Buying Off The Plan — What Every Property Investor Needs to Know

Are you considering buying an off the plan investment property?

Please think again and turn the other way!

There are just too many risks involved in this sector of the market.

However if you open any weekend newspaper you’ll still see a large number of proposed new apartment projects being marketed before building has even been commenced and it must make you wonder — why on earth would anybody buy a property that hasn’t been built yet?

Yet plenty of people are still tempted and still do buy off the plan.

While it’s rarely been a good investment strategy, this is now the most risky investment strategy in the current market and one to be avoided.

I know some investors are tempted to buying off the plan properties being enticed by the advertising hype of stamp duty savings, depreciation allowances and so called “cheap” prices.

Others hope that by getting in today and settling on their properties in a few years time the value of the property will have increased and they will have turned a relatively small deposit into a substantial profit, all while avoiding those nasty holding costs.

What are these new risks to off the plan properties?

While there are already major risks associated with this type of investment due to a number of factors, including oversupply, the introduction of Labor’s proposed tax reforms if they win this year’s federal election will compound them.

According to Doron Peleg CEO of Riskwise, should the ALP policy be implemented there will be reduced demand to purchase rental properties due to the creation of primary and secondary markets, and this will cause new dwelling prices to decline in many regions.

Peleg says that the second owner won’t receive the same tax benefits of depreciation etc as the primary owner when they buy a property.

They will not be able to claim negative gearing against their wages and the capital gains tax discount will be cut in half.

Therefore, the vendor will have to drop the value of the property because the benefits to the buyer are lower, and it is therefore not as attractive to potential buyers.

So, when a market is already weak, for example off-the-plan units in an over-supplied area, as we see in capital cities around the country, this will contribute further to the price reductions.

Add to this the recent Opal Tower disaster in NSW which has dampened investor confidence in the new apartment market and falling apartment values and you can start to see what I’m getting at.

So does buying off the plan ever make good investment sense?

The answer is usually no.

While a few investors have made money buying off the plan, the road is littered with much more who have regretted their purchase.

Frequently they’ve found the value of their property on completion is considerably less than they paid.

There are many other issues with buying off the plan, but before I explore them let’s first understand why projects are marketed this way.

While developers know they can get a better price for a completed property that buyers can see and touch and feel, today the lenders who are going to fund construction of the project insist a substantial proportion of units be pre-sold to ensure the viability of the project is underwritten.

Obviously, the banks expect the developer to make a reasonable profit margin — and so they should.

This is built into the final price as is the substantial marketing budgets which cover the cost of those full-page ads in the papers and expensive glossy brochures produced for the project.

Add to this the generous selling commissions given to project marketers and incentives offered to financial planners and you can understand why the initial selling cost is inflated.

Remember, there is no such thing as a “free lunch.”

If 10 -15 per cent of the project’s budgeted selling price is spent on marketing and selling costs, then the buyer must pay for this.

As the completion date for many high-rise inner city projects may be a few years away the inflated price can be buried in advertising hype such as “buy at today’s prices” and settle in two years.

The developers are counting on the fact that the longer the settlement period, the less chance you have of knowing if the final price will represent good value for money.

Looking back, many investors who have bought off the plan over the last decade found that the price they paid was way too high and on completion, their properties were valued at considerably less than their purchase price.

Here’s a few reasons I would steer clear of buying off the plan:

1. Too many fingers in the pie

I’ve seen far too many off-the-plan properties with large commissions built in for middlemen, marketing budgets and sales people, meaning the investor pays well over its true underlying value.

Don’t be lulled into a false sense of security just because you’ve been told a number of pre-sales have already occurred.

You’re likely to find many are at inflated prices to overseas buyers who are unable to buy established properties, have little knowledge of the local markets and have unique motivations for buying property in Australia such as a desire to emigrate in the future or place their money in a more stable country.

2. The banks won’t buy it!

Given that most loan approvals are only current for three months, obtaining a formal pre-approval for an off the plan purchase is a waste of time.

The problem is, currently we have 4 big banks in Australia and they each have a policy restricting their exposure to any one building; most won’t lend to more than 15% of the properties in a large complex.

This means that if there are 100 apartments in the building and you are the 16th person to approach the bank when the building is completed, they may decline your application and you’ll have to go chasing finance elsewhere.

And if they do lend for your purchase you may find because of the inner city postcode of your new high-rise purchase, they will lend at lower loan to value ratios, meaning you need a bigger deposit.

By the way… some investors who buy off the plan won’t be able to settle and will need to sell their property at whatever price they can achieve.

Unfortunately, that’s what the banks will value your property at — the going selling price on completion — not what you paid for it.

Combine this with a lower loan to value ratio and you’re likely to need an even bigger deposit than you initially thought.

Now the following graphic from Corelogic should be enough to put you off buying off the plan.

It shows the huge percentage of properties bought off the plan where, on completion, the valuation is lower than the contract price:

3. Low land to asset ratio

Remember that old investment rule; land appreciates while buildings depreciate?

