The condo hotel trend has been much ballyhooed, so why are lenders still sitting on the fence when it comes to consumer mortgage financing? Here are three simple reasons:
1.) The secondary markets (FNMA, FHLMC) have not seen enough condo hotel paper to grade the risks/rewards of this proportionately new asset class.
2.) Condo hotel is somewhere between a commercial hotel loan and a residential second home/investment property consumer mortgage, so they don’t fit neatly into existing portfolios/guidelines.
3.) The yield/interest rate that a well-healed condo hotel purchaser is willing to pay on a 30-year mortgage is much lower than timeshare and other vacation ownership rates. Making this new yet-to-be determined risk hard to justify.
Many of the new condo hotel offerings are even more difficult to mortgage at market interest rates and terms, because they are smaller than 600 square feet in size, do not have kitchens, include FF&E chattel in the sales price, and may be in projects that include mixed use and timeshare/fractional components. Each of these items defy conventional mortgage guidelines.
Yet even given these challenges it is clear that lenders are closely watching the evolution of the condo hotel market. With each high-net worth, private banking client who purchases a condo hotel, bankers are being asked, “Why won’t you lend me a conventional mortgage on this piece of real estate?” and lenders are being forced to get up to speed on this asset class.
As interest rates have risen, and the real estate markets in general have cooled, the lending community has been faced with increased capacity to lend. Lenders are beginning to seek new niche opportunities to fill their appetite for yield and loan volume, condo hotel mortgages present a unique opportunity that’s time may have come.
High Credit Quality
The typical condo hotel purchaser is a high net worth consumer who is seeking a quasi-vacation home with hassle-free rental property benefits and investment potential. As with most mortgages, these borrowers sign personally for the debt, and typically put 20% or more in down payment. Underwriting guidelines for most of the existing condo hotel mortgage products require a borrower to qualify for the debt without any credit for the potential rental income from the property. A cash-flow loss is not a loss at all, if the hotel should fail to deliver any rental income. If they are truly purchasing with an intent to use and enjoy their condo hotel unit as a second home alternative, this consumer will be getting a luxury vacation condo for a fraction of the traditional condo ownership expense.
Where the Risks Lie
The greatest risk to lenders and consumers in condo hotel ownership is in the sales approach and intent of the purchase. Is the consumer buying an investment property or a vacation condo alternative? If during the real estate sales process the income potential was emphasized, the consumer will have a claim against the developer/Realtor who represented what could be considered a security. The SEC issued a ‘no action’ letter that discourages such practices, but many sales operations find it problematic to stay completely away from the topic of rental income when a consumer directly requests such disclosure and information. As lenders assess their risks in this asset class, this issue of ‘perception of investment quality and intent for personal use’ is very difficult to measure, but is of optimal importance. You can imagine a borrower who looses money every month, but enjoys their ownership experiences and is very pleased with his condo hotel. Or an investment minded consumer who tires quickly of their condo hotel when they are consistently writing checks instead of receiving them from a condo he never visits. The value of service, amenities and condo owner experience has never had more importance to real estate value.
The on-going hotel management is the next risk that is foreign to conventional residential mortgage lenders. Lenders entering this niche are often unfamiliar with the metrics and cyclical nature of the hotel business, and need to approve condo hotel projects with an eye to the long-term viability of the hotel, not just the credit quality of the consumer. If the hotel is mis-managed, replacement reserves are grossly under funded, or if the viability of the hotel market is deteriorating the consumer’s ownership experience will suffer, and mortgage default risk rises rapidly.
Another risk is of valuation. The real estate industry measures of cost per square foot have been stretched by a residential condo hotel that includes name-brand management and designer label decorating, 42″ plasmas and fine furnishing, spas, gyms and ski valets as part of the real estate package. Valuations of $1,000+ per square foot have been obtained and the sky looks the limit if this is our measure. The purchasers view is often of price point not price per foot, and is skewed further by the thought of owning part of an income producing and legendary hotel operation. But at these prices, the math may not work as an investment beyond the trophy value.
Lenders will enter this new market niche in mass when the answers to these risks is easier to measure through performance of the first wave of condo hotel closings which just began to occur this fall. The seasoning of these loans will be short when the greatest need for mortgage capital occurs beginning in Q3 2007, this situation has the potential to create a short-supply of mortgage options for marginal buyers in marginal projects. The dream of easy, low cost money for any real estate asset is over, and it’s time to wake up and recognize that most buyers don’t want to pay cash even if they signed a ‘cash contract’, financing matters to the viability of the condo hotel industry.