, but because they make just enough money to pay for an $80,000 home.

Did you get it yet?

Weird? As in most business transactions, when somebody loses, somebody else wins. Let's analyze this.

The real winners:

- Investors, who purchased large rental properties and converted them to condos at the beginning of the "boom", sold them very quickly, with high profits. Often after some basic improvements, and large amounts of paperwork, they would convert rentals previously valued at 60 or 80,000 dollars, into units that sold at $ 200,000 and more. These apartments were giving a fair return on their investments to their previous owners, who grabbed the chance to cash on the valuation of their property after many stagnant years.

- Other winners: Mortgage brokers, mortgage bankers, appraisers, who got fat fees and commissions.

In the second and third round of this "bubble", things gradually changed. Developers started to increase their commissions to attract realtors, frantically arrange easy loans, and put together all kind of creative "incentives."

Those developers who moved fast managed to sell out. The rest was stuck with a large percentage of their condos, and then their financing banks started to worry. The last phase was fairly recent: banks foreclosing on developers of dozens of properties, or at least on the high percentage of unsold units.

Of course that due to many different situations I cannot generalize and simplify. Many appraisers, realtors, mortgage brokers, banks were the beneficiaries while it lasted. They had cooperated with these savvy developers who made most of the profit.

The big losers?

- Those homeowners who had bought and walked away, leaving the bank to foreclose on their mortgages, experienced an irreparable damage to their credit that will compromise for a long time their ability to purchase again a home.

- Real estate investors, who bought properties, hoping to get rich by "flipping" in the short term. Many of them let the banks foreclose. They have paid for sometimes the mortgage, the taxes, and the maintenance fees. At a certain point, they have given up. - The banks and mortgage lenders, of course, who will recover only a small percentage of their loans. - Fannie Mae, Freddie Mac and other GSE's who bought these mortgages.

- The buyers of all the bonds and other real-estate-related financial instruments; which could be foreign banks, a hedge fund, a sovereign-fund from an oil-rich country, or a Singapore investor.

Who is guilty?

- A key element was the acceptance by lending institutions of unreasonable increases in appraisal values, which had no basis other than speculation. Nothing can explain that a home built 30 years ago increases 300% in value in a two-or-three-years period. Nothing can validate it.

Of course that the process fed on itself, causing inflationary building costs, but this was not at all sufficient to justify the incredible raise in the appraisals. Banks took the word of appraisers for granted, ignoring common sense.

It was enough that two properties in the same neighborhood had sold at unusually and speculative high prices to allow an appraiser to use them in his "comparative analysis". And from then on, every house in the area could automatically be the beneficiary of a new value based on this "analysis", and so forth.

Banks would not object on the evident fallacy, and loans kept originating at a maddening pace. Buyers who had never saved a penny for a down payment, were granted homes they couldn't afford, thanks to negative-amortization loans that would let them live in their new homes for a couple of years, until the inevitable happened.

Naturally, mortgage brokers, lenders agents, everybody, would go along and perhaps encourage these appraisals. What about these "no-income-verification" loans? Did anybody doubt that they could sometime become the perfect instrument of deceit, fraud, and misrepresentation?

Complicity? Collusion?

How many objections did we hear from Fannie and Freddie, the most expert institutions in the US? on this matter? How many voices of reason from Wachovia, Countrywide or Bank of America? Their executives were perhaps too busy showing their shareholders their prodigious short-term balance-sheet results, and cashing their even more prodigious bonuses, while ignoring the fundamentals.

It was a vicious and unending circle of madness, which results we are living now.