With Bank Credit Scarce, Builders Hope for REIT Revival

With California banks unwilling to finance real estate construction, some homebuilders are pinning their hopes on real estate investment trusts.

Success in California could open the door when housing demand returns elsewhere.

A comeback for REITs would be a surprising turn of events, and the fact that they are being touted now is a measure of how desperate the credit crunch has become.

Following a meteoric appearance in the 1970s, dozens of these publicly traded partnerships eventually collapsed, leaving thousands of angry investors deep under water.

Problems from the Past

Although REITs offer some distinct lures in the current market, even boosters concede that the checkered past might be hard to live down.

"The problem is, you have to find investors," said Christopher Lucas, director of research for the National Association of Real Estate Investment Trusts.

Nevertheless, Jack Rodman, managing director of Kenneth Leventhal & Co. lists REITs among the handful of new financing vehicles poised to pump money into homebuilding. Some of these vehicles could also help finance other property types as demand increases.

Other Vehicles Emerging

While REITs gather momentum, other types of private funding vehicles are preparing investors for unorthodox real estate financing techniques.

SunAmerica Realty Partners and Broad Inc., for example, have jointly established a $500 million pool of capital. So far, a $110 million investment includes financing for three shopping centers and seven residential projects, said Jeffrey M. Gault, managing director of SunAmerica Realty Partners.

Alternative sources of capital compete with reluctant bank lenders, but ultimately, they may be doing bankers a favor by helping to establish more realistic price levels for real estate credit risks. That would open a window too narrow at present for most banks.

An Uncomfortable Rate

REIT investors, for instance, would expect a return of up to 13%, a tough pill for homebuilders used to rates under 10%, but one they are expected to swallow if the alternative means no financing at all.

However they are structured, these alternative sources of funding will have a large void to fill.

California banks are under regulatory pressure to reduce their exposure to real estate from more than 35% of assets to the national average of about 25%, Mr. Rodman said. This will suck $40 billion out of the market just as the inventory of homes begins to dwindle, he said.

Looking for Low-Risk Projects

Sensing opportunity, former bankers are among those trying to form new REITs to provide construction financing, Mr. Rodman said.

He declined to identify the former bank officials who are trying to create construction REITs, but said the funds would invest in low-risk projects in which untis have been presold.

All in all, though, Mr. Rodman played down the risks associated with REITs. Their problems resulted from overbuilding caused by "too much money chasing too few quality projects," he said. This time it will be different because the competition is not as intense, allowing the REITs to be more selective.

Tax Angle Remains

And REITs continue to appeal to investors thanks to a tax advantage. Structured as partnerships, they pay no corporate income taxes as long as 95% of net income is distributed to investors.

At the same time, he said, pension funds will link up with developers who can attract the limited bank financing that is still available. Plan sponsors are looking for 15% to 20% return in exchange for putting up a portion of the 30% of cost banks now require up front, he said.

But in at least one case, the pension money may be used for construction finance.

Montgomery Securities, which hopes to place a $150 million fund with pension investors by the first quarter of next year, had planned to provide joint venture money for residential projects in which a bank provides 60% or 70% financing. But the retreat of banks from the market in recent months has been such that sources say the firm now expects to focus on deals in which the fund in effect hires the developer for a fee to build a project.

So far, however, such funds as the one linking SunAmerica Realty and Broad Inc. are the only ones to make a major investment - despite the expectations of greater pension fund and REIT investment that have been around for years, Mr. Gault said. And he noted that bank financing can be had, albeit on a much more conservative basis than before.

"They have the production networks," Mr. Gault said of banks. "Its just, the rates will be higher. Where you used to see prime plus one eighth, now you'll see prime plus two or prime plus three."

Although others debate whether banks will lend at all, given the current regulatory environment, Mr. Gault said they will lend - on a highly selective basis. And they will provide only 70% of cost, rather than a much more generous 80% loan-to-value, a highly nebulous calculation that works out to over 100% of cost in some cases.

Mr. Rodman agreed that developers face a much more discerning marketplace - whatever the financing source.

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