For lenders looking for the next holy grail in the CMBS market, JPMorgan Securities' CMBS group has one suggestion: construction loans. While attempts have been made in the past to securitize these entities, the firm says the timing is right but do the rating agencies agree?
"The CMBS market has matured. It's been around for 10 years, there is a history of performance, a wide investor base and structures have evolved. Securitizing construction loans is the next frontier," said Steven Schwartz, managing director and co-head of the CMBS group at JPMorgan and the first bank to say publicly it is exploring ways to securitize construction loans for the market. "I hope it is a 2005 event but there is still a lot of wood to chop."
In order to securitize and sell a pool of construction loans there's a whole host of issues to be worked out ranging from the methodology on how to rate the pool of loans, to how the loans will be serviced and how will the securities be structured. Credit Suisse First Boston and Nomura Securities have both tried to do these deals several years ago, but it did not work because they were not traditional construction lenders.
With investors hungry for yield, the heat is on to work out the details. "We have had several issuers who have approached us over the past month about the possibility of rating construction loans," said Tad Philipp, co-managing director in the CMBS group at Moody's Investors Service. "The loans might wind up being packaged as CDOs as opposed to CMBS because CDOs allow a lot more flexibility as to what the collateral is."
To be eligible as a REMIC asset, a property's LTV cannot exceed 125%. Most construction loans during the construction period have a much higher LTV ratio, meaning the loan is much larger than the value because they are non-existing- properties, just dirt.
"Everything up until this point has always been current income producing in one way shape or form," said JPMorgan's Schwartz.
Industry participants are looking at ways to make construction loans REMIC eligible. "There is no template," said Philipp. He adds Moody's is looking at condo conversation loans as the closest model as those loans involve various amounts of construction so, "the progression to ground up construction is the evolutionary step." Moody's, he says, has a number of people on staff with construction lending background so they have started down the path of figuring out a methodology.
Susan Merrick, a managing director in the CMBS group at Fitch Ratings, said that many new assets could be securitized provided the issuers adequately address the risks in their underwriting and structure and, Merrick adds, it has been approached by more than one issuer considering securitizing a pool of these loans.
"In construction lending, there are additional risk you do not have in operating real estate, specifically, is the issue of completion," said Merrick. "Will the project be completed?" Lenders need to build additional structural protection into the loan in order to insure recovery. Another risk is the market risk. With projects taking an average of three years to complete, will the markets be as strong as they are today and will the property be occupied? Merrick asked. One more risk is debt servicing, because construction loans are more servicer intensive than traditional CMBS loans, you need a servicer with special expertise in this area.
Moody's Philipp questions the future as well, asking while, "Construction has recently been more evenly balanced with supply and demand but can that level of discipline be maintained so excess construction does not lead to a down turn in the future."
Rating agencies suggest some protections for lenders may be contingency reserves and interest reserves of two or three years to guard against problems such as budget overruns might be one way around the collateral issue.
"Make sure the borrower has enough liquidity income to come out of pocket should there be budget cost overruns with the project," said Fitch's Merrick.
Still, a diversified pool of construction loans, by property type, borrower and location, reduces the risks and enables investors and rating agencies to rely on diversity as well as individual market and project dynamics.
"One benefit to the lender is the diversity of the loans, either kinds of loans or geographic, because not everything is happening exactly the same way in every market," said Fitch's Merrick.
JPMorgan's Schwartz believes the initial construction loan pools will be comprised of smaller and middle sized loans with greater diversity because it is lower risk.
"Rating agencies and investors like that better than they like a large, single-asset loan. That is not to say ultimately large single asset loans won't be securitized," Schwartz said.
The bank believes what gives it the leg up on doing these types of transaction is the merger between of Bank One and JPMorgan, which combines construction lending experience with its CMBS capital market expertise.
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