I was skeptical of the condo boom before many others. Actually, I was too skeptical too soon, not realizing that there really are lots of people who want to live in dense urban housing. But when the sky filled with cranes, I became even more skeptical. Now that everyone KNOWS condos are overpriced, I’m wondering if perhaps they aren’t.
I put pencil to paper doing a pro forma on a condo investment purchase. For an example, I used the new John Ross building in Portland, because it’s brand new and known not to be selling too well. I grabbed the first five condo for rent listings on Craig’s list to estimate rental income of $1.57 per square foot. I grabbed the first five condo for sale listings to learn that asking prices are $411 per square foot, with HOA fees of $0.34 and taxes of $0.36. I ignored insurance and assumed occupancy 95% of the time. I used 3% for inflation of rents, taxes, and HOA. Mortgage rate assumed to be 6%, which is probably light for an investment property these days.
Even with 20% down, the property would not cash flow any time soon. But it doesn’t take too much price appreciation on a leveraged property to earn a good return on cash:
Price appreciation averages per year 5-year average return
0% -2%
1 4
2 9
3 14
4 18
5 22
For perspective, the long run average price appreciation of single family homes in the Portland area, before the boom (1976-2002) was 6.1 percent per year.
I guess the market isn’t that crazy after all. The big risk, of course, is that prices tumble 10 or 20 percent early on. In that case, you would have to longer than five years to get out with a nice gain. For example, let’s say you bought, then the price fell 20% in one year. After that, appreciation resumed at the historic average. You hold for 10 years you get an 11% internal rate of return on your cash. That’s pretty low for the level of risk you’re taking, but at least you come out whole. If the property value was just back up to purchase price by year 10, then the IRR is zero; early year cash losses are balanced by later year positive cash flow.
Would I buy? No. I don’t think the expected return is high enough for the risk one is taking. Key to understanding that issue, for the average person (rather than investment fund) is the relationship between real estate and the stock market in terms of risk. Read this old post to learn more about that.