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Debt & Equity Journal
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June 27, 2005
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| CMBS WATCH:Are Condo Conversions Loans To Risky For CMBC? |
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| Erika Morhy |
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New York City � Condo conversion loans have been increasingly capturing an ever-larger part of the underlying collateral of CMBS deals. Moody's Investors Service noted this phenomena earlier this year, along with the observation that a growing number of condo conversion loans are being included in commercial real estate CDOs.
Now a new Fitch Ratings report underscores the potential risk in this trend. It's not a total surprise that such loans are headed into CMBS deals. As Moody's points out, these loans offer comparatively higher spreads. Then there is the fact that the condo conversion market itself is red-hot. In 2004, according to statistic generated by Real Capital Analytics Inc. and cited by Fitch in a new eyebrow-raising report, the total volume of apartments purchased for condo conversion reached $13.3 billion in 2004, a whopping nearly 350% increase from the previous year. But in this report,
The Condo Conversion Market: Heating Up or Over-Heated?, Fitch worries about some of these loans included in CMBS transactions, believing that they are riskier than traditional CMBS loans. Condo conversion loans have an element of construction and renovation risk and the properties do not generate a sustainable in-place cash flow,
Fitch said. Also, several of the markets are overheating with speculative buyers, creating an overinflated sense of demand. �Assessment of these risks, as well as conversion stage risk and market risk, is paramount in determining the treatment a condo conversion loan should receive in a CMBS transaction,� the Fitch report states. Still, while some aspects of the Fitch findings are clearly true, many industry participants take a more nuanced, slightly more sanguine view of these loans and their role in CMBS.
For starters, while it may be a growing trend, many institutions are not very enthusiastic about securitizing condo conversion loans in the first place�often for the reasons Fitch cites.
�Many of these loans are not made to be securitized,� says Andrew Oliver, managing director and head of the capital markets group at New York City-based Sonnenblick-Goldman. �Instead they are being held on the balance sheet by lenders.� Those loans that are being securitized, Oliver says, are likely the most conservative or senior pieces. �
I see CMBS lenders doing these loans but not securitizing them,� he says. �There is too much flexibility needed for future funding, so securitizing them often does not work.� One case in point: GE Commercial Finance. The institution has been making a lot of condo conversion loans�but they are floating-rate debt kept on the books, says Dan Smith, senior vice president for North America debt. �These properties are in transition and tend to be short-term in nature so there is not a lot of profit to sell them,� says Smith.
More controversial was Fitch's finding about the health of the underlying loans themselves, a warning that many developers and brokers are applying to other projects and other firms. Fitch expects approximately 10% of condo conversion loans originated in 2005 to default, due to complicated conversions or conversions in overheated markets undertaken by inexperienced sponsors. Indeed, the entry of inexperienced sponsors has been noted and bemoaned by more established developers, who say these new players drive up prices during bidding.
There are many new developers in the market hoping to score a quick profit, says William S. Friedman, CEO of Tarragon Corp., a New York City-based developer and owner that controls more than 15,000 individual housing units. These new players, he says, are not experienced enough to recognize a property's true value and are overly optimistic about the duration of current market prices. For example, new investors are sponsoring condo conversion projects in secondary and tertiary areas of New York, says John Cicero, managing principal of Miller Cicero LLC, a locally based commercial appraiser. �
There is a lot of this activity in Harlem [in New York City], north of 125th Street, for instance,� he says. If the market were to retract, Cicero predicts, there is likely to be a flight to quality away from these newer developments. New York Condo Conversion Activity: Too Risky?
The condo craze certainly hasn't skipped the Big Apple�which makes some observers a tad nervous. In New York City, land- and deal-hungry condo developers are making unorthodox conversions�warehouses, for instance, or historical landmarks�in established areas. Sonnenblick-Goldman, for instance, recently arranged a non-recourse $17-million, 24-month, floating-rate mortgage for the acquisition and conversion of a turn-of-the-century industrial building at 209-211 Hester St. in Manhattan.
Once a stable, the property was converted in 1988 into condominiums. Now, developers plan to convert the building again into 16 high-end condominiums. Sonnenblick-Goldman managing director and head of capital markets Andrew Oliver notes that the total costs of the Hester Street project will tally around $700 per sf, which keeps everyone comfortable. �Sales are projected to be around $1,100 to $1,300 per sf, so even if the market collapses, everyone is still safe,� he says. And Lisa Maysonet, a principal at Group Maysonet and senior vice president at Douglas Elliman, says New York City condo developers are taking full advantage of strong pricing while maintaining sufficient caution in their numbers. �One thing all my developers are asking is 'can I still do this deal if the market significantly contracts?'� says Maysonet. �I haven't met a developer yet that isn't cautious.� The craze hasn't extended everywhere in the Northeast. In Boston, many of the same price and supply dynamics are unfolding, according to Larry DiCara, a real estate partner in the Boston office of national law firm Nixon Peabody. �The dollar values being received are quite extraordinary,� he reports. However, DiCara notes, because Boston is a mature market with virtually no additional space to develop, there is little threat of oversupply flooding the market. �The cost of entry is so great that no amateur can afford to do business here.� The upshot to New York's condo craze, most say, is that blanket assumptions do not apply. Condo conversion loans must be evaluated on a market-by-market and project-by-project basis. �Much of a condo conversion's success has to do with sales and marketing,� says Chris Kelly, head of real estate for Capital Source, a specialized commercial finance company. �Not every investor has the necessary level of skills and experience.��EM
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