Condo Conversions on the Carpet

Is condomania really to be feared? What happens when government limits conversions?

"Condomania," the hottest game in real estate—converting rental apartments into condominiums—has also become a burning political issue. In local skirmishes throughout the nation, public officials are locking horns with building owners and real-estate developers as the temptation to convert properties into condos grows. And behind this official opposition to condomania is the broad support of citizens seriously concerned that condo conversions are quickly stripping renters of housing. Why the current mania for condos, and how big a threat is it to the rental housing supply?

A HOME FOR ALL

Since the end of World War II the nation has been enjoying a move toward universal home ownership. The home has become a symbol of solid citizenship, achievement, and personal security. Rapid inflation and increases in the income-tax burden have served to intensify the demand for homes, adding financial advantages to the more traditional ownership appeal. And government policies have been intentionally biased toward ownership, on the premise that the homeowner represents a socially desirable citizen.

The 1949 Housing Act set as a national goal "a decent home for all Americans." Decent homes became translated into home ownership. Low down-payment loans were made possible by federal programs. New subdivisions were developed in areas opened by expansion of public services, sometimes financed through federal grants. The interstate highway system enabled metropolitan areas to spread over multicounty regions. Generous income-tax deductions served as incentives for home purchase. Even governmental failure to stabilize the purchasing power of the dollar served to induce home ownership, as people discovered the inflation-hedging power of real-estate investment.

For those who, for some reason, failed to respond to these incentives, further pressure was applied. Working primarily at the local level, government began to discourage the supply of rental housing. Among the local actions were rent controls, restrictions on eviction and non-renewal of leases, legitimization of renter strikes, and vaguely worded "warranty of habitability" laws that depress the profitability of the existing stock. To slow down the development of new units, restrictions were placed on site availability in the name of "growth control." In 1976 the tax laws were reformed to decrease the tax shelter available from residential income property.

The very predictable result of these policies was a boom in the demand for home purchases. Ironically, this emphasis occurred at a time when mortgage interest rates were soaring toward historically high levels. The combination of high prices and high interest rates presented a formidable barrier to first-time home buyers.

At the same time, environmental restrictions, tight supplies of building materials, competition for available capital, limitations on expansion of city services, and rising land costs have severely crimped the ability of developers to supply the growing demand for new, affordable homes. The construction of more units with less expense is one way of meeting demand, and clustered housing fills the bill. With the development of condominium law—which allows one to own a living unit outright while sharing the necessary outerstructure and associated facilities—individual ownership of apartment units, townhouses, and other forms of clustered housing is feasible. As lenders have grown more comfortable with this legal innovation, condominiums have flourished.

But the development of new units, even smaller structures on smaller land parcels, has not kept up with the exploding demand for homes. (The "baby boom" generation is now passing through the family formation phase.) Many rental projects have been found suitable for conversion to condominiums, often requiring only filing the necessary legal papers. Even where physical modifications are required, conversion provides a much less costly alternative to new construction.

As a consequence, conversion activity has boomed. During the latter 1970s the number of units converted annually in the United States doubled each year, from 20,000 in 1976 to 135,000 by 1979. Many tenants in converted projects have taken advantage of the opportunity to become homeowners, while building owners have made substantial capital gains. And entrepreneurs undertaking the risks of conversion have reaped handsome profits.

This heightened activity, however, aroused the suspicions of public officials. The condominium market, largely spawned by various governmental policies, came to be widely viewed as a serious threat to the nation's poor and elderly. According to this scenario, tenants were being deprived of their homes, a situation requiring governmental action.

CONTROLLING CONDOMANIA

Concern for the supposed victims of conversion has resulted in legislation in many states and municipalities. These laws range from establishing a set of protective measures for the tenant during the conversion process to an outright moratorium on activity. The protective measures generally include some combination of the following:

• Notice of conversion: Tenants must receive a written notice informing them of the impending conversion and its consequences on their continued occupancy. Such notices must be given from 60 to 270 days before actual conversion takes place, depending on the state or city.

• Right of quiet enjoyment during conversion: Converters are limited in the extent of construction activity allowable while the tenant remains. Also, access to the unit for the purpose of showing it to prospective buyers is restricted.

• Minimum sales to existing tenants: A certain percentage of existing tenants must agree to buy their units before the conversion is approved. In New York, for example, a converter has two options. He may file an "eviction plan," which requires purchase agreements from at least 35 percent of existing tenants. Nonpurchasers may then be evicted according to the prevailing rent-control laws (which may allow continued occupancy for up to two years). Under the "noneviction" option, the converter needs purchase agreements from only 15 percent of the tenants but may not evict nonpurchasers. The majority of New York conversions are accomplished under such plans.

