Why Are Condo Prices So Much More Volatile Than House Prices?

I have been searching for investment properties lately and recommending them to investors. Currently I have been focusing mostly on condos and townhomes. Questions I get a lot are, "Why do condo prices fall so much more sharply than house prices?" or, "Aren't they more risky?" The short answer is yes, they are more risky, if one measures risk by price volatility. Classic market theories do equate volatility with risk, however, no one really minds volatility to the upside, only volatility to the downside. I thought I would use this post to explain why I don't mind this volatility and why, at this point in time, I think it is a good thing.

Graphed above is an illustration I drew of real estate market cycles (click on the graph for a bigger version). Please don't draw too many conclusions from the exact size of the peaks and valleys, it is the relative sizes that matter. The left side of the graph is what I believe happens in a normal market cycle. The graph is normalized to a property's value as a rental property based on discounted future rents. A good way to think of these curves is as price/rent curves with the red line being the typical price to rent multiple for apartment buildings. Apartments tend to trade at or around this value, providing the owner with a fair return roughly equal to the market discount rate.

Houses, unsurprisingly, sell at a premium valuation. There are two main reasons for this. 1) Homeowners enjoy significant tax benefits that aren't available to renters and landlords. 2) The freedom to own your own home, not worry about rent increases or the owner deciding to sell, paint and make desired alterations all have a real value to homeowners which is reflected in the premium valuation. High end homes tend to trade at a greater premium due to the higher tax benefits and a relative lack of demand for renting high end homes that do come on the rental market. Most renters aren't willing to pay a lot more because of granite countertops and expensive moldings and wall coverings.

Condos are a bit of a hybrid. Their basic design and amenities are not significantly different from an apartment, but they allow the tax benefits and freedom of personal ownership associated with a house. Condos tend to be purchased by both owner-occupiers and by investor-landlords. In a hot housing market, the marginal buyer of a condo is an owner-occupier who place a premium on those tax benefits and personal freedoms that is similar to the premium places on houses. Many people purchase condos in hot housing markets because they can't afford a house. In a hot market, these buyers bid up condos until they trade near the price/rent multiples found on houses. However, when the market cools, demand tends to dry up for condos first. As demand falls from owner-occupiers, the marginal buyers become the investor-landlords who enjoy fewer tax benefits and place little value on the freedom to decorate and make upgrades. Consequently, in a bear real estate market, condos trade at price/rent ratios similar to apartment buildings. Thus, you can see the condo curve on the graph oscillates between the low tier house curve at the top of the market and the apartment curve at the bottom of the market.

Now, back to that question about risk. Yes, condo prices are more volatile than single family house prices. However, it is important to know where you are in the real estate cycle when you are looking to invest. Right now, the price/rent multiple on many condos and townhomes is at or below the price/rent ratio on similar quality apartment buildings. This signals we are close to the bottom of the bear market in condos. At this point in the cycle, the next leg should be the market recovery and on this leg volatility is your friend. Over the course of the next cycle, which tends to run eight to ten years, condos should appreciate faster than houses as owner-occupiers begin to return to the condo market.

Now, this isn't going to happen overnight, but when buying at current multiples the rents you collect significantly exceed your monthly costs, providing a very good cash flow return on your investment. So you get paid to sit and wait for the eventual recovery.