If you go by the book, you should aim for the highest land to asset ratio possible and aim to get as much valuable land under your apartment as you can.

However the developer wants the opposite and squeezes as many apartments on the site as they possibly can.

So essentially, the interests of the developer and you — the investor — are in direct opposition.

4. Investor imbalance

Most off the plan developments are sold to investors.

This means you end up with a building occupied by far more tenants than homeowners.

Fact is owner-occupiers tend to be far more careful when it comes to maintaining the building and enhancing the development’s long-term capital value.

By the way…it’s not much fun going to a body corporate meeting full of investors who are not keen on spending (or simply don’t have) money to maintain the building.

5. Too many too soon

Currently there is a significant oversupply of new apartments in some of our capital cities CBD’s and this glut of properties driving down prices poses a problem for investors relying on the value of their property to increase by the time it reaches completion.

According to research from Knight Frank, there are 26,680 apartments currently under construction or on the drawing board in Sydney.

Now that’s going to change the supply and demand ratio!

In Melbourne there are around 12,600 new apartments coming out of the ground and the REIWA recently warned that there is an oversupply looming in Perth

Of course you’ll be competing with all the other investors who are trying to rent out their new investments.

So an over supply of properties for sale and for rent means your investment will lack scarcity value, one of the factors that I look for to help increase the value of my properties.

And things will get worse…

With many investors unable to settle on their off the plan purchases because the banks have tightened their lending criteria — and this doesn’t just apply to foreign investors, locals are having real trouble too — there will be a glut of unsold properties hitting the market as developers try an unload their stock.

6. Developer dilemmas in off plan purchases

Did you know that many of the off the plan projects currently being marketed won’t get out of the ground?

Sure you’ll get your deposit back, but it means you’ve lost precious time with your money not working in the market.

On the flipside, when the developer completes the project don’t be surprised if they have made some amendments to the floor plans or substituted different finishes or fittings.

While they have the right to do so in the contract, you’ll usually find they changes are in their favour and not yours.

7. Rental guarantees are not as solid as you might think

Often developers will offer a rental guarantee to entice investors who might be more focused on their cash flow and worried about vacancies.

The problem is you pay for these rental guarantees in the purchase price, which is another cost that inflates the apartment’s already premium price.

And once the guarantee expires, the rental income reverts back to the going market rate which is usually lower than that offered in the guarantee.

What lessons can we learn from this?

Some of these problems could be avoided by buying from developers with a good track record and buying in buildings in prime locations, as there always seems to be a bigger demand for units in these buildings.

Also while buying off the plan has the potential for capital growth, if you bought a completed property it should also grow over the same 12 to 18 months you were waiting for your off the plan purchase to settle.

With a two or more year time-frame for the completion of most high-rise projects, it is very difficult to predict what the future will hold so I feel you should receive a sizeable discount for all the uncertainty of buying off the plan.

There is uncertainty about what the property markets will be like on completion, what will the interest rate be then, will the standard of finish be as good as in the display unit or will the developer have cut corners and what will be built in the future alongside, behind, or in front of the project.

What appears to be a great view today may be totally blocked out in two years’ time.

To cover all these uncertainties, surely you should be buying at a substantial discount, but in reality you are usually paying a premium — therefore giving your developer your first couple of years’ capital growth (and he doesn’t deserve it).

What’s the alternative to buying off the plan?

I prefer buying established apartments and to ensure I buy a property that will outperform the market averages I use a 6 Stranded Strategic Approach. I buy:

1. A property that will appeal to owner occupiers (because they’re the ones that push up property values.)

1. Below its intrinsic value — that’s why I avoid new and off the plan properties, which come at a premium price.
2. In an area that has a long history of strong capital growth and which will continue to outperform the averages.
3. I only buy properties with a substantial land to asset ratio
4. I look for a property with a twist — something unique, special, different or scarce about the property, and finally
5. A property where I can manufacture capital growth through refurbishment, renovations or redevelopment.

By using a strategic approach I minimise my risks and maximise my upside.

Each strand represents a way of making money from property and combining all five is a powerful way of putting the odds in my favour. If one strand lets me down, I have three or four others supporting my property’s performance.

Here’s what you can do about this…

If you want to take advantage of the opportunities our growing property markets will offer you now is a good time to consider your options.

If you’re looking for independent advice, no one can help you quite like the independent property investment strategists at Metropole.

Remember the multi award winning team of property investment strategists at Metropole have no properties to sell, so their advice is unbiased.

Whether you are a beginner or a seasoned property investor, we would love to help you formulate an investment strategy or do a review of your existing portfolio, and help you take your property investment to the next level.

Please click here to organise a time for a chat Or call us on 1300 20 30 30.

You may want us to formulate a Strategic Property Plan for you.

Originally published at https://propertyupdate.com.au on January 26, 2019.