In No Position to Buy

June 8th, 2015 by Potato

The Star featured a story last week of a family in a tight situation: they had bought a pre-construction house, which was delayed by several years and had shrunk from the sales model. They decided to cancel the deal and get their deposit back, which led to trouble of one sort.

And another.

The developer delayed for months on returning the deposit, which raises some interesting questions about the solvency and decency of Urbancorp. But as part of their complaint against the developer, the family claims that without the return of the deposit — a rather substantial $95,000 on a $850,000 house — they won’t be able to scrape together $5k for first and last on a rental.

It’s mind-boggling how an apparently well-to-do family with over a million dollars in real estate assets (between the pre-con house and existing condo), who were able to put down over a hundred grand on two places, doesn’t have an emergency fund of any kind — not even one month’s expenses.

Even if the pre-con house had been built according to plan and the original schedule, how were they going to close the sale with no assets? Where were their savings from living on a budget to prepare for the higher ongoing costs of the house? I could go on about this case, but that’s not what I’m here for today.

I don’t want to focus on their particular case: they were simply in no position to buy in the first place. It’s another Toronto family over-reaching for real estate.

Instead, I want to rant about the dangers of pre-construction. How most people are in no position to buy pre-con.

Lots of people made lots and lots of money in pre-construction in the early and middle phases of Toronto’s condo boom, without needing a lot of capital, effort, or smarts to do it. That’s helped create the widespread impression that pre-construction is a great, risk-free way to make lots of money — and developer advertising reinforces the investment message every chance it gets using dirty tactics that would not be legal in other investment industries like mutual funds or stocks.

Part of how these people made money was that pre-construction came with a discount to existing units — as David Fleming has most famously covered, that discount has been essentially non-existent for years. It’s supposed to compensate the investor for the risks and inconveniences of pre-con, so when it vanishes it indicates that the average pre-con buyer is not doing so from a detached, analytical investment perspective — or if they are, it’s from the footing of a speculator looking to boost the leverage used. The other big part that contributed to the profits reaching stupid levels is the use of leverage inherent to real estate and pre-con purchases (and again, the magnifying benefits of leverage are highly played up in developer ads).

However, leverage is risk and that cuts both ways. If things don’t go as hoped and there are problems, people buying pre-construction can face massive cash calls and losses. To try to protect the stability of our economy, development projects in Ontario must sell a certain percentage of units before they can get financing from banks to fund the construction. This helps provide the banks with a buffer so they won’t end up foreclosing on massive, empty towers that no one wants to buy in a few years’ time, leading to the collapse of the banking system. However, the pre-con purchasers then end up shouldering a lot of the risk for the project, risk they are by and large not equipped to evaluate or handle.

What are some of the worst-case scenarios with pre-con? Well, consider the case where you have done your due diligence on the builder perfectly, and they deliver a unit to you that looks exactly like the sales demo, exactly on the expected occupancy date (note: none of these things ever actually happen) — but the long-feared condo downturn actually appeared some time in the three and a half years between committing to the purchase and the completion of construction. Your unit is now worth 25% less than you thought, and because you haven’t been able to unload the place you were living at, the bank won’t give you a high-ratio mortgage. So you need to come up with ~30% of the original price to close.

Put some numbers to that: you like the looks of a $400k pre-con condo. You scrape together $40k as a deposit for pre-con, and plan to sell or refinance your existing place to free up another $40k upon completion so you can close. Instead, the market crashes and your pre-con is only worth $300k. The equity in your current place is gone, and the market is locked up so you couldn’t dump it even if you could stomach realizing the loss. The bank is only willing to lend against the current value ($300k) of the new place, but you’re contracted to pay the developer $400k for it. Somehow you have to come up with $60k just to get you back to even, and another $60k to get a mortgage on your second property — where are you going to get $120k from on what might be as little as a year’s notice?

Yes, it’s a rare event. But for many families, the low-but-not-zero likelihood events that can happen with pre-construction represent extinction-level events for their finances. Especially if they own two properties by buying pre-con before selling an existing place.

