Condo Conversion as an Exit for an Apartment Syndication: When the Math Works and What Can Go Wrong
On this page
A condo conversion turns an apartment building into individual condominium units and sells them one at a time, usually to people who will live in them. The owner records a condo declaration under the state's condominium act, which legally splits the building into units plus common elements owned together through a homeowners association (HOA). Then the owner renovates, gives tenants whatever notice and purchase rights state or local law requires, and sells units as they are ready. As an exit strategy for an apartment syndication, it works only when the sum of the unit prices, after all sell-out costs and carry, beats what the building would fetch as an apartment building today by enough to pay for the extra time and risk. In the illustrative example below, a 40-unit building worth $8,000,000 as rentals nets about $8,480,000 through a two-year conversion, a margin that disappears if unit prices come in 10% lower.
This post is part of our guide to real estate syndication. It covers how a conversion works, how to test the math, the risks, the tax point and what investors must be told. State condo law varies a lot, so work with a real estate attorney in the building's state from the start.
How does a condo conversion work?
- Check the law first. Read the state condominium act and any local conversion rules. Some cities require permits or approvals, cap the number of conversions, or restrict them in rent regulated buildings. See rent control laws for apartment investors.
- Prepare the legal documents. A survey and plats or plans of the units, the condo declaration, bylaws for the HOA, a budget and a reserve study. Many states also require a disclosure document (often called a public offering statement) delivered to each buyer, and some require the developer to register the offering with a state agency before selling.
- Handle the tenants. Depending on the state and city, tenants may be entitled to advance written notice, the right to stay until their lease ends or longer, relocation payments, and a first right to buy their unit or, in some places, the whole building. Washington, DC's Tenant Opportunity to Purchase Act is one well known example of a purchase right. Missing a step can stall or void sales.
- Renovate. Most buyers expect owner quality finishes. Systems such as roofs, plumbing and electrical matter more now, because unit owners will hold the HOA responsible for them.
- Record the declaration and sell units. Each sale is a separate closing with a separate buyer and, usually, a separate mortgage. Unsold units can stay rented while the sell-out continues.
- Turn the HOA over to owners. The developer controls the HOA board at first. State law sets when control passes to unit owners, often once a set share of units is sold.
When does the math work?
The core comparison is the net from selling units against what a buyer would pay for the whole building as apartments today. Apartment buyers price the building on its rental income (see how to sell an apartment building). Condo buyers price each unit against other homes for sale nearby. A conversion makes sense when the second number is much higher than the first, which tends to happen where home prices are high relative to rents.
Here is an illustrative example: a 40-unit building worth $8,000,000 today as apartments, with units expected to sell for an average of $300,000 over 24 months. Carry is net of rents collected from units not yet sold. The figures are an example, not market data.
| Line | Base case | Prices 10% lower | Sell-out takes 36 months |
|---|---|---|---|
| Gross unit sales | $12,000,000 | $10,800,000 | $12,000,000 |
| Renovation and conversion work | −$1,600,000 | −$1,600,000 | −$1,600,000 |
| Legal, survey, declaration, reserve funding | −$300,000 | −$300,000 | −$300,000 |
| Sales commissions and closing costs (6%) | −$720,000 | −$648,000 | −$720,000 |
| Tenant relocation and incentives | −$200,000 | −$200,000 | −$200,000 |
| Net carry (interest, taxes, insurance, HOA dues on unsold units) | −$700,000 | −$700,000 | −$1,050,000 |
| Net from conversion | $8,480,000 | $7,352,000 | $8,130,000 |
| Versus selling as apartments today | +$480,000 | −$648,000 | +$130,000 |
In the base case the conversion earns about 6% more than a bulk sale, but two years later and with far more risk. A 10% miss on prices turns it into a loss compared with selling today, and a slower sell-out takes most of the gain. That is why experienced converters look for a wide gap between unit value and rental value, not a thin one. Run the same test you would for holding versus selling: the conversion is a new investment of today's net equity, and it needs to earn enough for its risk.
What are the risks?
- Market timing. Units sell over months or years. Mortgage rates, local home prices and the number of competing listings can all change before the last unit closes, while the building's loan keeps accruing interest.
- Absorption. Every month a unit sits unsold adds carry. Lenders on conversion loans often require a share of each sale to pay down the loan, which can leave little cash for investors until late in the sell-out.
- Construction defect liability. The developer typically gives buyers warranties, and many states imply warranties by law. After turnover, the HOA can bring claims for roofs, leaks or other defects, sometimes years after the sale. Insurance for this is specialized and can be hard to get.
- Handing the HOA to owners. At turnover, owners take over the budget and reserves. If dues were set too low to look attractive, or reserves are thin, expect disputes and possibly claims against the developer.
