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Watch out for condo conversion loans

The conversion of properties into condominiums has risen considerably and rating agencies are starting to show concern that the sector is overheated. Fitch Ratings, in particular, said last week that these loans are riskier than traditional CMBS due to the element of construction or renovation risk with the properties not apt to generate sustainable in-place net cash flow.

Real Capital Analytics Inc. statistics showed that condo conversion leaped to $13.3 billion in 2004 from $3 billion in 2003, a roughly 350% jump - primarily driven by low interest rates and high single-family home prices. Fitch said that the buyers tend to be young, first-time homebuyers, empty nesters and second homebuyers - further buoyed up by sellers driven by the large premiums paid by converters. The rating agency does not believe that the current pace of condo conversions is sustainable specifically with interest rates rising and markets being overbuilt.

With condo conversion growth, there is also a corresponding interest in securitizing these types of loans. "Fitch is seeing more interest from a variety of banks in a CMBS execution for condo loans," said Zanda Lynn, managing director in Fitch's CMBS group.

The rating agency is concerned about the market becoming overheated with speculative buyers behind a significant number of condo sales in certain markets, thus creating an "overinflated sense of demand," analysts said. Fitch is also worried about the disconnect between the prices converters are paying to buy these properties and their rental values. If these properties are not sold, these overleveraged properties could default. The quality of developers has also become a concern. Fitch said it expects about 10% of condo conversion loans originated in 2005 to default, due primarily to the complicated conversions as well as those undertaken by inexperienced sponsors in overheated markets "Therefore investors should differentiate between the varying quality of projects to make an informed investment decision," Fitch said.

The primary risk in these loans are construction and renovation risk as projects that need significant construction are more likely to have unforeseen delays as well as cost overruns. Delays could also occur throughout the conversion process so Fitch is carefully monitoring the different stages, each presenting different types of risks. In the initial stages, for instance, a lot of time could be spent just waiting for conversion approval. Fitch also looks at market risk, including factors such as location, supply, demand, and demographics.

In evaluating these condo conversion loans, Fitch is relying on sizing the loan proceeds on an LTV basis rather than a debt service coverage basis. Since there is limited, or no, cashflow from condo conversions, the value approach is utilized, explained Fitch's Lynn. A main component of the debt service coverage is the cashflow.

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