It’s so often repeated that single-family homes (SFH) appreciate faster than condos that it’s taken for gospel. But that’s not the story the numbers tell lately. If you're thinking about purchasing a condo vs a home purely for investment reasons, you might be surprised to learn that you would've made out with more money if you'd bought a condo in 2011. According to data from Trulia, Realtor.com and the S&P, condo prices have increased more than single-family home prices since 2008. This is in large part driven by a shift towards urban centers and a multi-year shortage in starter homes. Yet condos come with their own risks. More than any other type of property, condos were at the heart of the 2008 housing bubble. We’ll cover what deal-breakers to watch out for to avoid repeating history.
What Is a Condo?
A condo is a form of ownership where members own the building jointly. Aesthetically, condos look like apartments. The key distinction between the two is: whereas you rent an apartment, you own a condo. When you buy a unit, you own the title to the interior “space” of your unit, not the land beneath the unit. This would be logistically impossible since condo units tend to on top of one another. Some people say that because you don’t own the land underneath, the condo doesn’t appreciate as much in value. However, the data tells a much more complicated story.
Myth: Condos Do Not Appreciate as Much as SFHs
Trulia compared the appreciation rates of condos versus SFHs from 2012 to 2018 by tracking millions of properties in the 100 largest metros. The result? Condo market values rose by 38% on average, while SFHs “only” increased by 28%. The data team at Realtor.com found a similar trend. Parsing through listing data from 2011 to 2016, they discovered that the smallest properties actually appreciate the fastest. Homes smaller than 1,200 sq. ft. appreciated 7.5% a year for the past five years, while homes bigger than 2,400 sq. ft appreciated 3.8% a year. According to Realtor.com data scientist Yuqing Pan, millennials and baby boomers are the driving force behind the demand for smaller homes. The former is looking for affordable starter homes, and the latter is looking to downsize. We also pulled data from the Case-Shiller national housing index. This ubiquitous index tracks the month to month growth of real estate prices by comparing repeat sales of the same properties. You can see that condo prices increased faster than SFH prices in all five major cities we looked at New York, San Francisco, Chicago, Los Angeles, and Boston. Remember that real estate is hyper-local. So while the trend persists in large cities, we can’t say that condos unilaterally appreciate faster than SFHs everywhere. For example, while the coastal areas of Fort Lauderdale have bounced back from the downturn, many homes in the urban core are worth less than they were more than a decade ago.
The Condo Bust of 2008
There is a dark side to investing in condos: they are more vulnerable than single-family homes to speculation and housing bubbles. Condos were at the heart of the real estate bubble leading up to the 2008 financial crisis. When researchers at the National University of Singapore found that condo loans originated in 2006 are 12% more likely to default within two years than single-family loans. They analyzed millions of loans originated during 2003–2007 in the US. Mocked in The Big Short as the poster child of the condo boom and bust, Miami exemplifies what happens when overeager buyers and developers flood the market. In late 2008, at the peak of the crisis, there were over 100,000 properties for sale in Miami alone. A big reason that condo buyers are more likely to default than homeowners is the former purchase units as investments while the latter purchase units to live in. When the mortgage goes underwater, investment buyers no longer have a financial incentive to stay current on their loan.
Investment Properties More Likely to Default
When you shop for condos, look for buildings with high owner-occupancy rates. In other words, make sure most of the owners actually live in their unit rather than rent it out. In the years leading up to 2008, buyers who purchased their condos as investment properties were 30% more likely to default than buyers who purchased a condo as a home. In 2007, at the peak of the cycle, condos purchased as investments were 88% more likely to default than single-family loans. On the other hand, condos that weren’t purchased as investment properties were 19% less likely to default than single-family loans. Manhattan condo prices performed the best of all the boroughs in New York and saw the lowest defaults. The reason? The condos are primarily an owner-occupied in the city. If history is any indication, condos are more vulnerable to speculative bubbles. “Condos are like the canary in the coal mine. They are the first segment of the market to dive when conditions weaken,” says John McClellan, a branch manager with Supreme Lending in Austin, Texas. If you do buy a condo, make sure it is not primarily owned by investors, but rather by people who live in the units themselves.
Reasons Why Condos are a Good Investment
Caution is always a good thing when it comes to making a big purchase. But there are a few data backed reasons that this time around, the appreciation in condos we are seeing is driven by solid market fundamentals.
Shift to Urban Areas
More people are moving to cities which offer better job opportunities in our information economy. This drives up condo prices because condos are more prominent in densely packed areas where land is very expensive and developers build up instead of out. According to Census data, 25 to 34-year-olds were 10% more likely to live near a city center in 1980. They were 32% more likely in 2000, and 51% more likely in 2010.
Low Housing Inventory in Cities
A decade after 2007, housing unit growth remains below 2007 levels in almost all states, according to 2018 Census data. Cities, where condos are heavily concentrated, are suffering the most from the housing crunch. Apartment List released a 2018 report that found that housing simply hasn’t kept up with employment. Unsurprisingly, downtown areas had the least supply available. For example, since 2010, the Bay Area has created 722,000 jobs but built only 106,000 housing units. Denver, another city grappling with growth, added 3 new jobs for every new housing unit. Denver rents increased by 52% between 2005 and 2015. It’s not just the coastal cities that are affected. Smaller cities such as Boise, ID, Reno, NV and Jacksonville, FL are also in a housing crunch, as evidenced by skyrocketing rents. In Boise, there’s demand for more than 10 times as many homes as the city is building, according to an analysis from the Department of Housing and Urban Development.
