Condo conversions are an undisputedly hot sector of the real estate industry. Last year the market seemed to come of age, after JPMorgan Securities managed the first condo conversion securitization in May 2005. Credit Suisse First Boston Mortgage Securities Corp. followed with a $1.99 billion transaction that financed the Manhattan House. This deal was considered the largest single building condo conversion.
Despite the handful of deals that followed, and continued intense activity in the sector, securitization professionals are not counting on condo conversions to become a steady, long-term asset class.
"I think you'll see condo conversion deals from time to time, but it will not be a huge, new, permanent asset class," said Brian Lancaster, managing director at Wachovia Securities, who heads up its structured products research group.
S&P's viewpoint
In a recent report, Standard & Poor's highlighted a set of unique risks in the condo conversion market that it said could complicate CMBS deals. Condo conversion investors borrow funds to finance the redevelopment of a building into condominiums, and then count on unit sales to provide repayment capital for the loan.
"Since most condo conversion properties require some level of construction before the units are ready for sale, repayment may also be affected by the amount of time and money required to complete construction and redevelopment," said S&P.
The renovation and construction schedule, plus unforeseen setbacks, can affect a condo conversion securitization's performance, said S&P. The company also considers the extensiveness of the renovations before the units can be sold. Converting regular apartment buildings into condominiums can be simple, but if the original property was another type of commercial building, such as an office building, the project could involve more regulatory and renovation complications, the company said.
As for those regulatory hurdles, condominiums are unique because the local housing authority must approve them. It might also require the investor to set aside a number of low-cost units to ensure affordable housing for local residents. In Credit Suisse's Manhattan House deal, 256 units are stabilized at below-market values, said S&P.
General economic conditions, specifically interest rate movements and unemployment rates, can directly affect local housing markets. If interest rates rise too rapidly, as well as unemployment figures, consumers might be unwilling to take out mortgages, said S&P.
On the other hand, a strong housing market continues to drive demand for condo conversion securitizations. Yields on condo conversion bonds satisfy yield-hungry investors, and will be around for a long time, according to a source familiar with recent deals.
Of course a lot also depends on the project's location. Developers prefer a condo conversion project in an area with high barriers to entry, such as scare open land for development, high real estate prices, and good public schools, according to market sources. Markets with a growing population, unlimited land and similar product nearby, however, might not be as resilient.
"Investors who don't take the rating agencies' [word] as gospel will assign different spread to the different asset classes," one professional said.
For instance, the lower-rated tranches on Lehman Brothers Floating Rate Commercial Mortgage Trust 2006-CCL C2, traded anywhere from 100 basis points to 150 basis points wider than recent hotel and health-care property deals, said Lancaster.
Perfect storm
Also, a so-called perfect storm of underutilized commercial properties, low borrowing rates, increasing housing prices and demographic trends has been driving the condo conversion market for the last few years, and the securitization business will get periodic sprinklings of deals backed by those loans, said Wachovia's Lancaster.
Major demographic trends will drive demand for housing in general, and the condo conversion market in particular.
"Everybody wants to be part of the American Dream, and Wall Street attempts to get people into that dream, making money in the process," said Lancaster. Similar to an interest-only loan or a negative amortization loans, some condo conversions are a way for first-time property buyers, such as children of Baby Boomers and immigrant groups, to own property as regular homes have gotten increasingly expensive.
Also, aging Baby Boomers look to owning condos as a way to buy a second home, which would eventually turn into a place for retirement, or to opt out of the hassles of maintaining a large single-family house after their children move out, said Lancaster.
While acknowledging the risks associated with condo conversion securitizations, Lancaster said investors are definitely being rewarded for taking on those risks.
"In the end, whether they are being rewarded correctly remains to be seen," he said. "As we note in our report, Condomania! It depends on the quality of the condo conversions in the deals and more broadly, what happens to the 10-year Treasury, because that drives cap rates, borrowing rates and mortgage rates and condo demand."
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