Why do condos even exist?

It sounds like a dumb question – they exist because people like the security of owning a home combined with the services and lower costs that apartments offer, duh! But upon further reflection, condominium-style tenure can be a bit problematic.

The main problem, as I see it, is that a building that’s been carved up into condo units can almost never be redeveloped. So much so that preservationists have been known to cheer on developers doing condo and co-op conversions of historic properties:

Indeed, sometimes preservation advocates look to condo developers as white knights. Since the Bialystoker Center for Nursing and Rehabilitation on East Broadway closed last year, Laurie Tobias Cohen, the executive director of the Lower East Side Jewish Conservancy, has been “extremely eager” for a developer to buy the historic building and convert it to co-ops or condos. The closing of the nursing home was a great loss, she said; the goal now is to prevent the demolition, or further deterioration, of the building. “What we don’t want,” she said, “is to lose any more of the built historic fabric.”

This is no doubt an elegant solution to the problem of unprotected historic buildings, but what about the less-than-stunning condos and co-ops that have been built in the US – and pretty much every where else in the world! – since the end of World War II?

Why are condo buildings impossible to redevelop? Simple: gravity! You can’t keep your apartment on the 17th floor while someone demolishes their 5th floor unit. In Canada, Australia, New Zealand, and Singapore, they call condos “strata” apartments, which reflects what they really are: floors of apartments layered inseparably atop each other. To redevelop a condo or co-op building, you have to buy every single unit, after which you can dissolve the condo structure and own the property in fee simple (i.e., ownership over both the land and the structures on it – the way you own a detached or attached single-family home, or a landlord owns a building). And buying up every single unit in anything but the smallest of buildings is next to impossible.

So in theory, carving a building into condos should diminish its property value. All buildings are depreciating assets (long-run historic potential is too far into the future to matter), but when you own property in fee simple you can replace the buildings on it, ideally with bigger, more valuable ones (although not always “bigger” ones…more on that later). This option basically doesn’t exist for condos and co-ops (which for the purposes of this discussion are the same). One would think that dividing a building into separately-controlled residential condos would be so damaging to property values that nobody would ever do it, and yet, at least in the United States, it happens quite often.

The federal enabling legislation for the condominium form of ownership didn’t actually exist until 1970, when it was enacted for the benefit of Puerto Rico, and not, I believe, because of pressure from mainland developers. There had always been co-ops, at least in New York City (like the Dakota), and I’m not sure if these prewar co-op buildings were ever redeveloped (anybody know?), but they were only for the very wealthy and were much rarer during New York’s unregulated prewar growth period than they are today.

But condos didn’t become popular on the mainland for another 10 years after the 1970 enabling act (remember, the federal legislation was not passed in response to demand by mainland developers), so the oldest condos in American cities aren’t more than about 30 years old. But these are beginning to age – aesthetically, functionally, and density-wise – and I think in the not-so-distant future we are going to begin to feel negative repercussions from buildings that basically can’t be torn down without violating someone’s property rights. (I’ll also discuss later how Singapore does exactly that to get around the problem of a nearly 90 percent home ownership rate in a city-state chock full of multifamily buildings and a culture that has no love for second-hand apartments.)

I should also add that the inflexibility that comes with dispersed ownership in condos and co-ops can be problematic even before redevelopment. I once spoke to someone at a firm that did energy retrofits for prewar buildings in New York who said that even when the return on investment is obvious, it’s sometimes very difficult to get co-op and condo boards to approve the upgrades. But apartment landlords, he said, are much more economically rational, and are therefore willing to invest money when they see the savings. That seems borne out in this NYT article about a highly polluting heating oil used in New York that the city is trying to convince apartment buildings to phase out. It doesn’t mention rentals vs. co-ops/condos specifically, but all the drama in the article revolves around trying to convince co-op boards – not landlords – that it’s in their financial interest to do the retrofit. (I don’t think those sorts of oil furnaces were still around by the ’80s when condos became popular.)

So, back to the original question: why the hell do condos exist?

Though most of the (very smart!) real estate professionals I’ve talked to about it had never thought about it, I’ve read a few theories, and have a few of my own, which I’ll list, but I encourage readers – especially those with knowledge of foreign property markets where incentives and outcomes differ – to chime in. (I’m interested especially in East Asia, where the value placed on new housing is much higher than in long-built out American and European cities.)

So, without further ado, a few possible reasons why condos and co-ops exist…

Tax subsidies. Henry Hansmann at Yale Law wrote a paper in 1991 arguing that condos and co-ops exist mostly for their tax advantages, and that absent these, there would be far fewer. I emailed Henry recently asking if he still believes this, and he was nice enough to respond that he did, but that he hadn’t really kept up on the issue since 1991. But the paper is pretty persuasive, with the caveat (as always) that the math is beyond me. Here’re the first two paragraphs of the paper, which is available as a free PDF:

Twenty-five years ago, cooperative apartment buildings were uncommon in the United States, and condominiums were virtually nonexistent. Since then, however, both forms, and particularly condominiums, have spread rapidly through the real estate market. This article explores the factors responsible for this development. In the process, it also assesses the relative transactional efficiency of consumer ownership and investor ownership in multiunit housing.