Pre-construction is too risky for most people out there who are doing it anyway — they are in no position to buy or to assume the risks that they are. It is not the everyday riskiness of the stock market, where there’s volatility and unpredictability and small losses all the time so you never forget it. It is the risk of rare events — the “black swan” — coupled with massive leverage that leads to what we term “blow-ups”.

IMHO, only accredited investors should be allowed to buy pre-construction in the province, or the rules should be changed to limit liability to the deposit. I’m a lefty protectionist bastard that way (and housing bear to boot), but an investment product that can lead to losses that are an order of magnitude higher than the deposits people are putting down (what they may naively assume is the limit of their liability) is one that should be most highly regulated. But that’s not going to happen, so instead here’s a short list of things to bear in mind with pre-construction:

  1. 1. Pre-con should be cheaper than something you can live in (and inspect) today. This is to compensate you for the risks, the inconvenience, the uncertainty, and the time you have to wait. If there is no pre-con discount (and David Fleming has made the case that there is not in Toronto), then do not buy pre-con1.
  2. 2. The moment you lock in to the contract (which may be as many as 10 days after you sign if you have a cooling-off period), you are on the hook for the unit, at the price you agreed to. If you also have a current owned unit (house, etc.), you now have two units. Do you have pockets deep enough to own and maintain two units through thick and thin? If not, then do not buy pre-con; or sell your existing unit and rent it back (or rent something else) until your pre-con unit is done for safety.
  3. 3. You will likely need liquid cash to close. If you do decide to ignore point #2 and hold two units, this is not the time to aggressively pay down your mortgage by making extra payments — you may need that liquidity, and you’ll need it most in the scenario where it becomes inaccessible as real estate equity (whether due to a down-turn in prices, tightened lending, or slowing in turnover in the market). That may mean losing out on interest rate differential by paying a 3% mortgage while holding cash that’s only earning 1% — it’s the cost of protecting yourself against a blow-up, and may serve as a reminder that you are in no position to buy pre-con.
  4. 4. Do not do it by the skin of your teeth. There are many things that have to go right for pre-con to work out: if even in that scenario you would be stretching, just don’t do it. You will need big buffers and emergency funds for the rare cases where it does not at all go according to plan — and some buffer for the exceptionally common cases where it’s off by a bit. These include:
    • a. The unit is not as advertised, or as polished as you expected, and you have to renovate your brand new unit in some way (e.g. refinishing floors, patching holes, replacing appliances, fixing plumbing issues). Do not count on help from Tarion.
    • b. The unit is late. Late here is a relative word as no condo project in the history of the city has ever finished by the date on the sales office billboards.
    • c. The unit cannot be flipped. So it’s no longer your bag, baby. Maybe in the 5 years you were waiting for your swanky 1-bedroom ultimate bachelor pad to be built you found a mate and spawned, and now live somewhere else. You want to flip upon completion — only to find that 42 other people in the building had the same idea. You’re going to have to either accept (and cover!) a loss to under-cut them all, or come up with the funds to close and rent it out for a year or two until the supply spike subsides and you can find a buyer — or carry it empty for months looking for buyers.
    • d. There has been yet another tinkering in the mortgage market and the financing terms you were expecting when you signed the contract 5 years ago no longer apply. Now you need to come up with more money and/or pay a higher rate than you expected. Or the unit isn’t worth quite as much as you were hoping for when the appraiser is done and you have to cough up a larger down payment to close.
    • e. Occupancy and carrying two units. Occupancy is a weird period in a new development. You have to pay monthly fees, but don’t really own the unit yet. You can live in it, but don’t want to because the rest of the building is still a construction nightmare. Add on illiquidity on one side or the other, and if you have two units you may have to be prepared to carry both of them for a time.

1. The bold statements here are for regular people who risk bankruptcy by placing leveraged bets on pre-con. Go ahead if you greatly resemble a land baron from Monopoly and are trying to spice things up with a bit of speculation.

2 Responses to “In No Position to Buy”

  1. Weekend Reading - Success, ETFs, Forbes, leverage, savings boost and more | My Own Advisor Says:

    […] Holy Potato had a small rant about being in no position to buy. I think he’s right. […]

  2. Weekend Reading: Impact Of Banning Commissions Edition Says:

    […] John Robertson argues that most people are in no position to buy pre-construction houses. […]