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Bracing for Defaults in Condo Market

Fitch Ratings is waving a red flag about the overheated condo conversion market. Last year, condo converters scooped up $13.3 billion of U.S. apartment properties, a whopping $10.3 billion increase over their 2003 take. Fueling that 350% year-over-year jump were low interest rates and soaring single-family home prices. And statistics from Manhattan-based property research firm Real Capital Analytics indicate that conversions are on a pace to exceed last year’s volume: between the start of the year and June 15, converters bought $7.05 billion in apartment properties.

Lenders are showing little restraint—virtually tripping over one another to finance acquisitions and subsequent conversions. But New York-based Fitch says it sees the potential for high default rates on these loans given overbuilding in the condo sector and the effects that rising interest rates could have on sales to consumers. In other words, converters could get stuck with unsold units and be unable to pay off their loans.

Fitch predicts that roughly 10% of condo conversion loans originated in 2005 will ultimately default. That’s a lot when you consider that only 2% defaults are predicted for all multifamily loans, reports Fitch. The conversion loan defaults will likely stem from complex projects being completed in overheated markets.

“Condo conversion loans have an element of construction/renovation risk, and the properties do not generate a sustainable in-place net cash flow,” says Zanda Lynn, a director at Fitch. “Assessing 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.”

Another warning sign that Lynn sees is the move by condo converters beyond hot markets, such as southern Florida and California. With apartment cap rates at record lows, converters are looking to buy properties in less desirable (but potentially more profitable) markets such as Columbus, Ohio and Lexington, Ky. In Lynn’s view, this shift suggests that conversion activity has gotten out of hand.

Even lenders bullish on the condo conversion market are beginning to pay attention to the potential danger of loan defaults. Sonnenblick-Goldman Co. is addressing the risk posed by the frenetic pace of development, says Andrew Oliver, managing director and principal at the Manhattan-based real estate investment bank.

Still, a cautious approach hasn’t dulled Sonnenblick’s appetite for conversion loans. The firm expects to finance more than $500 million in condo conversions this year alone. Sonnenblick recently arranged $10.25 million in mezzanine financing for an Orlando, Fla.-area condo conversion. And last August, Sonnenblick-Goldman arranged $78 million in senior, mezzanine and equity financing for another acquisition and conversion in Tampa.

“We definitely make sure we have the right development and marketing team on these deals, so we pay close attention to their track records. The deal has to make sense,” he says. In addition, Oliver says he spends much of his time researching local conditions to ensure that a supply glut isn’t on tap. His firm chiefly finances conversions of apartment buildings, which he believes hedges the turnaround risk. “It doesn’t take nearly as long to convert from apartment to condo as it does from, say, an office building to a condo. We can turn that apartment around very fast, and that helps cut the risk of missing the market.”

Lynn of Fitch says the greatest danger is inexperienced conversion sponsors looking to turn a quick profit buck. “This condo conversion activity just isn’t sustainable in the long run,” she says. “It’s the investors who buy these properties at high prices and might not be able to sell them for the right price who will ultimately default on these loans.”

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