Off the plan purchases – Everything you need to know. Part 2: The financial return drivers (Ep.59)

The Property Planner, Buyer and Professor continue analysing off the plan purchases, and in particular, high rise apartments. This week, in the second of two episodes dedicated to this type of property, their focus is on the financial risks of purchasing off the plan.   

In this episode David Johnston, Cate Bakos and Peter Koulizos take you through: 
  

  1. The ‘Pros’ of purchasing off the plan. The team start off outlining a number of financial benefits of purchasing off the plan, however many are short-term and what you could call a ‘catch 22’.  
  2. The risks of not being able to access finance (through no fault of your own). Lenders protect themselves by limiting their exposure to off the plans because they understand they are ‘risky’ securities – less likelihood of capital growth and hard to sell in a fire sale. That includes limiting the number of properties in a building or postcode they will take as security, limiting the loan to value ratio (requiring a higher deposit), and working to a minimum limit of the number of square metres in the apartment that they will lend against.  
  3. The contract can limit your re-sale options, with many contracts stipulating that only a particular real estate agent can on-sell your property. This is so the developers can maintain control of the sale prices within the block. 
  4. Homogenous dwellings of identical apartments in a building or houses in a development have significantly reduced scarcity value, and it is likely that sellers will have competition from properties that are similar to theirs. Buyers must consider what makes a property unique and desirable?  
  5. Over-supply can adversely impact the expected rental yield, particularly when many identical properties flood the market at the same time, causing a race to the bottom for landlords to find a tenant.   
  6. Limited capital growth prospects from low land to asset ratios, as the land component which is appreciating can make up only a small percentage of the overall asset value.   
  7. The likelihood that the value of the property will go backwards after you purchase, as the largest component of the asset (the dwelling) is depreciating.  
  8. The cost of management fees that are not certain upfront. Owners corporation and strata fees are not typically specifically outlined at the time of an off the plan sale. To compound the issue, future special levies for maintenance or issues arising out of poor quality builds can quickly eat into your available funds.  
  9. Lost opportunity costs in waiting years for an asset to be finished, that you could have invested in the meantime in an asset with superior capital growth prospects.  
  10. And of course, our ‘gold nuggets’ 

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Show notes

  • The advantages of off the plan:  
    • Leveraging – limited deposit or deposit bonds – you are putting in the minimum amount possible to purchase the property upfront. 
    • Capital growth performance advantages: They need usually need something that ticks the scarcity box which is very rare with medium to high density apartment or greenfield sites where this is an abundance of land and a lot of similar ‘Lego style’ properties.  
    • great location that cannot be flooded with competition in the sky or land. 
    • and a wonderful view that cannot be built out. 
    • It is more achievable with for example one of two townhouses, but still difficult for the reasons we will unpack today. 
    • Can be fantastic if capital growth ensues from signing the contract to taking the keys.  
    • Cash flow positives: 
    • You generally receive higher rents initially while they are new and shiny. 
    • Greater depreciation benefits because the dwelling value is reducing more rapidly than an established property. The higher rent and depreciation is initially due to the new dwelling and living amenities, but this can reduce over time as dwellings become dated. 
      • However, note that tax deductions are giving someone $1 to get 48 cents back, at best if you are in the highest tax bracket. Giving someone a dollar to get less than fifty cents back in return is not a good strategy in isolation.   
      • Importantly, if you purchase a building where you can claim depreciation, upon the sale, you pay capital gains tax on the depreciation claimed on the building. This is a fact that often gets neglected, especially by developers and those spruiking new property.   
    • Rental guarantees: bundled up in purchase price, it does give the purchaser a guarantee that they will have consistent rental income.  
    • Can commit to buy something you may not qualify to borrow for NOW – so taking advantage of the fourth dimension (time). 
  • Risks in accessing finance:  
    • Lender exposure to a block can be outside of buyer’s control. Where banks decide that they don’t want to have more than x% of properties in a particular development on their books and will decline to lend based on this situation.  
    • Lender appetite is lower – reduced maximum loan to value ratio for loans, they want a higher deposit. Some lenders will withdraw altogether. There are other ways lenders reduce their risk and exposure to these kind of properties. Square metreage, post codes, LVR – there’s less likelihood for capital growth and it’s harder to fire sell these types of properties. 
    • Restrictions on selling the property – buyer who has to fire sell can be limited by the contract – clauses that prohibit you from choosing your own real estate agent to on-sell, so that the developer can control how the information on sale price is leaked into the market.  
  • One low sale price in your block sets a benchmark for your property, maybe due to a forced sale can reduce the perceived value of all similar apartments. This will be a comparable sale when a valuer goes to value your property.  
  • Homogenous dwellings – identical apartments in a building or houses in a development – what makes your property unique and desirable? It significantly reduces the scarcity factor of these properties, and likely that you will have competition from properties that are similar to yours.  
  • Capital growth prospects – land to asset ratio 
    • Notional land value may be 25% of purchase price, 25% cost of materials used, and then the other 50% could be: 
    • Profit and costs of developer. 
    • New property is sold by developers and project marketers, so they often come with strong sales pitches and incentives to purchase that you need to be weary of which require profit for the Project Marketers and salaries for the sales staff commissions that come out of the cost of the property. 
    • Time of skilled labour for builders, contractors, tradesmen. 
    • When depreciation is highest, it’s likely that the value of the overall dwelling is declining, because the land component which is appreciating is a very small value of the overall asset.  
    • Aim not to be the first person to ever own a property – 5 to 10 years of depreciation means that you have moved into a more appropriate land to asset ratio, after the building has depreciated the most.  
  • Management fees – you don’t fully understand what this will be upfront. No clear picture of what Owners Corp or Strata Fees will be. Also, special levies for issues that arise can force owners to fork out large sums in addition to regular fees.  
  • Quality of the build – flammable cladding, inconsistencies with regulations and corners that have been cut. Developers try to maximise profit, which means that touch ups and maintenance could add to the cost 3 years down the track.  
  • When you go to sell – yours is not brand new anymore. There are brand new ones coming up.  
  • Lost opportunity costs – waiting for settlement or if the development falls through, what that same expenditure could have afforded you and the value of the asset now.  
  • Yield and over supply – could in turn adversely affect rental yield because prospective tenants have an abundance of similar apartments to choose from. Rent could be a race to the bottom if there are many identical apartments in the one building.   

David Johnston- The Property Planner’s Golden nugget: new property is more likely to be a cash flow focused asset initially, but this will lose its lustre over time. What you’re looking for with quality property is scarcity of the dwelling type and location of the land it sits on, status- demand for location and dwelling type within the macro market and historical demand through proven capital growth for the individual property and micro location, which you can’t really asses with a new property.  

Cate Bakos – The Property Buyer’s Golden nugget: investors should be mindful what they put their money into, particularly at the beginning of their journey, when what they are looking for is equity growth so they can spring board into other opportunities. The disadvantages that we’ve outlined with off the plan will hinder them from taking that next step.  

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