• Purchase option to tenants: Tenants are provided a "right of first refusal" for a limited period of time, generally 30 to 120 days. The unit may be purchased by a nontenant only after this option has been waived or allowed to expire.

• Relocation assistance: A few states require converters to provide financial and technical assistance for tenants who must vacate.

• Antiharassment: Converters are barred from using tactics designed to provoke tenants to move.

The strongest response to conversion activity, however, is the moratorium. Moratoria are always proposed as a temporary measure, providing the authorities time "to study the impact on the community." They are also intended to prevent a rush to convert at the hint of impending legislation. A permanent moratorium would be subject to extensive lawsuits over the taking of private property without compensation (which still exists, more or less, as a constitutional safeguard).

Temporary moratoria, of course, can always be extended to allow for proper deliberations. And after the termination of a moratorium, a set of very restrictive procedures often follows. Some examples:

• A high percentage of sales to current tenants may be required, such as in the New York eviction plan.

• A minimum vacancy rate in the rental housing stock may be established, below which a conversion moratorium may be reimposed or extended.

• A quota may be set on units allowed to be converted, based on the number of new rental units constructed.

• A converter may be required to provide a percentage of units for purchase or rent by low- and moderate-income individuals. Alternatively, the converter may have to contribute to a fund to be used for producing such units.

While a number of local governments attempt to hold would-be converters at bay, Congress has also been tempted to join the battle on the side of tenants. The Senate-passed version of the 1980 Housing Act defined a need to take action at the federal level to stem the crisis of a "disappearing" rental stock. Apparently sensing that the issue is controversial and not worth jumping into, however, Congress ultimately deferred to state and local authorities.

If conversion is to be stopped, it will be up to state and local politicians to do the job. But before state and local lawmakers carry out their work, perhaps the very premise of the controversy should be examined. Should condominium conversions be stopped or even slowed? Does conversion threaten to make rental housing extinct? Moreover, are tenants victimized by conversion and therefore deserving of special protection?

OVERLOOKED EFFECTS

To answer these questions, we should first examine the effects of condominium conversions within the housing market. Objectively viewed, conversions have a number of positive effects:

• They increase the stock of housing available for home ownership. Moreover, this increase also adds variety to the type of housing available: condominiums are generally smaller and often less expensive than single-family homes, and converted units may be more conveniently located than newly constructed condominiums.

• Conversions increase the aggregate value of the housing stock. The value of converted units is often much higher than that of the unconverted buildings, even when minimal physical transformation takes place.

• Conversions generally upgrade the social character of a neighborhood, often coinciding with the revitalization of older urban areas. Transient renters are replaced with more stable homeowners who have a financial stake in the neighborhood's future.

• Conversions promote a higher level of maintenance. This reflects not only the converters' efforts to improve the marketability of the units but also the future behavior of resident-owners to protect their investment.

• Conversions enhance the appreciation outlook of all rental buildings with conversion potential. This essentially reduces the risks of owning residential rental property. Without this option, apartment owners must look toward rental income for the bulk of investment return. Therefore, rents may actually be higher when the conversion option is precluded than in an unrestricted market. The increased risk may also adversely affect the level of new construction.

From the foregoing, we can begin to gauge the effective costs of conversion restrictions: fewer opportunities for home ownership, lower overall housing values (reflecting an inefficient allocation of housing resources), greater obstacles to neighborhood revival, less upkeep, and higher rents.

Though much citizen opposition to condo conversions appears to focus on the profits derived by converters, it is the home ownership and neighborhood-up-grading effects that seem to inspire most official opposition to conversions. The framers of conversion restrictions fear that rental housing will eventually disappear should conversion go unabated. There is also concern that low-income and elderly tenants are being brushed off in favor of affluent home purchasers.

Despite years of enacting laws restricting the rights of landlords and keeping multifamily housing developments out of respectable neighborhoods, local governments have now concluded that it is the condo converter who is cutting off the supply of rental housing. With conversion profits so high, reason local officials, what will stop the movement before rental housing becomes extinct?

OVERCOMING CONDOPHOBIA

What is the biggest threat to the rental supply: conversion activity—or the combined activities of public planners, code enforcers, rent controllers, and tenant-rights advocates? The effects of restrictions are ubiquitous. According to Roger Starr, writing in a recent issue of The Public Interest:

Since World War II, in the local-government jurisdictions of the United States, housing legislation has extended government's supervision over rental housing.…[T]aken all together, they have imposed obligations on landlords that are extremely difficult to meet in the normal course of business.…[T]he potential for arousing caution on the part of prospective builders/owners and their bankers would appear limitless.

