Lenders dig into newest frontier in construction loans.

US lenders are entering the New Year on the crest of yet another learning curve after Fitch Ratings issued the first ever formal criteria for the securitization of commercial construction loans.

"Securitized lenders have been trying to find new ways to lend money to developers for some time," said Andrew Oliver, managing director and principal at Sonnenblick-Goldman, LLC.

"It's taken them a while to figure it out because it is much more complicated and labor intensive [than normal securitized lending], but lenders are always looking for higher profit margins and this is one way to do it."

Until now, developers have depended on banks and finance companies to fund their projects, which are inevitably surrounded with uncertainties--cost overruns from material hikes, labor shortages, strikes, even bad weather can impact the final cost of a development.

But as competition for real estate loans of various sorts have put a damper on profit margins, the move to construction securitization was seen as inevitable as investors look for higher returns.

This week, in response to what it called "numerous inquiries" regarding its view of commercial real estate construction loans as a product for securitization, Fitch became the first major rating agency to release formal rating methodology on construction loan pools.

Analysis of construction loans is different than for conventional CMBS [commercial mortgage backed securities] loans for several reasons, none more so than the fact that the loan is secured by something that hasn't been built. "The unpredictable nature of a construction project makes the responsibilities and expertise of the sponsor and servicer critical throughout the entire project," said Fitch senior director Joe Kelly.

"A loan's repayment is contingent upon the successful completion of the construction project because the loans do not initially generate sufficient cash flow to cover debt service."

Fitch's construction loan model calls for an incremented allocation of the loan money, based on the successful completion by the developer of the construction project. This kind of careful oversight helps manage the risk of default, a significant concern for a loan made with virtually no collateral.

Patty Bach, Fitch senior director, explained, "Although recent default rates for construction loans show a close correlation to that of traditional CMBS loans, Fitch believes a capital constrictive lending environment or a stressed real estate market would precipitate significantly more defaults for construction loans compared to traditional CMBS loans."

However, it is exactly that risk that's expected to make construction loan securitization such a hot commodity in 2006.

"There is more risk and fewer people doing it," said Oliver, "[Lenders] can charge a higher spread--maybe a 100 basis point spread--than on an existing loan."

According to Susan Stupin, managing director at the Prescott Group, LLC, the move will undoubtedly be welcomed by developers, lenders and investors alike. "The lender is looking at the [construction] project and underwriting it saying 'If we could get this rating, we could get this kind of pricing.' It forms a structure to the financing they can give to the borrower. Then you have investors who will invest in the bond because there is a rating attached to it.

"It will also bring more transparency and liquidity into the construction marketplace and bring standardized loan terms which may also bring additional discipline to the market place."

Stupin added, "It's an exciting and interesting development that will create the potential to get more participants in the marketplace and more opportunities to access different pockets of capital in the debt marketplace."

The very nature of the construction process prompted Fitch to use what it describes as a comprehensive model to review and rate construction loan servicers.

Fitch director, Richard Carlson said, "Commercial construction projects are complex and contain many moving parts, putting substantially more onus on the servicer.

"Because this type of servicing relies upon a different skill set than CMBS servicing, Fitch-rated CMBS servicers are not automatically qualified by Fitch to service construction loans."

"On a traditional CMBS loan there is much less to monitor," said Sonnenblick's Oliver. "In a construction loan, every month you need to fund more money based upon the completion of the building.

"You need to verify the contractors were paid, the materials were paid for and that the project can still be completed for the original budgeted costs. That's why it's taken a while for securitized lenders to make construction loans--normally they fund money up front because they want to sell the bonds based on certain loan amounts."

In the past, commercial banks have been the trough developers have fed from and they are expected to lead the field in securitized construction lending because they already have the people and expertise to monitor the various project parts.

The banks have, until now, used their own money and given developers some flexibility, but the new rating system is expected to make the system more rigid.

All eyes will now be on who will become the pioneers of this new frontier in lending.

According to Oliver, Wachoiva, Credit Suisse First Boston and Bear Stearns are all likely contenders. "Sonnenblick Goldman has arranged many construction loans with banks and investment banks, but they have kept them on the balance sheet.

"The new lenders in the market tend to start with renovation loans--warehouse to residential, and office to condo conversions--but that's usually just a taster for new construction.

"Whoever does it first, the other lenders will follow. The first one [to offer securitized construction lending] will make a difference and the other lenders will say. 'We should be doing it, too,' and try to figure out how."

Stupin has no doubt they will figure it out and, as for the final frontier, she said, "The Mississippi looked like the final frontier at one time, but that was before people went to the moon.

"This is an evolving market and there is a lot of demand out there. The [rating] facilitates the flow of demand into that market and spreads the risk and, potentially, creates opportunity for new and creative ways for construction financing."