Bonds Backed By Condo Conversion Loans Face Many Risks

By Danielle Reed
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--Bonds backed by condo conversion loans carry more risks than typical commercial mortgage bonds - and those risks could be exacerbated by a slowing housing market.

As demand for condos soared during the housing boom, real estate developers have taken scores of buildings - often made up of rental units - and converted them into condominiums. This rush fueled demand for short-term loans used to finance the conversions, and the securitization and sale of these loans became the logical the next logical step.

The first condo conversion bonds appeared in 2005. So far there have been just a handful of such deals, though investment banks expect the numbers to increase as investors become familiar with the bonds.

The natural buyers of these securities are savvy investors looking for more exposure to real estate and the higher yields associated with bonds backed by commercial real estate.

But because these bonds are new, they are also somewhat untested. And investors holding them face a number of risks that go beyond the reasons that drive defaults in more typical, longer-maturing commercial mortgage bonds.

One big risk is that bondholders could be left holding the bag if the borrower has trouble selling the condominiums.

While a borrower may have an option to extend the loan, if sales are delayed long enough or simply don't happen at close to the projected pace, the likelihood of borrower default increases.

And there are always unexpected hurdles that can come up during the conversion process.

Regulatory approval - from local or state government agencies - can take longer than expected, for example. Existing rental tenants in a given building, who often are not pleased at the prospect of having to buy their homes or move, can sometimes successfully stonewall a project. Because renovations are almost always required, construction delays can also be a factor.

And of course, there is always the risk that the housing market can slow just as a developer is getting ready to sell units.

"In this market anything that drags out the condo conversion process is a risk factor," said Brian Lancaster, head of structured products research at Wachovia Securities. Especially, he said, because "construction costs are going up and condo markets are cooling."

Evidence that condo markets are cooling mounted last Thursday, as the National Association of Realtors reported that existing condo and co-op sales had fallen to an 839,000 seasonally-adjusted annual rate in April, down from a rate of 862,000 in March. The inventory of condos and co-ops for sale rose to a 7.1 months' supply at the current sales pace, up from 6.9 months in March and up from 4.1 months in April last year.

The median sales price for co-ops and condos was $222,000, down 0.2% from $222,500 one year earlier.

Case In Point: The Manhattan House

Some of the first condo conversion projects may already be experiencing some headwinds.

Consider the case of the Manhattan House in New York, a sprawling, 22-story, 1951 white-brick building with 583 apartments that takes up an entire block in Manhattan's East 60's.

The developers converting the rental building into condos borrowed a total of $756 million, of which $450 million is included in a $1.99 billion bond underwritten by Credit Suisse that was sold in 2005. The Manhattan House loan is the largest single loan in the transaction.

Rating agencies Fitch Ratings and Standard and Poor's flagged a few concerns about the loan, including the fact that the condominium offering plan had not been filed with the attorney general's office at the time the financing was put in place. Approval by the Attorney General is a requirement before sales can begin. The rating agencies also noted that a little over 250 apartments in the building were rent stabilized as of late 2005.

Units that are rent stabilized cannot be converted automatically into condominium units. Tenants have the right to remain in the apartments, often at rental rates well below market rates.

Meanwhile, market-rate rental tenants typically have rights to renew their leases once the condominium offering plan has been approved.

The tenants of Manhattan House seem prepared to fight for their rights to remain in place. They've hired a lawyer, David Rozenholc, who specializes in representing tenants.

The offering plan has now been filed with the New York State Attorney General, but has not been approved. During this time, Rozenholc said, the tenants "have an opportunity to raise any objections to the plan," and they certainly intend to do that. "We have many objections," he said. These include allegations that the developer harassed tenants in an effort to empty the building of as many renters as possible.

In addition, Rozenholc said, while the developer maintains that market-rate rental tenants don't have rights to renew their leases during the time between when the offering plan has been filed but before it is approved, "we disagree," he said. The issue, "is not clear," he said, and it's now "being tested in the courts."

Still, even if tenants are able to delay regulatory approval, it doesn't automatically mean that bondholders have to worry, analysts said. Regarding the Manhattan House loan and the bond it is backing, ratings agency Fitch Ratings said that it assumed delays in approvals and in construction when rating the bond. Rating a bond involves determining, for example, how much of a cash cushion should be required in order for the most senior classes of notes to receive a triple-A rating.

"We always assume it will take longer" to get approvals from regulators, said Zanda Lynn, managing director in Fitch Ratings' commercial mortgage-backed securities group. "Litigation could still occur in that time frame."

30-05-06 1751GMT

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