In fact, conversion is one response to such debilitating restrictions.

Nevertheless, people do fear that the conversion of, say, a 20-unit apartment building to condos will reduce the supply of rental housing by 20 units, in the face of high demand for rentals. How realistic is this fear?

The Department of Housing and Urban Development (HUD) addressed this and other questions in a nationwide study of condo conversions. Published in the fall of 1980, the report (The Conversion of Rental Housing to Condominiums and Cooperatives) reviewed all 366,000 conversions that took place in the 10 years beginning with 1970.

What happens when a unit is converted, HUD found, is usually one of three outcomes. The converted unit may be bought by the person who had been living there as a tenant. In that case, although there is a reduction of one unit in the supply of rentals, there is also a reduction in demand by one unit—the buyer is no longer in the rental market. A similar thing happens if the unit is bought by a former renter in some other building. In purchasing the converted unit, the buyer removes a rental unit from the market, but by moving out of his old apartment, he frees up that unit for some other renter. Once again, both supply and demand for rentals have decreased by one unit. What if a "speculator" buys the converted unit? In this case there is clearly no loss of supply, since he is buying the unit not as a residence but as an investment; it remains on the rental market.

Altogether, transactions of these three types predominate when conversions take place, HUD found. The net effect was that, out of every 100 units converted, there was a net reduction in supply relative to demand of only five rental units. In other words, 95 percent of all condo conversions did not alter the supply/demand balance for rental units.

Furthermore, although conversions have picked up steam at a rapid rate in recent years, converted units still represent a tiny proportion of the rental housing stock. Even though the number of conversion has been doubling each year, according to the 1980 HUD study, all the units converted in the 1970s accounted for only 1.3 percent of all rental housing units. A conversion moratorium, therefore, would hardly be the salvation of rental housing.

OBSERVING THE MARKET

Some argue that the conversion movement is in its infancy, that the vast financial advantages of conversion will assure its burgeoning growth—like a cancer, it will grow wildly if allowed a foothold. But this argument assumes that the entire rental stock sits as an inviting target for converters.

The reality is that there are two very real market constraints on continuation of conversion activity. The first is a supply-side constraint: all buildings are not suitable for conversion. In fact, very few are appropriate. The HUD study estimates that only 5.5 percent of the 1977 rental stock represented prime conversion prospects; another 5.4 percent were marginal; and another 9.4 percent could be converted with significant rehabilitation. Several hot conversion markets, such as those in Chicago and Houston, are already slowing down due to shortages of readily convertible stock. Even assuming economic incentives were strong enough to convert all these units, the large majority of buildings would be untouched.

The second constraint is on the demand side. Home ownership, even with all its financial and psychic advantages, is not for everyone. There will always exist a market for rental units, even among the affluent, because of the mobility and freedom from responsibility offered by renting. And among those aspiring to home ownership, a good proportion lack the ability to purchase. That proportion is likely to grow as mortgage interest rates remain high.

Even within the group who are willing and able to purchase housing, only a fraction will opt for a converted apartment unit, no matter how convenient or luxurious. Although tastes have been changing gradually, the vast majority of would-be homeowners continue to favor the detached, single-family house.

Considering these factors, it seems somewhat overwrought to forecast continued exponential growth in conversions sufficient to absorb all rental housing. More than likely, the trend will be barely noticed in terms of impact on the aggregate housing stock. The numbers are simply too limited.

Unquestionably, conversions are beneficial to owners of rental units, converter-entrepreneurs, and unit purchasers. The HUD study profiled the typical condo-conversion purchaser. Nationwide, compared to homeowners generally, the people who bought converted units were young, of modest income, often single, and more likely to be minorities—exactly the people otherwise frozen out of home buying. About one-half were 35 or younger, and 57 percent were single. In fact, single women constituted the largest group of condo-conversion buyers—36 percent (compared with only 10 percent of all homeowners nationwide being single women). Some 61 percent of all households purchasing converted units earned less than $30,000. And about 10 percent of the new owner-occupants were black (compared with only 7 percent of all homeowners nationwide).