Starter Homes Aren’t Affordable
Many buyers are scooping up condos because they can’t afford traditional starter homes. Starter home prices have risen for years. According to Trulia, starter home prices are up 14% from 2018. If you’re hoping for a nice two bedroom, two baths, be prepared to shell out 41% of your income, up from 34% a year ago. The soaring prices are a simple matter of supply and demand. In 2017, the number of starter homes for sale declined 16% from the previous year. This sharp decrease has flattened somewhat in recent years, with starter home inventories down “only” 2% in 2019. But we are still hurting for inventory. These economics mean that starter homes are now out of reach for most. The situation is pushing buyers to either look at condos or continue renting. A buyer in Washington DC explains, “While buying a condo as a rental property is not an ideal real estate investment due to HOAs, shared expenses, and condo associations, they are the most attainable properties for me at this stage.”
Higher Lending Standards
Easy credit fueled the condo boom leading up to 2008. Fortunately, banks have since tightened their lending standards. This round of condo buyers is much more creditworthy than their predecessors. At the peak of the bubble, banks were issuing “liar loans” which didn’t require any information from borrowers, other than their credit score. That changed when the real estate bubble burst around 2007. Condominium foreclosures put Fannie Mae into a downward spiral. Reeling from losses, Fannie and Freddie put out new lending requirements for condominium purchases in 2009. Fannie will only purchase condo loans where more than half of the condo units are owner-occupied. They will not purchase mortgages in buildings where 15% and more of owners are delinquent on association dues. They also stipulate that one owner cannot own more than 10% of the units. In fact, Congressman Barney Frank (one half the team behind the Dodd-Frank Act which regulated Wall Street after the 2008 financial crisis), actually petitioned Freddie and Fannie to loosen their lending standards because he felt they restricted credit too much.
Condo Association vs HOA
One important factor to weigh when considering when choosing between a condo and a house is whether you want to deal with a condo association. It’s worth noting that single, detached houses can also have HOAs. HOAs are common in California and Florida and rare on the east coast. But condo associations have much more authority and control over your property than HOAs. That’s why it is an important risk factor to consider if you’re thinking about investing in condos.
Your Neighbors' Finances Affect You
When you own a house, you only need to worry about your mortgage. However, in a condo, your neighbor going into foreclosure directly affects you. Despite never missing a payment for her unit in a glassy Miami condo tower, Barbara was still negatively affected in 2008 because her neighbors, on the brink of foreclosure, stopped paying their association fees. With one in six residents going into foreclosure in her building, the remaining owners had to cover an extra $1,000 assessment (on top of their $450 maintenance fee). Adding insult to injury, it was now impossible for Barbara to sell her unit. Even buyers who wanted to scoop up her unit couldn’t line up financing, since lenders, reeling from the recession, wouldn’t underwrite loans to buildings with a high percentage of missed association payments.
Can't Rent Your Unit Out
Even though you own the unit, there's no guarantee that your association will let you rent it out. Some associations like to make sure that at least half the units are owner-occupied, which is in line with Fannie’s lending requirements. If 3 out of 6 units are already rented out, the association can refuse to let you rent since that would push the owner-occupied percentage below 50%. Other associations ban renting outright.
Want to make extra money renting out a room on Airbnb? Forget it. Most condo bylaws prohibit short-term rentals. They stipulate "under no circumstances can a unit owner permit unit to be used for a hotel or transient purposes." Even if you are currently allowed to rent, the association has the power to change this at any time. Colorado lawyer, Douglas Hsiao faced this situation. He rented his Dupont Circle condo for 18 years, but in 2012, the association wanted to ban renting. After two hours of debate, the association doubled the monthly rental fee but decided to allow him to continue renting out the unit. Hsiao says, "The outcome was not perfect, as it will put me deeper in the hole on my cash flow, but I felt some relief that something more drastic did not pass which may have effectively required me to sell my apartment."
Financing a Condo versus Financing a Home
The downside of stricter lending standards is, financing a condo is more difficult than financing for a house. Getting an FHA or VA loan is particularly difficult. When it comes to condo loans, it’s not just your finances and credit score that matters. Lenders care about the financial health of your building. Condos that don’t meet Fannie and Freddie’s requirements are deemed unwarrantable. You can still get financing through small, local banks who are portfolio lenders (this means they don’t try to sell their loans to Fannie and Freddie).
There isn't one answer to the age-old condo vs home debate. Condos get a bad rap since they were responsible for a disproportionate percentage of defaults in 2008. But we challenge the conventional wisdom that condos are worse investments than houses. The migration to urban areas, low housing supply in cities, and lack of affordability of traditional starter homes are three driving forces behind the demand for condos. Those demographic trends won’t reverse anytime soon. However, owning a condo comes with its own minefields. Rental restrictions are going to be a dealbreaker for some buyers. Units in buildings with a high percentage of renter-occupied units (as opposed to owner-occupied units) are more likely to default than detached homes. That's why it is imperative buyers do their due diligence.