Real Estate Investing Basics

Thinking About Investing in a Condo? Stop! And Read This First…

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A friend who happens to also be a business partner in one of my non-real estate ventures reached out this week with a question. He does this from time to time, seeing as I am such a big shot real estate expert and all…

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This time, the text read: Hey, Ben – how about this condo…?

This was worth a telephone call. He needed to understand a few things!

Two Basic Reasons to Buy Real Estate

There are only two reasons to buy real estate – cash flow and capital gain. Cash flow accomplishes the objective of financial freedom, which is defined as capacity to generate income outside of W2/1099. Equity, on the other hand, builds the balance sheet, which makes us rich. No big, earth-shaking discoveries here…

Related: NO, Condos STILL Aren’t Good Real Estate Investments!!

Why Condos Are Problematic

Indeed, condos are problematic with respect to both of the stated objectives. First, by and large, condos don’t appreciate as much as free-standing single family residences. Also, the cash flow can be unpredictable…

While there are obviously exceptions to the rule, mostly this is true, and there is a good reason for this:

Condos have an extra cost of ownership, which most houses do not — the condo association fee. Let’s remember that a lot of what drives values of owner-occupied real estate is availability and affordability of credit, which is to say the more people can afford to borrow, the more they will pay. Consumerism galore.

Well, when qualifying folks for mortgage loans, banks underwrite two metrics: the Debt to Income Ratio (DTI) and the housing expense ratio. I haven't looked at the exact percentages in a long time since they are not pertinent to my business model, but essentially you are permitted to spend only a certain percentage of your income on all of your combined expenses, not including the debt service on the mortgage loan that you are applying for. And that new mortgage payment can't inflate your total DTI above a certain percentage more.

Therefore, since your income is what it is, the crux of the matter relative to how much you can borrow is a function of expenses. Obviously, anything that adds to the expenses has the effect of diminishing the amount of P&I that your DTI can absorb…

Guess What?

Condo association fee is an expense, is it not? If your DTI permits your total hosing expense to be $1,200/month, then without a condo association fee, you’d be able to borrow the full amount of mortgage, resulting in PITI of $1,200. However, if there is a $275/month association fee, then since your total housing expense has to remain at $1,200/month and since taxes and insurance are what they are, you now must compress the P&I to result in lower debt service by $275/month. Well, crap…

Such is the logic. There are caveats, exclusions and intricacies that apply. If interested, please do further research. But since prices are set by what ready and willing buyers can afford to pay, which in a lot of ways is a function of what they can borrow, hopefully this explains why valuations of condos are structurally compressed.

So What’s the Problem?

The problem is that we want two things in a real estate investment – cash flow and equity appreciation. The condo association fee compresses appreciation of equity, as we just discussed. And since rents on most condos are not higher than rents on SFRs, but there is this additional and often substantial expense, the cash flow objective is also problematic indeed.

We have many “wants” when it comes to our investments, but there is only one “must have” — control, and this is perhaps the biggest issue with condos. The association fee will go up in tandem with CapEx, and unless you have substantive vote on the committee, you won’t be able to avoid paying.

Importantly, as that fee goes up (while the building is aging), your rents will likely not keep up. There’ll be newer and better amenitized condos in the marketplace by then. Ouch.

increase-noi

Related: Should You Buy a $30,000 Condo?

So, these will get cheaper, and investors will start buying more and more of them… because investors often think that cheap is good. Guess what? When there are too many investors in a condo development, the banks lose appetite for providing mortgages to investors, which completes the spiral cycle, and when you are ready to refi and bridge the equity, you may not be able to.

Conclusion

There is but one strategy that works well with condos, but that’s beyond the scope of this article. All and all, there are some serious problems with condos. Be smart!

[Editor’s Note: We are republishing this article so our newer members can weigh in!]

Investors: Do you agree? Disagree? For those of you who HAVE invested in condos, what has your experience been?

Leave your comments, stories and tips below!

Ben has been investing in multifamily residential real estate for over a decade. An expert in creative financing, he has been a guest on numerous real estate-related podcasts, including the BiggerPockets Podcast. He was also featured on the cover of REI Wealth Monthly and is a public speaker at events across the country. Ben is the creator of Cash Flow Freedom University, the author of House Hacking, and a noted Multifamily Underwriting coach. Through his company, Source Capital LLC, Ben currently operates $40M of multifamily real estate. Learn more about him at JustAskBenWhy.com.
    Justin Smith from Charleston, SC
    Replied almost 4 years ago
    While I’ve found everything you’ve outlined in your article to be true, and there are even a few more downsides I can think of not mentioned (and several upsides), I still net about 1-2 K average per month on my short term rental condo that I’m all in on for 100K. This has been an easy and lucrative entry into real estate investing and certainly will be for others in the right market as long as you can find a way around the non-warrantable condo issue.
    Hyacinth Dolor Investor from Bridgeport, Connecticut
    Replied almost 4 years ago
    Great post In my experience, if you’re looking to invest in condos get all the numbers. Get to knowing someone in the complex or the complex board you’re interested in. A newly developed complex is way better to invest in than one that’s over 15 years old. Assessment will come sooner than later and try not to invest in a complex that have vacant lots near by. Most likely it’s going to be developed and the current complex will have to upgrade to keep up with the competition thus imposing new assessments. In CT most of the condos are good cash flow until you get upgrades or assessment. Our last condo sold for double what we paid within 5 years 80-170k.
    Scott
    Replied almost 4 years ago
    I am a small part time real estate investor and have owned condo rentals for 7 years and treat them as income producers…don’t really expect appreciation. There are years where I haven’t had a single expense receipt. This is never the case with SFH plus the time requirement of maintenance. Also insurance is less than half and taxes are lower. SFHs have more sq footage and seem to have more consequences of of rental occupants lack of care.
    Whitney Tutt Investor from Mableton, Georgia
    Replied over 3 years ago
    I was recently against condos due to HOA fees and rental restrictions. However, I have recently discovered some condo neighborhoods with no HOAs and the homes still look okay. So I am definitely interested in these, however, I will not invest in a condo with an HOA. Too may risks involved in my opinion. Increasing of HOA fees and what if when I’m ready to sell, the neighborhood has reached its rental cap? OR the neighborhood is not accepting FHA or VA loans. These are all situations I’ve ran into recently when viewing properties. I can’t afford these type of stipulations when I get ready to sell and definitely do not want to have to deal with increasing HOA fees. I love having an HOA for my primary residence but will stray away from it for my rental properties.