Friday, September 25, 2009
Yes…and no. It depends on the market, the deal and you. First, we need to understand….
What is preconstruction?
Buying preconstruction, or off-plan, is where you buy into a development before it has been constructed. You are relying on a set of architectural plans. Frequently, developers will offer substantial discounts to buy off-plan. The best preconstruction projects will sell out before a shovel goes in the ground. Often the best units go to “insiders.???
Why would a developer do this?
Developers need investor funds to stay in business. That’s a strong incentive to create simple and profitable investor terms. Also, bank finance for construction costs will typically be dependent on a certain level of presales. The developer will want to hit that number as soon as possible. By shortening the length of the project, he can increase his return on investment (ROI). This timing issue creates a symbiotic relationship between developers and investors. The developer will also want to share some of the risk by selling preconstruction. He knows he is giving a good deal based on today’s prices but who knows what the market could be like when the units are delivered in two years time.
If the developer has a good track record, banks practically compete with each other to lend him the money for a deal like this (under normal credit market circumstances). With presales in place, the bank’s risk is minimized. By simplifying the deal, the developer minimizes his administration costs while securing his construction funds at a competitive rate.
Who is preconstruction for?
Buying off-plan makes more sense for the investor than for someone buying for personal use. For the investor, the unit doesn’t have to meet your personal taste, and you probably don’t mind that it will take up to a few years before you take possession of your unit, as long as the market is seeing appreciation.
Buying preconstruction you need to make sure…
It should, however, be a property that a large portion of the general public wouldn’t mind owning or renting. You are buying the unit to eventually sell or rent to an end user, and you want to make sure the property will be attractive to that level of the market.
The end user may be a long-term renter, a first-time homebuyer, a short-term vacationer, or even another investor. That will depend on where and what you are buying. Analyze who the end user will be before you put your money down, as you will want to make sure there will be a big enough market to sell your property into. Pay attention to how much similar supply is in the pipeline in the area.
Leverage…preconstruction’s silver bullet
You get a discounted price to compensate you for taking on some of the early development risk, but the real incentive to buy preconstruction comes from leverage. While the terms of the payments vary from project to project, no matter what the terms are, you are leveraging your returns to some degree. A typical deal will start with a small down payment…say, 5%...and work through various staged (progress) payments during the construction period, until you have paid anywhere between 5% and 80%. The balance is due when the keys are turned over.
Let’s walk through a sample deal to show how leverage works when buying preconstruction. You purchase (preconstruction) a $100,000 condo with a 10% down payment. The balance is due on completion in two years’ time. A 20% increase in price during the build period means a 200% return (net of fees) if you were to flip. Of course, leverage, like buying an option, can work in two ways; a 10% fall in price means that you are down your entire investment.
Preconstruction as part of a wealth accumulation strategy
Buying preconstruction can be a great way to accumulate a rental portfolio. Capital appreciation can mean that at closing, a bank will lend based on the new valuation, not the price you paid. This can mean that you can pull cash out of the property the day you pay for it. I’m using preconstruction as part of a medium term wealth accumulation strategy in Fortaleza.
When in the market cycle does preconstruction make sense?
Buying preconstruction is a strategy that will maximize the retail investor’s ROI in the early-to-mid stages of a market appreciation cycle. Buy preconstruction at the top of the market and you risk losing your entire investment…and maybe even more than you have invested, if you are contractually bound to complete and that clause is enforceable. All the benefits of buying preconstruction are tied to a rising and active market. Without a rising and liquid market preconstruction almost never makes sense.
If there isn’t activity in the market you run the risk that the project you buy into won’t be completed or if it does get completed half the building will be empty. This can be a big problem when it comes to maintaining communal areas or amenities and security.
Does Buying Preconstruction make sense today?
Yes…and no. It depends.
As you know I’m bullish on Fortaleza/North-east Brazil and certain crisis opportunities in Spain, Portugal and the UK.
In Fortaleza prices are appreciating at an annual rate of upwards of 15%, but we have been able to buy with as little as 1% down (now that’s leverage!) from major developers. There is a short-term rental shortage and a scarcity of developable land. Demand seems likely to continue to rise for the foreseeable future.
On my first trip to Fortaleza in April 2008 I bought a couple of units at a project launch. The guy I was with bought 2 also. At contract signature we were into each condo for about $1,000. Two weeks later I got a call from the guy I was with. He had just sold his condo (which was a contract really) for $20,000 more than he had paid. He turned his $1,000 into $20,000 in a couple of weeks. He kept his second unit and was wondering if I’d like to sell one of mine. I passed. It would have been nice but I was happy to stick with my strategy.
Of course you should never rely on flipping. Only buy preconstruction if you have the resources to go the course. But, this is an example of what can happen in a white-hot market.
Tip: You should always check if your contract is assignable when buying preconstruction. It’s always nice to have that exit option available.
More recently I have bought preconstruction here for 15% less than preconstruction launch prices. Prices have subsequently risen before launch and before construction even started. I have bought these units as part of a medium term investment strategy as opposed to a speculative play.
So, for the right deal in a hot market like Fortaleza, preconstruction can make sense today.
White-hot preconstruction markets can frequently overheat. Too much supply becomes a problem. Prices rise too fast. If prices rise to the point where there is no expectation of future price increases the market will stall. Five years ago Panama was one of the hottest preconstruction markets I have seen. Today, it’s a different story. As I said…you want to play the preconstruction market in the early to mid growth stages of the market. Mr. Market punishes late arrivals who think prices will continue to rise as they have been rising all along.
Crisis Opportunities and Preconstruction
Spain and the UK are awash with crisis opportunities. Today, we can buy in for as little as 50 cents on the euro or pence on the pound. Developers have overstretched themselves and now banks are forcing sell-offs.
To refresh your memory:
My three golden rules for buying crisis opportunities are:
1. Buy quality.
2. Don’t take on any construction risk…buy completed units.
3. Don’t take on any project risk…make sure the condominium is functioning.
This clearly rules out preconstruction deals that are in distress.
Again, does buying preconstruction make sense today?
It can when you follow the golden rules. Look for:
-An appreciating market in the early to mid stages of growth
-A developer with a strong track record who is financially stable
-Supply constraints…a lack of developable land for instance
-A market with an abundant supply of end users
As with any other investment, buying preconstruction requires a clearly thought-out strategy and an understanding of the risks involved. Get it right and you will reap the rewards.
You do however need to be sure that you are comfortable with signing a contract based on a rendering. This is where you need to make sure buying preconstruction matches your appetite for risk, and your investment strategy.
Margaret told you last Saturday to make sure you always hire a fully independent attorney. Take her advice if you decide to buy preconstruction…and stay tuned for her next nugget tomorrow.
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