I argue that two factors appear principally responsible for the recent spread of cooperatives and condominiums. First is the large tax subsidy to owner-occupied housing that has existed since the Second World War and that has been particularly large during the past two decades. Second is innovation in the forms available for organizing ownership in multiunit dwellings. A variety of considerations suggest that the first of these factors has been more important than the second and that, in the absence of the tax subsidy, cooperatives and condominiums would occupy a much smaller share of the housing market than they do at present. In support of this analysis, this article offers the first sophisticated calculations of the magnitude of the pure tax subsidy to owner-occupied housing, as opposed to rental housing, and of the changes in that subsidy over the past fifty years.

In support of his tax theory he mentions the relative paucity of commercial condos, where ownership is not privileged in the tax code over renting. In fact, I recently worked with a New York City developer who bought and carved an aging postwar skyscraper across from the United Nations into condominiums to market (very successfully, it turned out) to foreign countries for their permanent missions to the UN, specifically because they don’t have to pay property taxes by virtue of their sovereign status, while their landlords do.

Rent regulation. In certain cases it appears obvious that condos and co-ops were created because rental profits were artificially capped through rent controls. This was definitely the case with the massive wave of co-ops that appeared in the ’80s in New York City. Landlords realized they couldn’t make much money renting the units at regulated prices, so they sold them to tenants at unregulated ones. Because the current tenant was the only person they could sell to, the tenant had an unusual among of pricing power (especially in the ’80s, before prices started skyrocketing and, at least I assume, raised the possibility of luxury decontrol so that landlords gained the upper hand), and therefore many got “insider deals” – that is, they bought their apartments as co-ops for less than market value.

I once read – but cannot confirm – that rent controls in prewar Europe had a similar effect on tenure choice in new construction. Rents were regulated but sales prices were not, so many builders (and maybe landlords with already-built buildings?) decided to simply sell the units outright as co-ops or condos (can’t remember which) at prices that were unregulated. Then again, in Europe there is (and was) also the aforementioned issue of restrictive land use regulation, which was introduced earlier than in the US (where the really restrictive stuff didn’t start till the 1960s), so it may have been a factor in encouraging condos/co-ops. (Someone who actually knows what they’re talking about regarding Europe, rent regs, and housing tenure – please validate me and/or set me straight!

Restrictive land use regulation. This is one that I thought of on my own, although I don’t think it’s as solid as the tax subsidies and rent regulation explanations. Redevelopment can only happen if the government lets it happen, and though zoning doesn’t (usually) forbid you from razing and rebuilding, it does often prevent building a bigger structure. Some will eventually redevelop their property even if they can’t raise the square footage, but they’re much less likely to do so. And if your right to redevelop is curtailed anyway by land use regulations (even more so if it’s got historic preservation protection), then you’ll have less compunction about giving it up entirely by carving your property into condos.

Time value of money. Economists dating back to the School of Salamanca have taught that a dollar today is worth more than a dollar tomorrow, and that a dollar in a million years is practically worthless. Redevelopment is by definition far into the future from the time that the developer is making the choice between rentals and condos. The “option to redevelop,” as one developer I spoke to called it, may simply be too far into the future to matter, and especially to overcome the benefits of owning your own home without having to maintain the grounds and, at least in cases where the units are stacked on top of each other (i.e., in an apartment building), without having to pay for your own plot of land.

* * *

While the problem of impossible-to-redevelop condos is most acute in apartment buildings, where you physically cannot redevelop one unit without disturbing the rest, it has also hindered non-stacked condo units. Lydia DePillis (peace be upon her) recently noted an example in DC’s ritzy Logan Circle neighborhood of non-stacked condos, usually found in more suburban locations, that were originally built as affordable housing, but now can’t be redeveloped because the owners can’t all agree to sell. Which is a reminder that condos’ lack of redevelopment potential is not only a problem for a city’s overall affordability and fabric (and aesthetics, in many cases!), but it also really sucks for condo owners who’d like to cash out but can’t because of their intransigent next-door neighbor.

Now onto the case of Singapore. Singapore has highly encouraged homeownership as a means of social engineering (despite its free market bonafides, Singaporean housing policy is highly interventionist), and has been very successful at it: at 87 percent, its homeownership rate is trumped only by former communist countries that simply deeded people’s state-owned apartments to them after the fall of the wall (which I’m sure is going to become a huge problem once Eastern Europeans become wealthy enough to want to redevelop their infamous housing blocks).

But Singapore is also an incredibly dense city-state where the vast majority lives in multifamily buildings, so “homeownership” means owning your own strata unit (their term for a condo, also used in Australia, New Zealand, and Canada). And like all strata and condo buildings, the owners will almost never reach an agreement to sell, so they cannot be redeveloped by conventional means. Combine that with the ugliness of the buildings and the fact that Singaporeans, like all East Asians, place a high value on new homes, and you can begin to see the problem. (Worthwhile to note that en bloc sales were not allowed until a few decades after the homeownership policy took off, and it wasn’t private investors who built the unredevelopable strata towers in the first place – it was the government.)

