Getting a winning deal: the current pace of condo conversions may not be sustainable. Experts offer a transparent methodology for analyzing the risks involved in condo conversion loans.The conversion of properties into condominiums has increased dramatically over the past few years, with the total volume of apartments purchased for condo conversion Generally stated, a condo conversion is a process of entitling an income property or other lands currently held under one title to convert from sole ownership of the entire property (which often already is a multi unit property) into individual for sale units. reaching $13.3 billion in 2004. This is up from $3 billion in 2003, representing a leap of "almost 350 percent, according to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. Real Capital Analytics Inc. (based on properties valued at $5 million and greater). In addition, other property types, such as hotels and office buildings, are being converted to residential condos with increasing frequency. Low interest rates and high single-family home prices appear to be the primary drivers of the surge in conversions. Depending on the market, buyers tend to be young, first-time homeowners, many looking for Looking for In the context of general equities, this describing a buy interest in which a dealer is asked to offer stock, often involving a capital commitment. Antithesis of in touch with. affordable alternatives to high-priced single-family homes; empty-nesters, reinvesting in lower maintenance condos, often in downtown areas; or second home buyers, often pulling equity out of their primary residence to finance a second home purchase. Sellers, motivated by the large premiums being paid by converters, usually sell their properties (apartment buildings and other property types) to converters at prices well above the rental value rental value n. the amount which would be paid for rental of similar property in the same condition in the same area. Evidence of rental value becomes important in lawsuits in which loss of use of real property or equipment is an issue, and the rental value is the of the building. Converters continue to benefit from high unit sales unit sales Sales measured in terms of physical units rather than dollars. Unit sales data are often used by financial analysts when evaluating the health of a company. prices and the ability to finance their projects at low interest rates. As the U.S. condo conversion market continues to heat up, and in some markets overheat o·ver·heat v. o·ver·heat·ed, o·ver·heat·ing, o·ver·heats v.tr. 1. To heat too much. 2. To cause to become excited, agitated, or overstimulated. v.intr. , Fitch Ratings Fitch Ratings An international rating agency for financial institutions, insurance companies, and corporate, sovereign, and municipal debt. Fitch Ratings has headquarters in New York and London and is wholly owned by FIMALAC of Paris. has seen greater activity in condo conversion loans in the commercial mortgage-backed securities Commercial mortgage-backed securities (CMBS) are a type of bond commonly issued in American security markets. They are a type of Mortgage-backed security which are backed by mortgages on commercial rather than residential real estate. (CMBS CMBS See: Commercial Mortgage Backed Securities ) market. Fitch Ratings is a global rating agency with headquarters in New York New York, state, United States New York, Middle Atlantic state of the United States. It is bordered by Vermont, Massachusetts, Connecticut, and the Atlantic Ocean (E), New Jersey and Pennsylvania (S), Lakes Erie and Ontario and the Canadian province of and London that provides independent opinions on the world's credit markets. Fitch has taken a cautious outlook toward condo conversion loans, as Fitch believes these loans to be riskier than traditional CMBS loans. In particular, condo conversion loans have an element of construction/renovation risk, and the properties do not generate a sustainable in-place net cash flow. Assessment of 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. Fueling Overheated o·ver·heat v. o·ver·heat·ed, o·ver·heat·ing, o·ver·heats v.tr. 1. To heat too much. 2. To cause to become excited, agitated, or overstimulated. v.intr. Markets Fitch is concerned that many markets are becoming overheated and believes that investors or speculative buyers are responsible for a large percentage of condo sales in certain markets, creating an over-inflated sense of demand. In addition, Fitch is wary of the disconnection between the prices converters are paying to acquire properties and the rental value of those properties; this price disconnect raises the concern that if the units cannot be sold, the overleveraged properties may default. Furthermore, Fitch believes it is becoming harder for developers to complete condo conversions on time and on budget and that the lure of quick profits is attracting inexperienced developers. Fitch expects approximately 10 percent of condo conversion loans originated in 2005 to default. These expectations are based on a sensitivity analysis of current loans, as well as the inherent risks associated with all condo conversion loans. Fitch expects the defaults to arise primarily from complicated conversions or conversions in overheated markets that are undertaken by inexperienced sponsors. Therefore, investors should differentiate between the varying quality levels of projects to make informed investment decisions. A complicated conversion is any