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The construction loan market from 2000 to 2007 was extremely profitable for banks. Loan spreads were strong, opportunities were plentiful and there was no shortage of buyers for finished properties. The permanent loan markets, including commercial mortgage-backed securities (CMBS), government-sponsored agencies (GSE) and life insurance companies were all aggressive and accommodating for the buyers. Defaults were virtually non-existent. Even poorly executed deals were bailed out by the ever-growing needs of real estate investors.

When the real estate transaction world slowed to a crawl in mid-2008, the pain started for permanent loan holders of CMBS, mezzanine and whole loans. Values dropped, and holders were forced to take markdowns on their financial statements. The slowdown in transactions and falling values will have an even greater impact on the banks that originated construction loans between 2005 and mid-2008, as these loans were based on ever-increasing rent rolls and even lower cap rate exit assumptions.

A few facts about construction loans in the current market:

* Most apartment construction loans have a 3-year term with two built-in extensions for a year each. The terms for obtaining the extensions varied widely between asset type and lender. Loans originated in 2005 have already expired on the original term, and the developer is living off the extensions. As each month passes, the number of loans going into the extension periods increases.

* Even loans with the most conservatively stress-tested cap rates are probably underwater by 50 basis points in the current sales market.

* Rental rates, occupancy and absorption rates are generally below pro forma.

* Most construction loans were indexed off Libor with spreads ranging between 150 and 300 basis points. Libor has dropped from approximately 3 percent in 2005 to 0.20 percent today, helping borrowers to offset the lower effective NOI with lower borrowing costs. This also has helped the built-in “interest reserve” to last much longer than anticipated.

Based on a 25 percent drop in asset values, apartment construction lenders are projected to face a loss of almost $22 billion (17 percent of total loan balance); original equity investors — who invested 10 percent of total construction costs, on average — have already lost all their equity. If the original developers are to refinance the completed assets at 65 percent loan-to-value (based on the new values), they would have to raise an additional $36 billion for equity alone. Considering that the entire apartment real estate investment trust universe had a total market value of only $28 billion on September 1st, this is a significant amount of capital to raise.

Although there will be considerable pain for banks on all asset types, they will most likely fare better on apartments solely due to the existence of GSEs like Fannie Mae and Freddie Mac. Unlike other assets, GSEs are still active and continue to provide new permanent debt at 65 percent loan-to-value..

— Mike Kelly is the president and co-founder of Caldera Asset Management.

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