The Tricky Business of Condo-Conversion CMBS: Commercial Mortgage-Backed Securities Issuers Have Found a Way to Package Condominium-Conversion Loans and Deal with the Added Risk of Uncertain Cash Flow. Where Is This Trend Headed?

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In the past few years, the number of condominium conversions in the United States has skyrocketed. In fact, the dollar volume invested in these properties has more than quadrupled, according to New York-based Real Capital Analytics Inc. (RCA). The firm reports there were $11.5 billion worth of condominium conversions nationwide in 2004, compared with $2.6 billion in 2003. This figure takes into account the buildings that were converted, rather than individual unit sales. (RCA tracks properties valued at $5 million or more.) [??] As the condo-conversion market becomes more active, condominium-conversion loans are showing up in the commercial mortgage-backed securities (CMBS) market with more frequency, although most lenders are not creating offerings made up exclusively of these loans. [??] "They are put into the multifamily bucket with conduit deals, so it is difficult to detect them," says Lisa Pendergast, managing director of real estate finance at RBS Greenwich Capital, Greenwich, Connecticut. Yet, they are becoming a more significant component of the business, she says. [??] Last April, New York-based Credit Suisse (formerly Credit Suisse First Boston; the company is dropping First Boston from its name this month) issued the first securitization made up entirely of condominium-conversion loans. Because of the success of the initial offering, which was worth $666 million, the originator issued another all-condominium-conversion CMBS issue in November, worth about $2 billion.

"We are always looking at new opportunities to lend," says Barry Polen, managing director, head of CMBS, U.S. capital markets, at Credit Suisse. Because there are many investors buying buildings to convert to condominiums, this will be an ongoing part of Credit Suisse's business, he says.

To entice investors, the company is offering spreads that are 25 to 75 basis points higher for CMBS bonds associated with condominium-conversion loans than those offered for more conventional deals, because they are perceived to be riskier than conventional deals.

Most commercial real estate loans are securitized only after properties are stabilized and there is cash flow. The reason that condominium-construction loans, or any kind of construction loan, have not yet been securitized, says P. Sheridan "Schecky" Schechner, managing director and national head of CMBS originations at JPMorgan, New York, is that the rating agencies look at cash flow and, with construction loans, there is no cash flow--"so they consider the loan-to-value [LTV], which banks loathe doing because it is hard to determine the value," he says.

In these circumstances, the only way lenders or investors can be assured that they will get paid is if the borrower puts aside a reserve, says Schechner.

Although people in the industry, including some at JP Morgan, are talking about securitizing construction loans, says Schechner, no one has yet devised a way around the cash-flow problem. The only reason the securitization of condominium-conversion loans works, he says, is that rental income from units not yet sold is used to pay down the loan, in addition to proceeds from unit sales.

JP Morgan has no plans to issue an all-condominium-conversion securitization anytime soon, says Schechner, but the company is planning to include them in its next floating-rate securitization. JP Morgan securitizes floating-rate loans for different property types all in one issuance twice a year, he says. The next one is slated to take place early this year.

Condominium-conversion securitizations have unique risks

Condominium-conversion loans do carry some risk, says John Levy, president of John B. Levy & Co., Richmond, Virginia, an investment banking firm. How much risk depends on the developer and how many presales the project has. As for the Credit Suisse issuance in April, it was composed of solid deals, Levy says.

Although the first Credit Suisse all-condominium-conversion CMBS issuance was successful--it was rated by New York-based rating agencies Moody's Investors Service and Standard & Poor's (S & P)--many market experts have doubts about the quality of these investments, given the overheated nature of some condominium and condominium-conversion markets, especially in places such as South Florida and Chicago. …