project that requires significant construction or reconfiguration. Such projects could be alternate-use properties such as hotels, offices or warehouses that are being converted to residential use (so they probably need to have walls moved, kitchens and baths installed, etc.). These projects also usually undergo a more significant or complicated approval process (i.e. zoning, landmark, architectural review The Architectural Review is a monthly international architectural magazine published in London since 1896. Articles cover the built environment which includes landscape, building design, interior design and urbanism as well as theory of these subjects. boards). According to Fitch, as of mid-June, Las Vegas Las Vegas (läs vā`gəs), city (1990 pop. 258,295), seat of Clark co., S Nev.; inc. 1911. It is the largest city in Nevada and the center of one of the fastest-growing urban areas in the United States. and New York, along with Miami (South Florida in general), San Diego San Diego (săn dēā`gō), city (1990 pop. 1,110,549), seat of San Diego co., S Calif., on San Diego Bay; inc. 1850. San Diego includes the unincorporated communities of La Jolla and Spring Valley. Coronado is across the bay. and Chicago were considered overheated markets. This report addresses the risks inherent in condo conversion deals, how Fitch assesses those risks, the structural features Fitch believes necessary to mitigate certain risks, and the Fitch methodology for rating condo conversion loans. Understanding the Risks The primary risks that Fitch assesses in its evaluation of a condo conversion project are construction/renovation risk, conversion stage risk and market risk. Construction/Renovation Risk. Understanding the magnitude of construction/renovation risk is vital to the evaluation of a condo conversion project. Projects that require significant construction are more likely to have unforeseen delays and cost overruns Noun 1. cost overrun - excess of cost over budget; "the cost overrun necessitated an additional allocation of funds in the budget" cost - the total spent for goods or services including money and time and labor . For example, condo conversion projects in Las Vegas have been delayed due to a shortage of general contractors A general contractor is an organization or individual that contracts with another organization or individual (the owner) for the construction of a building, road or any other execution of work or facility. , projects in New York City New York City: see New York, city. New York City City (pop., 2000: 8,008,278), southeastern New York, at the mouth of the Hudson River. The largest city in the U.S. have been slowed by unforeseen interruptions in construction supply deliveries, and projects in certain Florida markets have been held up due to a cement shortage. Fitch divides construction/renovation risk into three categories--minimal, moderate and extensive. * Minimal construction projects require limited renovation to an existing apartment property. In most cases, these properties have been recently constructed, so renovation is limited to the painting and carpeting of units and minimal cosmetic upgrades to common areas, such as landscaping. Many of these projects continue to generate rental income Noun 1. rental income - income received from rental properties income - the financial gain (earned or unearned) accruing over a given period of time while units are being renovated and sold. The renovations usually take three to six months to complete. * Moderate construction projects require more significant renovation to an existing multifamily property. In most cases, these properties are older and require a complete unit renovation, including new kitchens and bathrooms, as well as a more extensive common area renovation. Many of these projects continue to generate rental income while units are renovated and sold. The renovations usually take six to 12 months to complete. * Extensive construction projects require major renovation or reconfiguration of an existing property. In most cases, these are alternate-use properties, such as hotels or office buildings that are being converted to residential condos. For most projects, no cash flow is generated during the conversion project. The renovations usually take a minimum of one year to complete. Conversion Stage Risk. In addition to assessing construction risk, it is necessary to consider a project's stage in the conversion process. The conversion timeline can be loosely delineated de·lin·e·ate tr.v. de·lin·e·at·ed, de·lin·e·at·ing, de·lin·e·ates 1. To draw or trace the outline of; sketch out. 2. To represent pictorially; depict. 3. as follows: file condo conversion documents; receive approval; and sell units. Depending on the market and the complexity of the conversion, the time to receive approval for a conversion can take as much as one year or more. Projects in an early stage of the conversion process have a greater chance of being delayed. For example, the time to receive an approval in New York City has doubled from three to six months due to an increase in conversion applications. Market Risk. Fitch believes that understanding the current market conditions of a proposed condo conversion project is essential to understanding that particular property's potential performance. Fitch assesses factors including location, supply (existing, under construction and proposed), demand, demographics, barriers to entry and comparable properties to determine a proposed project's