What is preconstruction?
When you’re buying a “preconstruction” or “off-plan” home or condo, you’re buying into a place before it has been constructed. You are relying on a set of architectural plans. Sometimes, developers will offer substantial discounts to buy off-plan. The best preconstruction projects will sell out before a shovel goes in the ground. The best units go to first purchasers who are often “insiders.”
Why would a developer do this?
Developers need funds to operate their business. These projects need several millions of dollars to complete. Most developers simply don’t have that kind of cash. Furthermore, bank finance for construction costs will typically be dependent on a certain level of presales (usually a dollar value not a certain number or percentage of units sold). 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/buyers. The developer will also want to share some of the risk by selling preconstruction. He might be giving a good deal based on today’s prices. However, no one knows what the market could be like when the units are delivered in two, three or four years time.
If the developer has a good track record, most banks will lend him the money for a deal like this. With presales in place, the bank’s risk is minimized. Developers first goal is to secure construction funds.
Who is preconstruction for?
Buying a preconstruction unit 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 as long as the market is appreciating, you probably don’t mind that it will take three or four years before you take possession of your unit.
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. Where and what you are buying will depend on who your future buyer is. 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 may 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.
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?
Of course you should never rely on flipping. Only buy preconstruction if you have the resources to go the distance.
Buying preconstruction can make sense 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.
What do I think?
Ten years ago Waterloo Region had few condos. Today we have many. Seagram, Kaufman, Bauer, City Centre, Arrow Lofts are just a few of the big names that come to mind. The local real estate market was generally growing at around 6% per year until this year when it has leveled off to about 1%.
Some developments have done well (Bauer Lofts), some not so well (Eaton Lofts). The reputation of the builder is important, for sure.
The condo market leads the market. it is the first to appreciate wildly when things are hot, and the first to take the plunge when the economy is unstable.
Three more things:
You should always check if your contract is assignable when buying preconstruction. It’s always nice to have that exit option available.
Tread carefully…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. You want to play the preconstruction market in the early to mid growth stages of the market. The market punishes late arrivals who think prices will continue to rise as they have been rising all along.
Make sure you hire an independent lawyer, not the one the developer recommends.