Banks offer letter of credit to finance 2nd homes

Banks offer letter of credit to finance 2nd homes

Thursday, May 19, 2005By Kemba J. Dunham, The Wall Street Journal

Buy beachfront property! Almost no money down!

More investors prowling some of the hottest real-estate in the country have discovered an old-fashioned financing tool -- the letter of credit -- and are using it in a way that may be adding fuel to an already overheated housing market.

Regional banks active along the Gulf of Mexico, where thousands of luxury condominiums are planned, are offering letters of credit to high-end home buyers, who use them instead of a cash down payment to reserve condos before they are built.

A person who obtains a letter of credit is promising to make a future payment, or else the bank that wrote the letter of credit is on the hook. Some letters of credit are secured by the person's assets; some aren't. They have long been used by companies, often when there is a lag between striking and closing a transaction, such as in securities transactions or the import/export business.

Using a letter of credit to buy a home has been rare -- until now -- in beach communities in Florida, Alabama and Texas, where baby boomers are buying second homes. Estimates call for 20,000 condo units to be built in Florida and Alabama alone in the next two years, many at prices of $500,000 to $1 million. Some commercial lenders won't advance construction financing for condo developments until the builder "presells" at least 60 percent of the units, even though they may not be built for a couple of years.

For customers who don't want to tie up cash that long, the letter of credit is attractive. "You're not using any of your cash, and protecting your cash is one of the most important things to an investor," says Kathy Martinez, who has been investing in real estate for 25 years and currently owns eight condos and seven preconstruction units along the Gulf Coast.

In Alabama, buyers are allowed to use a letter of credit for as much as 20 percent of the down payment. In Florida, a buyer can get a letter of credit for half of a 20 percent down payment; the rest must be in cash.

How letters of credit get used to buy condos is fairly simple. Typically, a developer "presells" by letting a buyer reserve one or more units with a small cash payment. The buyer then has 30 to 60 days to get a letter of credit covering up to 20 percent of the purchase price. Once the developer gets the letter, the deal is binding, and the reservation becomes a sale. The buyer may then get back that initial cash payment.

Ms. Martinez recently received a letter of credit from Vision Bank in Gulf Shores, Ala., for 20 percent of the value of a $460,000 condo there. Like other investors, she hopes the property will appreciate by the time construction is complete, allowing her to sell for a profit -- without spending anything but the letter-of-credit fee charged by the bank. Such fees are in the 1 percent-to-3 percent range of the letter-of-credit value per year.

Helga James, a Gulf Shores mortgage broker, says "everyone makes out" with letters of credit: Banks get fees and customers, buyers get to invest their money elsewhere while waiting for construction, and developers are assured their money.

Some say letters of credit make it too easy for speculators. Economists estimate about 20 percent of residential property sales involve investors, not families or individuals who plan to live in the home. Such purchasing could be artificially lifting prices and demand and could destabilize a market should speculators start dumping homes, these economists fear.
"If these letters of credits are being given in markets that have a high share of investor purchasing, then it seems speculative, and it's something I'd pay attention to," says Doug Duncan, chief economist at the Mortgage Bankers Association in Washington.

The banks believe waterfront property is unlikely to lose value, and they see letters of credit as a way to attract high-end clients amid competition from the nation's biggest residential mortgage lenders, including Countrywide Financial Corp. and Wells Fargo & Co.
Offering the letter of credit "has been very profitable for us and has allowed us to build relationships" with wealthy clients, says Danny Sizemore, chairman and chief executive of Vision Bank. Mr. Sizemore says the bank manages its risk, requiring that customers have equity in an existing property, cash in a certificate of deposit or other assets.

SunSouth Community Bank in Destin, Fla., a division of the Bank of Bonifay, Bonifay, Fla., is issuing an increasing number of letters of credit. The most popular type, an unsecured letter, requires no collateral, but the customer has to have a good credit score, a stable job and income and between one half and two times the letter-of-credit amount in stocks, a CD or in a checking or savings account. Most applicants qualify, but because of strong demand, "we have reached our cap for unsecured credit," says Jayce Holley, a vice president at the bank.

J. Collier Merrill, a developer in Pensacola, Fla., says banks do a good job with letters of credit, and the market does the rest. "We do have a lot of investors on our rolls right now, but there are enough baby boomers out there who are going to want condos here for at least another 10 to 15 years, and they're going to buy from these investors," he says.