average unit price per square foot (psf), presale activity and absorption pace. Desired Structural Features Loan Paydown. Condo conversion loans are structured with a heavy amortization feature; as units are sold, the loan amount is paid down and the collateralization In medicine, collateralization, also vessel collaterlization and blood vessel collateralization, is the growth of a blood vessel or several blood vessels that serve the same end organ or vascular bed as another blood vessel that cannot adequately supply that end organ of the remaining loan balance is reduced. Fitch believes the loan should be paid off in full before any money is returned to the developer and that certain conditions, such as minimum sales prices and predetermined pre·de·ter·mine v. pre·de·ter·mined, pre·de·ter·min·ing, pre·de·ter·mines v.tr. 1. To determine, decide, or establish in advance: sales thresholds, should be stipulated in the loan documents to help ensure the expected sellout pace and proceeds. Furthermore, Fitch believes the payoff rate should be equal to a minimum of 90 percent of gross sales Gross Sales A measure of overall sales that isn't adjusted for customer discounts or returns, calculated simply by adding all sales invoices, and not including operating expenses, cost of goods sold, payment of taxes, or any other charge. proceeds, with the remaining 10 percent used to cover expenses. Reserves. Fitch believes that condo conversion loans should be structured with upfront conversion cost and interest reserves. Conversion cost reserves should include the total of the hard and soft costs of the conversion, as well as a contingency reserve of at least 10 percent to deal with cost overruns. Interest reserves should be enough to cover debt service obligations from loan origination The examples and perspective in this article or section may not represent a worldwide view of the subject. Please [ improve this article] or discuss the issue on the talk page. through the retirement of loan principal. If no rental income is in place, reserves must be adequate to cover expenses, such as real estate taxes, insurance and other operating expenses Operating expenses The amount paid for asset maintenance or the cost of doing business, excluding depreciation. Earnings are distributed after operating expenses are deducted. . Sponsor. Fitch is concerned that inexperienced sponsors are undertaking condo conversion projects in search of a quick profit. For this reason, Fitch believes that the sponsor and its team (including the general contractor and marketing staff) should have prior experience with condo conversion projects. Fitch assesses the sponsor's condo conversion experience, including the number of projects completed, as well as the sponsor's familiarity with a particular project's market. In addition, Fitch assesses a sponsor's financial capacity to handle potential cost overruns. In the case of large-scale conversion projects, Fitch expects to see recourse completion guarantees from well-capitalized entities. Servicing. The servicing of condo conversion loans is significantly more complex than the servicing of typical CMBS loans, as it requires the administration of both construction costs and unit sales. Therefore, Fitch expects to see servicers who are experienced in servicing loans with construction risk. One Methodology As condo conversion properties do not generate a sustainable in-place cash flow, the methodology used by Fitch is based on sizing the loan proceeds on a loan-to-value ratio Loan-to-value ratio (LTV) The ratio of money borrowed on a property to the property's fair market value. (LTV LTV See: Loan-to-value ratio ) basis, as opposed to a debt service coverage ratio The debt service coverage ratio (DSCR), or debt service ratio, is the ratio of net operating income to debt payments on a piece of investment real estate. It is a popular benchmark used in the measurement of an income-producing property’s ability to produce basis. Fitch first determines a net sellout value for the property and then sizes the loan based on that value. Using the Fitch multifamily property hurdles as a starting point Noun 1. starting point - earliest limiting point terminus a quo commencement, get-go, offset, outset, showtime, starting time, beginning, start, kickoff, first - the time at which something is supposed to begin; "they got an early start"; "she knew from the , Fitch applies additional stresses based on its assessment of construction risk and conversion stage risk to determine the appropriate LTV hurdles. All other items such as market risk and conversion risk being held constant, a property with a minimal amount of construction risk could support a 65 percent loan-to-value of investment grade debt by Fitch's calculation. If the same property has a major amount of construction risk it could support a 45 percent loan-to-value of investment grade debt, in Fitch's opinion. Determine Net Sellout Value. To determine the net sellout value, Fitch first determines the gross sellout value, which is the total sales revenue of the property units over a projected period. The gross sellout value is based on Fitch's determination of the average price psf and absorption pace (the velocity of sales). The average price psf and absorption pace are based on Fitch's own stressed analysis of current market conditions and review of actual unit sales information, if any. Fitch then converts the gross sellout value to a net sellout value by estimating