You’ve been hearing it everywhere: the Manhattan condo market is soft. Very soft. But who is ultimately holding that risk?

If the 2009 financial crisis has taught us anything, finding the ultimate holder of risk is not always a straightforward exercise.  Let’s start with some background.

Lower Condo Sales, But New Projects Continue

Today, real estate developers are sitting on several thousand unsold Manhattan condos. And although they have been steadily lowering prices, unit sales have remained tepid while hundreds more new units come to market each month.*

In fact, according to Corcoran, new development condo sales have declined by 29% since 2017, but new projects continue to break ground.

A rational person would assume that condo prices would drop to a market-clearing price and development would come to a screeching halt. But that hasn’t happened.

Here’s why.

Condo Inventory Loans are the Drug of Choice

Condo developers typically borrow as much as possible to build new buildings. They then repay those construction loans gradually as they sell units. If sales are slow and lenders are willing, developers often repay pricy construction loans with a “condominium inventory loan” to bridge the gap between when construction has finished and when the very last condo has sold.

Lenders like these condo inventory loans because they are less risky than construction loans, but still pay a juicier rate than a stabilized loan. Developers like them because they can lower their financing costs considerably (by about 1.5 to 2 points).

Luckily for developers, banks today are pretty eager to make condo inventory loans. So, condo inventory loans have become the drug of choice for Manhattan developers. Instead of having a fire sale to dump unsold units, developers can buy time to sell units at higher prices later--much later, like when more buyers magically materialize or the market improves.  

Which means that although sales have slowed, nobody has really taken the pain yet.

Shifting the Risk to Main Street?

Condo inventory loans typically have terms ranging from one to three years. Until the loans mature, the collector remains at bay. But if a loan matures before it has been fully repaid, the developer has to either find a new lender to pay off the first lender or, as a last resort, hand over the remaining unsold units to the bank. When interest rates rise, these unconventional loans will be harder to find, which leaves only one option: handing over the unsold units to the lender. Unfortunately for the lender, the very last units to sell tend to be the worst ones in the building.**

All of this means that the regional banks and pension funds that have financed these condo inventory loans could be left holding the bag with a bunch of crappy condos and and unpaid loans.

Which institutions hold these loans on their balance sheets? The lenders who have made the loans include big and small financial institutions alike, including names like First Republic, Deutsche Bank, Midfirst, TPG, Blackstone and Apollo. Lenders often carve up the loans and sell little pieces all around, so again, it’s not always easy to follow the crumbs, but we do know that much of the cash comes from public pension funds--retirement savings for state workers--and bank deposits. Yet again, Wall Street ingeniously shifted the risk to Main Street.

Today, banks are falling over themselves to put money to work in riskier instruments that pay higher rates--instruments like condo inventory loans. This all feels kind of like the high times of 2007 when spreads tightened and kooky loans flowed freely.

At Compound, we’re watching the condo inventory loan market closely.

Of course, we’re concerned about what its implosion might mean for broader financial markets, but we also smell an interesting opportunity--one that is ultimately secured by Manhattan condos, which we believe are some of the best assets any investor can hold in his or her portfolio. To learn more about non-performing condo inventory loans, email a member of our team or visit our website to read more about the real estate investment landscape.

*Figuring out exactly which units remain unsold can be difficult. Condo project websites intentionally obscure the total number of units available for sale to make projects seem more desirable. (It’s worth noting that when we press on-site brokers for sales information, they confide that many more units remain unsold than developers are openly admitting.)  

**What’s even worse: condo inventory loans typically sweep the proceeds from condo sales and use them to pay down the loan’s principal balance. However, in today’s market, a shrewd developer can negotiate to “leak” some cash to his investor-partners.