So to solve it they instituted something called en bloc sales in 1994. The basic idea is that if a certain percentage of a designated building’s residents choose to sell their units (it used to be 90 percent, now it’s 80), then the developer wins the option to buy all the units (including apartments belonging to the “minority owners,” or those who did not approve the sale), which he can exercise at whatever price the supermajority agreed to.

The policy started with buildings that were built by the state-owned Housing Development Board, which is responsible for the vast majority of housing in the city-state, but I was told by Dr. Alice Christudason, an associate professor in the Department of Real Estate at the National University of Singapore, that private developments became subject to en bloc sales with less-than-unanimous consent in 1999 under the “Land Titles (Strata) Act,” which “supersedes any contracts made,” which of course didn’t contain any provision allowing for non-unanimous en bloc sales. (Not sure if newly-built private strata buildings contain any en bloc provisions?)

En bloc sales are very controversial, though (there’s even a TV show about them), and I can’t imagine a non-authoritarian country like the US or Japan tolerating that sort of routine violation of property rights quite the way Singapore does it.

It’s also worth noting that in some ways, a lack of redevelopability can be a positive externality. The ugliness of a 30-year-old condo building next door is mitigated by the fact that it won’t be replaced with a larger one that will take more of your light and air. And if the building is attractive – like the New York City co-ops of the turn of the last century, or possibly 1980s condo towers in the year 2100 (who knows, it could happen!) – then it’s not such a bad thing that it can’t be torn down. A lot of people much smarter than me don’t seem too concerned about the issue: I talked to NYC real estate guru Jonathan Miller about this a few months ago, and his thought on it was that it just contributes to a skyline that reflects all the layers of New York’s history.

But I do think that at some point it’ll become problematic, at least in East Asia. Thirty years from now, for example, is a 90 percent-urbanized China really going to want today’s unattractive, shoddily-built, auto-oriented condo towers marring the skyline and taking up precious land? Authoritarian China may adopt Singapore’s en bloc method of redevelopment, but what about democratic countries like Japan and South Korea that have more respect for property rights? (I’ve been told Japan didn’t have the condominium form of ownership until the early ’70s, but that means the older buildings are starting to become ripe for redevelopment.) Eventually I suppose everything will become attractive in an historic way, but what about the intervening years? (Or am I overestimating the number of condos in East Asia, and they’re actually a relatively rare form of housing tenure in multifamily buildings?)

Update: Here’s an article from March that @graemebone on Twitter sent me about Vancouver strata buildings facing this exact issue, with ballooning maintenance costs being the trigger. British Columbia passed its “Strata Titles Act” in 1966, so they’re facing these issues a few years before we will in the US. Some interesting bits about how they’re just now starting to deal with it:

“There is an implied provision in the Act, which is that if you have more than 10 units in a project, there will be one jerk,” says lawyer Patrick Williams, one of the city’s premier condo-law experts. “One jerk can bring down the whole house of cards, hold everyone to ransom.” Gioventu, from the owners association, is also less than reassuring: “If you live in a 64-unit building, think of those other 63 people you have to sell with as being like your in-laws.”

Until now, those dysfunctional relationships have been tested over familiar stresses: leaks, maintenance reserves, noise, pets, prostitution, grow-ops. Williams knows of just two cases in B.C. where judges have issued decisions on impasses between owners who want to stay and those who want to demolish and sell the land. (In both cases—one a three-owner condo in Kitsilano, the other a larger project in Burnaby—the judges ruled in favour of the owners who wanted to demolish over those willing to keep pouring money into maintenance.)

Even getting to those decisions hasn’t been easy. “The Strata Property Act here is really in its infancy,” explains Williams. Buyers don’t realize how fuzzy the law is when it comes time to shut it all down. It also sets the bar high for how much agreement is needed: 100 percent. Condo owners who can’t get that in their buildings have to go to court—as the Cypress Gardeners have done—to try to get a judge to order a sale. As if that weren’t enough, there’s another hurdle: the institutions that hold the mortgages may not go along with the deal.

And here’s some interesting research on en bloc sales in Singapore, in the same article:

In search of other jurisdictions where condo dismantling is further along, UBC professor Tsur Somerville and a group of colleagues looked to Singapore. “This is where we’re all headed,” says Somerville. They looked at the sales of 285 condo buildings after 1994 (when the government introduced regulations allowing developers looking for low-density properties to tear down and rebuild at higher densities). Their study found that the more units in a complex, the less likely the owners would agree (and the less likely a sale would happen). They found that another factor blocking sales was the difference between the smallest and largest units in a building: where units were similar in size (and, consequently, price), sales were more likely. Buildings that were owned mostly or entirely by investors reached sales agreements more easily. And sales became more likely when Singapore changed its law, reducing the owner consensus needed from 100 percent down to 80 or 90.

All this makes me wonder: why do condos/strata exist in Canada? Were they given tax subsidies similar to those in the US?