condo arbitrage

In the comments of a recent post a couple of us speculated on the ins and outs of flipping behavior in new condo pre-sales. in today's seattle times, Jane Hodges, writes a timely article that throws some light on the local situation--which, it seems, pits developers and builders against flippers. according to Hodges:

- flips create competition for the builders' unsold units
- flippers are more likely to walk away from the purchase before closing
- high percentage of flippers decreases the perceived value of a building
- high percentage of flipping creates a false sense of demand

i've been wondering about the flipping angle with increasing disdain for flippers. as a new resident of the cosmo, i must say that i am bothered by the feeding frenzy of the pre-sales sort. however, my disdain could very well be misplaced.

as a former house owner, i'm aware of the fix-and-flip phenomenon. an "investor" purchases a house, does some remodeling, and then flips for a profit. although there is certainly a range of quality in the fix-and-flip improvements--from sketchy to really good--the flipper is typically adding some value along the way.

in pre-sales condos, however, flippers only seem to extract value from the eventual consumer who ends up residing in the unit. here's where i think i may be misplacing my disdain. i think what we are seeing is a form of condo arbitrage. while arbitrage typically occurs with currency and other financial instruments, the basic premise is the same-- "arbitrage is the practice of taking advantage of a price differential between two or more markets." in this case the two markets in question are the market available to investors and the market available to consumers (by consumers i mean residents).

so the questions are, a) why is there a price differential? b) who has access to pre-sales? and c) the benefits of flipping come at whose expense?

the price differential comes from the appreciation of a property during the 18-24 months between the time you lock in the price and the time you close. there is also risk to purchasing a pre-sales unit, if for example the value depreciates causing you to close for more than it's worth on the open market. theoretically, pre-sales are open to anyone who asks for an appointment or makes a reservation to select a unit. pre-selling creates a pre-construction market and a post-construction market.

if we consider this from the standpoint of arbitrage, the flipper would seem to be adding value to the system, if not to the property itself. by exploiting the market differential they are accelerating the onset of an arbitrage equilibrium. with arbitrage, this would eventually tend to bring prices from the two markets into parity. but will this really happen with condo flipping?

two mechanisms are discussed in the times article; the investor cap and the contract addendum. as we see with the large number of re-sale listings at 2200 and the Cosmo (currently 36 and 39 respectively), investor caps seem to have had little bearing on the situation. a contract addendum that prevents resale until some period of time after closing could dissuade some flippers, but to whose benefit?

Hodges says: "Some argue that the discrepancy between who makes money — the builder or the investor — is hardly sympathy-inducing, as both parties are motivated by profiting from a marketplace where housing can be hard to find."

in the short-term it would appear that the flipper benefits at the expense of the consumer/resident. but once the flippers are squeezed out of the process, where does the excess value go? back to the developer? to the consumer? or simply to a smaller set of flippers?