Where have all the condos gone?

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Time was, not so long ago, when condominiums were the default homeownership option for people at opposite ends of the age spectrum — those starting out and those winding up.

To young people, condos offered a path to ownership at a lower price than a conventional single-family house. For older folks, they were an efficient way to exchange their labor-intensive (think lawn mowing and snow shoveling) suburban manse for a dwelling that was efficient and less costly to maintain.

These days, however, new condo developments have become as rare as Bactrian camels. In the Twin Cities metro, where apartment complexes are rising out of practically every vacant piece of land, you can count the number of condo complexes under way on the paw of a three-toed sloth. You heard right — I found only three. Stonebridge Lofts, a 164-unit luxury project on 2nd Street South near the Mississippi River in Minneapolis; ParkSide, near Shelard Parkway in St. Louis Park with 22 units ranging in price from $169,000 to $399,000; and Regatta Wayzata Bay Residences in downtown Wayzata, a complex with 59 units priced from $450,000 to $2 million.

Those paltry numbers present a dramatic contrast when you put them alongside the condo totals for the Twin Cities a decade ago. In 2004, Minneapolis had 1,900 units under construction and 2,700 proposed. In St. Paul, 980 were being built with 775 in the planning stages, and in the suburbs some 2,300 units were on the rise.

So what happened?

For starters, there was the traumatic collapse of the housing bubble in 2008. During any downturn, condo prices usually drop more drastically than single-family houses, and this time was no different.

Previously, says Caren Dewar, executive director of Urban Land Institute Minnesota, a nonprofit land use and real estate development organization,”people were buying anything.” Young condo owners figured — incorrectly — that prices would continue to rise, allowing them to sell and trade up to a single-family house. Instead, prices dropped, and owners saw their equity disappear, leaving them unable to move. The retirement crowd, for their part, couldn’t sell the houses they owned; ergo, they couldn’t buy condos, no matter how much they lusted for indoor swimming pools and underground parking.   

Renters can walk away

Younger buyers came to see ownership as risky. “People discovered renting,” says Dewar. A condo with an underwater mortgage keeps its owner stuck in place. A renter, however, can walk away without penalty. And under the cold light of analysis, it became clear that homeownership wasn’t exactly an investment bonanza. From 1994 to 2009, the value of homes in 10 cities rose by 4.7 percent annually. That’s a real return of only 2.2 percent after inflation. Sinking one’s entire net worth into a house started to look a bit stupid.

“It became way cooler to rent,” says Dewar.

Maybe so, but in survey after survey, most Americans still affirm that they want to own. And, insists Arthur Nelson, director of the Metropolitan Research Center at the University of Utah and author of “Reshaping Metropolitan America,” “there’s been no change in preferences for condo opportunities.

In fact, demand is pretty high — at least for the few projects now under way in the Twin Cities. Stonebridge already has commitments for 75 percent of its units, even though it won’t be finished until April. ParkSide has sold nearly half of its units, and Regatta Bay has only 36 left even though it may not be ready for occupancy until early 2015.

Condo building should be booming, but, says Nelson, very odd financial and regulatory quirks are choking off development.

Financing is a huge obstacle. After bingeing on condo projects during the bubble, banks suffered a bulimic reaction when the market collapsed. Now they’re gorging on financings for apartment developments.

“They always react to the last crisis,” says Phyllis Baumann, professor of real estate law at Northeastern University in Boston. “The next crisis might be a glut of apartments.”

Post-bubble requirements

Banks might overcome their condo nausea, says Nelson, were it not for post-bubble requirements exacted of condo developers by FHA, Fannie Mae and Freddie Mac, who are the largest bundlers and resellers of loans for multifamily projects. For condos to be eligible for a Fannie Mae-insured loan, developers must presell 70 percent of their units. (The threshhold used to be 51 percent.) Freddie Mac adopted a similar guideline in 2010. The FHA requires that 30 percent of the units be presold and that at least half of a building’s units belong to owners who occupy their units, and that no more than 10 percent be owned by a single investor.

Banks are following the agency rules, which, Nelson says, are “crude and insensitive.” They were designed to correct excesses that occurred in the markets that overbuilt the most during the housing bubble, for example, Miami, Las Vegas and Phoenix. “The FHA is using a sledge-hammer,” he insists. “There’s no reason why the requirement shouldn’t be calibrated to reflect conditions in the local market, why Minneapolis and St. Paul couldn’t have a 25 percent requirement.” As things stand now, says Nelson, “the agencies are depriving whole segments of the population” of dwellings they might want to buy.

The presale requirement spells delay for developers. To hit the 50 percent threshhold may take six months, says Mary Bujold, president of Maxfield Research, a Minneapolis real-estate research consultancy. That’s on top of all the two years or so needed for financing, construction and everything else. Pre-construction buyers would have to make a purchase commitment 30 months ahead of moving in. “It’s hard to get presales that early,” Bujold says. “A lot of people don’t want to wait that long.”  

Long-tailed liability

Would-be condo developers have an additional concern: a Minnesota law that holds them — and as of 2010, their subcontractors — responsible for major construction defects for 10 years. Usually, the condo board sues the general contractor. But large projects may have dozens of subcontractors, any of whom might themselves be sued by the general contractor. The result is expensive and lengthy multiparty litigation.

Jocelyn Knoll, chair of the construction and design practice group at Dorsey & Whitney, in a Power Point presentation, observed that condo developers face potential direct liability for a long time. In one case, REC, Inc. developed an Edina condo project in 2002. A buyer who purchased a unit in 2005 discovered “water intrusion” in 2007, and the condo board sued in 2009. So in theory, though the condo developer had completed work in 2002, s/he was still on the hook for damages seven years later.

It’s uncertain just how much litigation has occurred as a result of the law, but the mere whiff of lawsuits is enough to discourage banks from financing condos. What’s more, says Knoll, contractors are trying to mitigate risks by obligating developers not to permit new mutifamily construction to be used for condos. To protect themselves from lawsuits, she adds, contractors either have to buy costly insurance or somehow build the risk into their prices.  

The condo shortage may not change much in the next few years. With hundreds of apartments coming on the market, rents may drop, further discouraging ownership. On the other hand, if demand drives up condo prices, developers might decide to try to overcome all the obstacles to reap heady profits.