- Buyer financing rules. Most buyers need a mortgage, and lenders check the condo project, not just the buyer. Fannie Mae's Selling Guide, for example, requires the lender to determine that a project meets its eligibility standards before delivering a loan on a unit, and treats new and newly converted projects differently from established ones. FHA has its own condo approval process. Too many units still rented, too many owned by one entity, thin reserves or pending litigation can make units hard to finance.
- Rental restrictions. If the plan is to keep unsold units rented for a while, check how the declaration, state law and lender rules treat investor owned units, and what happens to existing leases when units sell.
- Securities issues in the sale. Selling units with a rental pool or a promise to manage them for the buyer can turn the unit sale into a securities offering. Ask counsel before offering buyers any rental arrangement.
Why is a conversion a different business?
Holding apartments is a rental business: lease, collect, maintain, report. A conversion is development and retail sales. The sponsor manages a construction project, a sales team or listing broker, dozens of separate closings, buyer lenders, an HOA and warranty claims. Income shifts from steady rents to lumpy sale proceeds. The team that runs an apartment building well may not have done any of that. Investors are right to ask whether the sponsor or a partner has.
The tax point: dealer treatment
Gain on selling an apartment building held for investment is generally capital gain, with depreciation recapture taxed separately (see depreciation recapture). Selling condo units to buyers can be different. The tax code excludes from capital assets property held primarily for sale to customers in the ordinary course of a trade or business (26 U.S.C. 1221). Subdividing, improving and selling many units can make the owner a dealer, so the gain may be ordinary income, and a 1031 exchange is generally not available for property held for sale. The facts matter: how long the building was held as a rental, when the intent changed and how the sales are run. Some sponsors look at structures that separate the rental period from the sell-out. Get a CPA involved before deciding, because the answer changes what investors take home.
What investors must be told
If a conversion is a planned or possible exit, the offering documents should describe it plainly. See PPM risk factors. At a minimum:
- The business plan, including that the exit may be a sell-out of units rather than one sale, and the expected time to sell.
- Legal steps and approvals still needed, and tenant protections that could delay or limit the plan.
- Construction, defect liability, HOA turnover and buyer financing risks.
- That distributions may be uneven or paused while sale proceeds pay down debt.
- The possible tax character of the gain, including ordinary income, and that investors should consult their own tax advisers.
- Any extra fees the sponsor or affiliates earn on unit sales, and who the listing broker is.
- What happens if the conversion stalls: hold as rentals, sell in bulk, or sell some units and keep the rest.
Changing the business plan to a conversion after closing is a material change. Check what the operating agreement requires, and see syndication exit strategies for how exits are usually described.
How DoorRaise fits in
DoorRaise helps sponsors raise equity to buy apartment buildings with 5 or more units from their friends and followers, in 506(b) and 506(c) deals. A building bought and run as apartments, with a conversion described as one possible exit, fits that. DoorRaise does not sell condo units, list them or act as a real estate broker, so the sell-out itself is work for your broker, attorney and title company. DoorRaise forms the deal's LLC, prepares the offering documents, files Form D and verifies every investor's accreditation. Investors fund by wire into escrow at Enterprise Bank & Trust. After closing it runs the investor side: quarterly distributions from the deal's bank account, investor updates and K-1 delivery (the deal's accountant prepares the K-1s). DoorRaise charges two flat fees: $1,500 to set up (non-refundable) and $5,000 a year for administration, the first year paid at closing from the money raised and only if the deal closes.
See how sale proceeds would be shared with the free profit split tool.
FAQ
What is a condo conversion?
Turning an apartment building into condominium units by recording a condo declaration under state law, then selling the units one at a time, usually to people who will live in them.
When does a condo conversion make sense for investors?
When the net from selling units, after renovation, legal costs, commissions, relocation and carry, beats today's value as apartments by enough to justify the extra time and risk.
Do tenants have rights in a condo conversion?
Often. Depending on the state and city, tenants may get advance notice, the right to stay through their lease or longer, relocation payments and a first right to buy. Some places restrict conversions.
Why does buyer financing matter?
Most unit buyers need a mortgage, and lenders review the whole project against their standards. A project that does not qualify can sell slowly or only to cash buyers.
Is the profit from selling condo units capital gain?
Not always. Selling many units to customers can make the seller a dealer, so the gain may be ordinary income. Ask a CPA before you plan the exit.
Can I switch to a condo conversion after I buy?
Possibly, but it is a material change to the business plan. Check the operating agreement and tell investors before you commit.
Sources
- 26 U.S.C. 1221, capital asset defined (Cornell LII)
- IRS Publication 544, Sales and Other Dispositions of Assets
- Fannie Mae Selling Guide, B4-2.1-01, General Information on Project Standards
- SEC, Investor.gov: investor bulletin on private placements under Regulation D
This article is general information, not legal, tax or investment advice. The example figures are illustrative. DoorRaise is not a real estate broker, lender, law firm, broker-dealer, investment adviser or funding portal.