TENANTS AS VICTIMS

But what about the tenants who cannot afford to purchase the converted unit and must move out? Aren't they unfortunate victims who should be given protection? The HUD study surveyed these people, too. Although half of them had some difficulty finding new housing, only 18 percent ended up being "adversely" affected—either by finding lower-quality housing for the same rent or the same quality at higher rent. Furthermore, 90 percent of all former residents told HUD they were satisfied with their new housing; this is about the same degree of housing satisfaction expressed by those who moved into the converted units.

Even though the tenants' plight has been greatly exaggerated, many people continue to feel the government should intervene on their behalf. Such intervention is an attempt to create tenants' rights that go beyond those established by the standard lease agreement. In other words, since the tenant has committed himself to the property by the act of taking up residence, he is entitled to some authority over what happens to it.

However much a tenant feels he has committed himself to a property, his legal obligation extends in fact only as far as the lease term. For a lease arrangement to entitle the tenant to a voice in the disposition of the property or to provide a renewal option of indefinite duration, would require much more compensation to the owner.

Security in one's place of residence is a prime attraction of home ownership. It is true that the requirements for purchase are beyond the reach of many tenants, especially the elderly on relatively fixed incomes. As noted earlier, this is an unfortunate outcome of government policies that consciously and unconsciously encourage home ownership. The problem is not greed on the part of property owners and converters. Their access to large profits simply reflects rapid changes in the housing market, specifically, the expansion in home ownership demand. To "protect" the supply of rental units through conversion restrictions is to create a shortage of housing for first-time home buyers.

So the tenants' quarrel is not with the building owners or the converters. They are merely agents for the scores of young families anxious to reserve a seat on the home ownership bandwagon. To argue the tenants' cause, then, is to say that tenants are a special class who deserve governmental protection from the forces of inflation at the expense of those who attempt to build for their future. The issue, however, is rarely presented in this manner. To paraphrase a central point made by Henry Hazlitt in Economics in One Lesson, the aggrieved tenants are visible, while the deprived condominium buyers are easily overlooked.

ZERO-SUM GAME

The issue of conversion restrictions essentially pits tenants threatened with displacement against aspiring condominium buyers in a zero-sum confrontation. Might there be alternatives that work for the benefit of all groups involved while still protecting the rights of property owners?

It appears that the real tenant problem is the sudden disruption, introduced by conversion, of an expectation. The tenants, in many cases, fully expected their rental units to remain available indefinitely, not merely to the end of their current leases. The possibility that they could not renew the lease was so remote it deserved no consideration. Consequently, they never concerned themselves with ensuring against such a possibility. There are options, however, that allow tenants to provide themselves with more security.

• Negotiate longer-term leases. Tenants who do not need the mobility offered by the rental arrangement should seek a longer-term lease, perhaps five years or longer. Landlords may be reluctant to agree to such terms, but probably can be persuaded by a higher rent or some fair-handed rent-indexing method (such as providing automatic annual rent increases based on changes in the Consumer Price Index). Of course, long-term leases also commit the tenant to the rental unit, but most landlords will release the tenant from the lease if the tenant locates an acceptable tenant to take it over. A short-term lease with a renewal option is another alternative.

• Arrange a sale-leaseback with an investor. This is, in effect, a third option to the buy-or-move decision faced at the time of conversion. The tenant agrees to purchase the unit and finds an investor who simultaneously purchases the unit and leases it back to the tenant. The tenant remains in the unit, although probably at a higher level of rent. This option is especially feasible when converters offer tenants discounted prices in exchange for a buy commitment. (The Wall Street Journal reports that in New York a secondary market has developed for tenant options in conversions.)

• Organize a tenant-sponsored conversion. When nothing else works and conversion is imminent, this may provide an alternative. This option, however, is the most difficult and does not achieve the objective of allowing the tenant to avoid purchase. But it does offer the possibility of retaining the unit.

All of these alternatives force tenants to accept a greater level of responsibility. They reject the "tenant as victim" approach characteristic of conversion-restriction programs. As such, they are consistent with the principle that in a free society, individuals should accept responsibility for their personal decisions and well-being.

Condominiums are an important innovation in housing, especially as housing costs soar. Conversion of rental units represents a basic upgrading of the housing stock, often in locations that are in the greatest need of an uplift. These benefits, however, go largely unnoticed as both the public's and officials' attention focuses on the plight of a relatively small number of inconvenienced renters.

But it is on this limited view of the current condo craze that public policy is decided. So while conversion-restriction policies may appear to protect some renters, all the other players—owners, would-be buyers, and other renters—lose in the long run.

Jack C. Harris is an assistant research economist at the Texas Real Estate Research Center of Texas A&M University. The opinions expressed in this article are the author's and do not necessarily represent the viewpoint of the center.