Condominium developers are starving for construction financing as commercial banks focus on rental projects. With condominium markets soft and the capital markets in turmoil, the banks that still finance condominium development are demanding more equity and higher interest rate spreads—terms that desperate developers are happy to accept because they often have no other choice.

“The few guys that are making condo financing deals are being much more selective,” said Emanuel Westfried, vice president of construction finance for Meridian Capital, a New York City-based mortgage broker.

Interest rates for construction loans are on the upswing. Commercial banks now typically charge floating rates ranging between 250 and 300 basis points over the London Interbank Offered Rate (LIBOR). That’s roughly 50 basis points more than the spreads over LIBOR offered two years ago, according to experts interviewed for this story.

LIBOR has also increased sharply, with the net effect that the prime rate for short-term financing has nearly doubled, to reach a range of between 8.25 percent and 9 percent, according to Spencer Garfield, managing director for Hudson Realty Capital, a national lender based in New York City.

Typical bank construction loans to condo projects are getting smaller, covering just 75 percent of the cost at the maximum, compared to up to 85 percent two years ago. Mezzanine lenders refuse to fill the gap. A typical mezzanine loan added to a 75 percent commercial bank construction loan will now cover only up to 80 percent of a condo project’s total cost, Garfield said. That’s a big change from two years ago, when Hudson’s mezzanine loans added to bank financing could cover up to 90 percent of the cost of condo deals.

Smaller developers often have trouble finding the extra equity to start construction. “There are a lot of projects that are not underway,” said Garfield.

Banks are also now skeptical of promises and projections made by developers—and this skepticism shrinks the amount they are willing to lend. In many markets, lenders assume condominium prices will fall as much as 10 percent from their current depressed levels. With the cost of construction up by more than 20 percent over the last 12 months, lenders also are asking developers to sign agreements with all of their contractors to guarantee a maximum price for labor and materials, rather than leaving their options open, experts say.

Not only are underwriting rules tougher, banks are also less likely to bend their rules than they were two years ago. In part that’s because many banks already have enough or more than enough of these commercial real estate loans on their balance sheets. “The majority of them have been overallocated in condos and haven’t completed a lot of the deals that they funded two, three, or even four years ago,” said Scott Peterson, vice president and mortgage expert in the San Diego office of CB Richard Ellis Group, Inc.

That’s a big change from just a few years ago, when many institutional investors increased their investment targets for commercial real estate. With billions to invest and only so many deals to invest in, banks were eager to convince themselves that multifamily projects were strong. Questionable condominium developments could lure wary lenders by showing that they had pre-sold a large number of units. Today, lenders that question the strength of a development will simply refuse to lend, no matter how many units have pre-sold, according to mortgage brokers.

Banks that have room on their balance sheets to invest in the multifamily market are increasingly turning to rental projects, according to Westfried of Meridian Capital. Ninety percent of Westfried’s multifamily lending business was in condominium loans two years ago. Now his business is split about 50-50 between apartment loans and condominium deals.

“Lenders are being very aggressive with rentals,” Westfried said. “They are tired of seeing condos.”

The smallest condominium developers, with less experience and equity to bring to their projects, are suffering the most as banks turn from condos. “They’re screwed right now,” Westfried said.

Only the most experienced condominium developers with the strongest financials still have it easy. A few lenders will still compete hard to lend to the strongest, safest condominium projects by offering low interest rates and forgiving terms.

“There are 20 developers in New York City who have no trouble borrowing money at aggressive terms,” said Garfield of Hudson Realty. “And then there’s everybody else.”

Corus Bank, based in Chicago, offers the most experienced developers interest rate spreads even lower than the spreads on offer during the condominium boom. Corus’ loans typically cover 75 percent of the cost of a condominium project, with interest rates ranging from 275 to 325 basis points over LIBOR. Over the last two years, those rates have dropped to the lower end of the range. “Pricing is down,” said Dwight Frankfather, first vice president for Corus.

Condo defaults still low

Still, relatively few condominium loans have defaulted, even in the most glutted condominium markets. Corus, for example, has only foreclosed on one condo loan in the last 10 years. It closed $929 million in condo loans in the first half of 2007, down from $1.4 billion in the same period the year before. That volume makes Corus one of the biggest condominium lenders in the country.

Defaults are low in part because many troubled projects that couldn’t pay their debt service have been rescued over the past two years by easy financing that allowed them to renegotiate their terms, Peterson said.

The high price of multifamily properties also saved some troubled condo developers from bankruptcy. So far, banks have generally been able to sell foreclosed condominium properties for at least the value of the loans they made to the properties, according to condominium market experts like Jack McCabe, president of McCabe Research and Consulting, based in Deerfield Beach, Fla.

That safety net is beginning to tear, as loans become harder to get and the price of multifamily properties relative to the potential income from rent begins to drop. Experts like McCabe expect the rate of foreclosures among condominium developments to rise, along with the amount of money that lenders lose on those foreclosures.

That vicious cycle may mean the worst is yet to come for condo developers.