Last year, condo converters bought $13.3 billion worth of U.S. apartment properties in a whopping $10.3 billion increase over their 2003 take. That's a 350% year-over-year jump driven by low interest rates and soaring single-family home prices.

The investment pace isn't slowing. Between Jan. 1 and June 15, converters bought $7.05 billion of apartment properties, which is on a pace to meet or exceed last year's $13.3 billion volume, reports Real Capital Analytics.

None of this would be happening if lenders weren't tripping over themselves to finance these acquisitions and subsequent conversions. But concerns are rising that many condo conversion loans might sour, given the prospect of higher interest rates and overbuilt condo markets. For its part, Manhattan-based credit ratings firm Fitch Ratings warns lenders to pay close attention to the risks that come with these projects.

“Condo conversion loans have an element of construction/renovation risk, and the properties do not generate a sustainable in-place net cash flow,” says Zanda Lynn, a director at Fitch Ratings. “Assessing these risks, as well as conversion-stage risk and market risk, is paramount in determining the treatment a condo conversion loan should receive in a CMBS transaction.”

Condo converters are moving out of core markets such as southern Florida and California where apartment cap rates are very low, says Lynn. In fact, Columbus, Ohio and Lexington, Ky., largely ignored by condo investors, have attracted converters in recent months. This shift suggests to Lynn that conversion activity is getting out of hand: bid prices are so high in core markets that converters are seeking alternatives in other locations.

This combination could have serious consequences for condo lenders. How serious? Fitch predicts that roughly 10% of all condo conversion loans originated this year will ultimately default. That's a substantial default rate given that Fitch expects only 2% of all multifamily loans originated in 2005 to default. The defaults will likely stem from complex projects undertaken in overheated markets, Lynn believes.

Even lenders bullish on the condo conversion market are paying attention to the potential danger of loan defaults. Sonnenblick-Goldman Co. is addressing the risk posed by the frenetic pace of development, says Andrew Oliver, managing director and principal at the Manhattan-based real estate investment bank.

Still, caution hasn't dulled Sonnenblick-Goldman's appetite for conversion loans. The firm expects to finance more than $500 million in condo conversions this year. Sonnenblick-Goldman recently arranged $10.25 million in mezzanine financing for a condo conversion in Orlando. And last August, Sonnenblick-Goldman arranged $78 million in senior, mezzanine and equity financing for another acquisition and conversion in Tampa.

“We definitely make sure we have the right development and marketing team on these deals, so we pay close attention to their track records. The deal has to make sense,” says Oliver. He also spends time researching markets to ensure that a supply glut isn't on tap.

Sonnenblick-Goldman has simplified its investment strategy by focusing on conversions of apartments to condos. That helps the firm limit its risk. “It doesn't take nearly as long to convert from an apartment to a condo as it does from, say, an office building to a condo. We can turn that apartment around very fast, and that helps cut the risk of missing the market.”

Lynn of Fitch Ratings says conversion sponsors looking to turn a quick profit pose the greatest risk to lenders. “This condo conversion activity just isn't sustainable in the long run,” she says. “It's the investors who buy these properties at high prices and might not be able to sell them for the right price who will ultimately default on these loans.”