Builders put the squeeze on lenders as condo market booms.

The present construction lending market, flush with capital, may be great for developers, but for lenders it means tapering returns at a time when the risk profile for some development could be increasing.

"Spreads in the construction lending market have compressed markedly," said Suzanne Kliegerman, senior vice president of Commerce Bank. "It's amazing how low they've gotten, with respect to the risk profile."

Condominium development, probably the most built property type right now both in Manhattan and around the country, has become so profitable and with presales so brisk, senior lenders are supplying bigger portions for the cost of its development, oftentimes over 80% of the financing, up from a 70-75% portion just a few years ago.

"Lenders see how the condo market is booming right now and they're willing to put more money in," said Victor Woolridge, managing director at Babson Capital, a subsidiary of MassMutual that provides mezzanine financing for real estate development. "We're seeing presales that can cover up to 75% of the cost of development, so lenders are responding with their willingness to go up the capital stack."

Mezzanine lenders in turn, who generally have no direct collateral, save a pledge of the borrower's equity interest in the project, have responded to their thinning slice of the capital structure by providing more of the cost of development as well.

"I am working with a REIT that will do mezzanine financing up to 100% of the project," said Jerry Swartz, a partner at Pergolis Swartz Associates, which closed $20 million of construction financing in May. "I've seen developers get from 8590% off with the mezzanine piece, but 100%? That's something new."

What has resulted is that developers, depending on their track record for good projects and the attractiveness of the development they are seeking financing for, now are in a rare position where they can finance a deal nearly in its entirety without having to put in a significant portion of their own equity. While this abundance of capital has allowed developers to mobilize and capitalize on the searing hot residential boom, some lenders fear that, without their own equity at stack, some developers may not be as motivated to see a project succeed or perform up to its potential.

"We like to have a good alignment with the borrower," Woolridge said. "And the less of their money is at stake, the less the alignment. If you have one developer with a 25% stake and another with a 2% stake you can bet that the former is going to be working pretty hard. It's a lot easier to walk away from 2%."

Swartz indicated that, despite the tight competition between lenders for construction projects, he has not seen bad developments go up.

"Lenders have not veered away from strong underwriting," he said. "The basic underlying credentials of a borrower as well as careful consideration whether a project is well conceived still predicate whether a lender will provide financing for a project."

"We aren't afraid to walk away from a deal," Kliegerman said.

But borrowers, particularly mezzanine lenders, could still take a hit if the condo market slows down even slightly. Mezzanine debt and equity stakes are typically subordinate to the money owed to the senior lender. Senior lenders also have a lien on the development. If pricing for condos declines, the mezzanine and equity stake will be the first to be wiped out.

"It's ideal if the developer can add his profit margin and still be below where the market is," Swartz said.

But Swartz indicated that some developers do stake their profits on projections that the market will continue to rise.

Although condo development could carry risks if the residential market does an about-face, office development has been perceived as a property type carrying among the most uncertainty. Spurred by poor fundamentals nationwide, there has been a freeze for the most part on new office construction. Steve Kohn, president of Sonnenblick Goldman who is active in structuring construction loans, indicated that that could change in New York City and Washington D.C., the country's strongest two office markets where rents and vacancy have begun to buoy.

"We could see some speculative office development in Manhattan," Kohn said.

A mezzanine lender providing financing for such a development would likely command a high premium, Kohn indicated.

"It would be priced like equity, which has a very high yield," Kohn said.

Mezzanine financing typically returns in the mid teens while a preferred equity stake can reap over 20% total returns.