Five Golden Rules for 2010 | Pathfinder International

Monday, January 18, 2010

Dear Reader,

Does buying pre-construction make sense in 2010? Yes…and no. It depends on the market, the deal, and you. Find the right deal in the right market and returns can be 100%, 200%, or even more. How do you know if it’s the “right deal?” Follow my golden rules.

Buying pre-construction 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 pre-construction projects will sell out before a shovel goes in the ground. Often the best units go to “insiders.”

Developers do this as they 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 pre-sales. The developer will want to hit that number as soon as possible. The developer will also want to share some of the risk by selling pre-construction. 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?

Buying pre-construction 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.

When you buy a unit pre-construction, however, it should 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.

You get a discounted price to compensate you for taking on some of the early development risk, but the real incentive to buy pre-construction 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 pre-construction. You purchase (pre-construction) a $100,000 condo with a 10% down payment. The balance is due on completion in two years. 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.

Buying pre-construction is a strategy that will maximize the retail investor’s ROI in the early to mid-stages of a market appreciation cycle. Buy pre-construction 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 pre-construction are tied to a rising and active market. Without a rising and liquid market, pre-construction 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.

White-hot pre-construction 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 pre-construction markets I have seen. Today, as you know, it’s a different story.

As I said…you want to play the pre-construction 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.

The “right deal” should always tick all these boxes:
1. An appreciating market in the early to mid-stages of growth
2. A developer with a strong track record who is financially stable
3. Supply constraints—a lack of developable land, for example
4. A market with an abundant supply of end users
5. A liquid market with a large volume of transactions

As you know, I am bullish on Fortaleza, Brazil. Pre-construction here can tick all these boxes. I’m also bullish on distressed opportunities in Europe. In this case, however, pre-construction doesn’t make sense. One of our golden rules for distressed deals is that we shouldn’t take on any construction risk.

Follow my golden rules above and you will find the right deal in the right market…and the returns can be handsome.

Ronan McMahon