One of the biggest residential development projects in Arizona history is quietly turning into a major bust.

The question now is whether the big homebuilders involved in the deal -- Toll Brothers ( TOL) and Meritage Homes ( MTH) -- are properly marking down their land investments in the much-heralded venture.

In early 2006, the two high-end homebuilders partnered with the country's largest mall owner, Simon Property Group ( SPG), to pay $312 million for a 5,485-acre parcel of land northwest of Phoenix in the city of Surprise, Ariz.

With the once-hot Phoenix market crash-landing, it now appears that Toll Brothers and its partners ended up paying too much for the land, on which they likely cannot build today for a profit.

At the time of the purchase, Toll Brothers, the general partner of the joint venture, trumpeted the deal as the "most expensive" land transaction in Arizona history, citing research from the Arizona Republic. The plan called for the companies to build a mixed-use, master-planned community with 15,000 to 31,000 homes that were originally expected to go on sale in 2009.

Simon Property was planning to build the retail portion of the development. But a source at the real estate investment trust tells that the company has decided to scrap the retail portion of the project, which is the reason for a writeoff of the venture last week.

In a warning about upcoming fourth-quarter earnings, Simon announced a $50 million charge to write down the entire value in the venture. Simon gave few details of why it was writing off the project, only saying the move coincided with the writedown of the joint venture's value by the general partner, Toll Brothers.

On its own earnings call last week, Toll Brothers mentioned that there were write-downs related to the project, but it didn't give specifics. The issue wasn't addressed in the company's earnings release, and was only discussed on the call when an analyst questioned the builder about the project.

But the fact that Simon Property wrote off its entire investment in the project is turning some heads. As the company now likely pulls its retail development, some wonder whether the project will ever get built.

"My understanding is the venture itself, the whole group, is not thinking it is going to work at this time," says RBC Capital Markets analyst Rich Moore, who covers Simon Property and other real estate investment trusts. "It is rare for a developer to write something down unless they feel pretty certain it is not going to work."

Moore says he doesn't know the precise details and hasn't spoken to Toll Brothers or Meritage.

The Simon Property source says the company's writeoff does not reflect the overall viability of the project.

"Toll Brothers, as the general partner, would make that call," the source says.

Executives from Meritage and Toll did not return calls seeking comment from A Simon representative declined to comment.

Regardless of whether the homebuilders abandon the project, the Simon Property writeoff raises questions about whether the companies are being conservative enough in their valuations of land holdings.

"Builders are not being aggressive enough, generally speaking," says an analyst who was on the Toll call last week. "They are not doing what Simon did."

Toll management said on the call that the company had just $59 million of joint venture writedowns in the quarter. Those were spread out over a few JVs, but Toll declined to give a breakdown.

The company's chief financial officer, Joel Rassman, said the impairments represented a small piece of the ventures' total asset values and were primarily related to the risk of JV investments.

Phoenix Falling

The Toll project is tied to land located in an area outside of Phoenix -- one of the country's hottest housing markets during boom time. Now, the region is getting hit hard by high inventories and reduced affordability.

Stephen East, a homebuilder analyst with Pali Capital, says he visited the market a month ago and was surprised at the "sheer amount of property."

"There is such a massive oversupply," East says. The market is bifurcated between the central city areas of Phoenix -- where there is still some demand -- and the outer areas, which are "extremely slow," he says.

In October, new-home sales in the Phoenix area totaled 3,159 units, down 29% from a year earlier, according to the latest data from R.L. Brown Housing Reports. Permits for new homes totaled 1,325, down 43% from last year, the data said.

Surprise, where the Toll project sits, is considered an "edge city" that is in the "direct path of future growth," says R.L. Brown, the author of the market reports. Nonetheless, as the entire Phoenix housing market corrects from boom times, outer areas like Surprise may face even more difficulties because they are so far out and have traffic congestion.

Gasoline, at $3-per-gallon in Arizona, is also hurting housing prices in outlying areas, industry watchers say.

"If they build it today with the land base they had, it could be real challenging," Brown says about the Toll project. "But like any development opportunity of that size, it will span a decade.

"I don't think they are in any long-term negative position relative to that piece," Brown adds.

If Simon does end up pulling the retail piece and no other partner comes in, this "will put even more pressure on the housing component," says Jay Butler, director of realty studies at Arizona State University.

Butler agrees that the Toll project probably could not be built at a profit today given the high price paid for the land.

In early 2006, when the deal closed, "the market had begun to slow down, but I don't think anyone had bought into that idea yet," Butler says. "People were still buying land with the idea that Phoenix would grow forever.

While investors in Simon Property Group can be comforted that there will be no further writedowns related to that project, shareholders in Toll Brothers and Meritage continue to sit in the dark as to future impairment charges on the projects.

It's appropriate that the project is in a place named "Surprise."

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