sales expenses, operating expenses and holding costs, netting out any existing income or reserves. The net expenses are deducted from the gross sales proceeds to derive net sales Net Sales The amount a seller receives from the buyer after costs associated with the sale are deducted. Notes: This amount is calculated by subtracting the following items from gross sales: merchandise returned for credit, allowances for damaged or missing goods, freight proceeds. The net sales proceeds for each period are discounted back and summed to arrive at a net sellout value. Size Loan Proceeds. Once Fitch has determined a net sellout value, it determines the LTV hurdle ranges that will be used to size the loan. The ranges are based on Fitch's assessment of the magnitude of construction/renovation risk, whether minimal, moderate or extensive (as described under Construction/Renovation Risk section). Once the degree of construction risk has been established, Fitch determines whether the low-, middle- or high-end of the LTV hurdle range will be used, based on the project's stage in the conversion process. Additional stresses to the hurdles may be necessary should Fitch identify concerns such as inadequate reserves or lack of sponsor experience. Along with sizing the loan proceeds, Fitch performs the following analyses: * Loan paydown analysis, to determine the property's ability to meet debt service obligations from origination through maturity and to confirm that the loan will pay off by maturity. * Reserve analysis, to determine the property's ability to meet expense requirements from origination through maturity. * Stress analysis, to determine that the loan is properly sized by stressing variables such as average sales price psf, absorption pace and presales. * As-is property underwriting and sizing, to determine as-is value. Outlook Fitch does not believe that the current pace of condo conversions is sustainable, particularly when interest rates rise and markets become overbuilt o·ver·build v. o·ver·built , o·ver·build·ing, o·ver·builds v.tr. 1. To build over or on top of. 2. To construct more buildings in (an area) than necessary. 3. . In the meantime Adv. 1. in the meantime - during the intervening time; "meanwhile I will not think about the problem"; "meantime he was attentive to his other interests"; "in the meantime the police were notified" meantime, meanwhile , Fitch has created a transparent methodology for analyzing condo conversion projects that should help investors assess the potential risks associated with these projects, as well as differentiate between the varying quality levels of projects, to make an informed investment decision. Condo Conversi on in Orlando Fetches Record Price Per Unit Apartment Realty Advisors (ARA Ara or Arrah (both: ŭ`rə), city (1991 pop. 157,082), Bihar state, NE India, on the Son Canal. A major road and rail junction, it is the administrative center for a district that produces grain, sugarcane, and oilseed. ) announced the side of Donglas Grand at MetroWest, a 398-unit, luxury garden apartment community located in the exclusive MetroWest area of Southwest Orlando. The property was purchased by MCZ MCZ Museum of Comparative Zoology (Harvard University, Cambridge, Massachusetts) MCZ Mystic Cave Zone (Sonic 2 level) Development/Centrum Properties based in Chicago for $69 million, or $173,367 per unit, and is slated to be converted into condos. Kevin Judd, Senior Vice President, and Marc deBaptiste, Principal, of ARA represented Winter Douglas Partners in the transaction. Douglas Grand is newly completed and consists of 16 apartment buildings and one clubhouse building 158 of the units are three-story townhouses, while the remaining are garden apartment units in three-story buildings. According to Judd, high-quality construction and unit design helped Douglas Grand set a price point $25,000 per unit higher than any other transaction to date in the Greater Orlando Greater Orlando, alternatively known as the Orlando Area or Metro Orlando, is third most populated metropolitan region in the state of Florida, and the 27th-largest metro area in the United States. region. These features, combined with its premier MetroWest address, enable Douglas Grand to compete effectively with ground-up condominium condominium In modern property law, individual ownership of one dwelling unit within a multidwelling building. Unit owners have undivided ownership interest in the land and those portions of the building shared in common. developments. Condominium converter demand in Greater Orlando has been bolstered by a 34 percent increase in median home prices during the past year and Orlando's No. 8 ranking among the nation's highest home price appreciation level increase over the same period. Overheated Markets According to Fitch as of mid-June the following five markets were overheated for condo conversion: Las Vegas New York Miami (South Florida) San Diego Chicago A Growing Trend The conversion of properties into condominiums has increased dramatically, with the total volume of apartments purchased for condo conversion up almost 350 percent *: 2004 $13.3 billion 2003 $3 billion * Real Capital Analytics Inc. (based on properties valued at $5 million and greater) Dina Treanor and Zanda Lynn are analysts with Fitch Ratings. Treanor can be reached at 212/908-0784 or dina.treanor@fitchratings.com. Lynn can be reached at 212/908-0601 or zanda.lynn@fitchratings.com. |
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