It is a fact: there has not been much investment activity in the downtown Austin condo market. Most of the buyers plan to occupy their units. As we reported last week, this is one of the reasons why Austin is less likely to see a Miami-style bubble explosion anytime soon.
There are lots of reasons why investors have stayed away: anti-flip provisions in contracts, credit issues in the mortgage markets, special deed requirements for renting, etc. One likely reason that has not received much attention is that investors may not stand to earn much money in the current condo market.
Let’s say that you purchase a 1,200 square foot unit in a new building for $400 per square foot. Your unit would cost $480,000 and you would likely need to put up at least 10% — $48,000 — early in the construction process. If you are like many real estate investors, you would likely finance 80% of the purchase price to take advantage of cheap real estate financing. By taking loans, you can increase your total return by buy speading your cash across multiple properties .
Since restrictions would likely prevent you from flipping the unit until after construction is complete, you would have two choices: either trying to earn money by flipping the unit once no-flip provisions have expired, or by holding the unit for a longer period of time. By holding the unit, an investor would hope to capture rental income during the short term and capital appreciation over the long term.
Here is the problem, downtown Austin rental rates won’t cover the costs of the unit. Let’s review the math:
Monthly Revenue Received From Renter
$2,700 (Rent @ $2.25 / SF)
– $ 540 (20% Allowance for unrented months / leasing costs)
$2,160 Total Income
Monthly Costs Paid by Owner:
$1,920 (Interest-Only Mortgage @ 6%)
$ 504 (Condo Association Fee @ $0.42 / SF)
$ 878 (Monthly Property Taxes @ $2.20 / $100 Assessed Value)
$3,302 Total Costs
Monthly Loss from Renting: – $1,142
So, on a $480,000 unit, an invest-and-rent strategy would likely loose $13,704 per year on a $96,000 (plus fees) cash investment: a rate of return of (-)14.3%. In order to break-even on paper, a unit would need to appreciate at 2.5% per year. While this is possible, that just gets the investor to break-even, which is not a very exciting return. One important thing to note is that the economics change over time for investors that plan to hold for a decade or more. While mortgage payments stay level, and may even go down if the owner refinances, rents will likely continue to rise over time. Although property taxes and condo association fees also rise, they are only 40% of the cost equation in the first year.
But that’s not all! If you are buying a unit in a new project, you will likely have to put money down –$48,000 in this case — at least a year before project completion and sometimes even earlier. This money doesn’t begin earning a return until a renter occupies the unit, adding to the start-up costs required to invest in a downtown condo.
Finally, one more issue for investors is that the Austin condo market is new. Nobody knows what the demand will be for the planned supply of units. It is a market that doesn’t exist today, and there is always a risk of under or over-building. For investors, returns must be weighed against the risks of the individual investment. Since market uncertainty raises the perceived risk, investors will only put money on the table if they believe that they can achieve an appropriately high return.
These economics explain why there has not been much of an investor market for downtown condos. At this time, it is important to note that these economics don’t really apply to buyer who plan to live in their units. For one, the economics of buying are very different as mortgage interest and property taxes are fully tax deductible. In addition, buyers get value out of their owner-occupied unit every month that they live there without the costs of finding and keeping renters.
These economics are not permanent, three variables can change the math at any time. If prices go down, rental rates go up, or interest rates go down, the economics can look very different. In the current market, rental rates are going up as interest rates continue to drop, making investor returns more attractive everyday. While construction costs are unlikely to drop significantly, oversupply could possibly lead to a drop in purchase prices. More likely, new unit costs will continue to inch upward. So if you are thinking of investing and can get the right deal, it may be possible to make the numbers work.