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Buying off-the-plan your complete guide

By MoneyQuest
In First Home Buyer, Home Loans, Investment

Buying a property off-the-plan can have significant benefits – but it carries major risks, too. Here’s a complete summary in how to make sure you don’t get burned.

Off-the-plan properties are tricky beasts. On one hand, they offer great opportunities and benefits and the possibility of capitalising on value growth before the property is even completed. On the other hand, horror stories about shoddy construction and plummeting values are all too common. So, how can you make sure that you get the best deal?

What is off-the-plan?

Buying off-the-plan is agreeing to buy a property before it’s been constructed. As the property doesn’t yet exist, all you have to go on are the blueprints – hence ‘off-the-plan’. Unlike buying an established property, you don’t need to obtain finance straight away – instead, you pay a deposit of around 10% of the value of the property, and settle the rest at completion. Off-the-plan projects often take well over a year to complete construction, or sometimes two years or more.

Buying off-the-plan has several attractive features for investors. Firstly, several states offer incentives to buyers to promote the building of new properties to address undersupply issues – the largest of these is NSW’s Home Builder Bonus, worth over $22,000.

Buyers can also benefit from better cash flow once the property is completed, as newly-built properties often command premium rents, require less maintenance and have generally lower running costs. Brand new properties also receive full depreciation allowances. In some circumstances, this can even tip a property into cash-flow positive territory.

The most attractive aspect of buying off-the-plan is the potential to benefit from capital growth while the property is being built – and before you shell out on mortgage repayments and other holding costs.

Essentially, you’re buying on a fixed price contract, but you benefit from equity growth during the build phase. You can make a lot of money during the build phase if you buy at the right time of the market. Of course, the opposite is also true – if the market falls, then the lender will only lend against the end valuation, meaning you might need to put your hand in your pockets to fund the shortfall. There’s also the fear that the end result won’t be what you signed up for, or that it won’t materialise at all. While you can never completely eliminate those risks, you can mitigate them with thorough due diligence.

The market

It’s essential that the market in which you’re buying is one that is or will experience growth. Therefore, analysing your chosen area’s growth drivers is of paramount importance. Understanding the property cycle is very pertinent to off-the-plan because you’ve got the opportunity to make a lot of money during the build phase.

Most people who are looking for an area with capital growth potential will focus on suburbs that have had 15% growth for the last three years. The assumption they’re making is that the above-average growth is going to continue indefinitely. That’s the first mistake, in those situations, the market has probably peaked and will experience slower or no growth in the coming years – and could even fall in value.

If you’ve bought at the peak and the market corrects or dips a little bit soon after, you may not see any value growth for a few years. In that situation, many people will sell – at the bottom – and you can more or less guarantee that within a couple of years the market will then recover.

Instead, look for (amongst other things):

  • strong population growth
  • varied employment opportunities
  • public and private infrastructure spending

If an area has been showing 2% growth and if it ticks all the other boxes, it’s probably at the right stage to experience significant growth over the next few years.

The developer

The single most important thing you can do is to make sure you’re buying from a reputable developer.

Always, always, always buy from a developer with a track record. Talk to local real estate agents and to your other contacts – find out how the developer is generally viewed in the industry. Be aware that you may not get unbiased comment though. You should also Google the developer and do an ASIC search, to make sure there aren’t any outstanding court cases.

If you do find something that sets off alarm bells, confront the developer directly. The developer’s response will be a sign, and if they’re defensive about it, be on guard. Researching the developer can also help allay fears over build quality as well.

Most developers tend to concentrate on core property types; the unit builders will have built unit blocks in the last few years. A lot of them are ‘cookie cutter’, so you’ve got a pretty standard design and level of quality. Again, Google can be your best friend. Check online to make sure there haven’t been issues with build quality, noise complaints and suchlike. If possible, go and look at existing developments in the flesh to get a good idea of standard of workmanship and finish. For this reason alone, you should be very wary of a developer who’s building his or her first project.

Fair value

The other fear that many investors have is that they’re going to pay over the market rate for an off-the-plan property, thanks to developers’ marketing budgets, less room to negotiate on price, and pricing based around government incentives rather than ‘real’ value (for example, there are an awful lot of off-the-plan units priced just under $600,000 in the Sydney area – is this coincidence, seeing as the state government stamp duty exemption stops at the $600,000 mark?)

There’s no substitute for research. WBP Property’s Victorian valuations manager Brendan Smith recommends looking at the resale market for similar properties, perhaps projects completed in the last two or three years, to see what they are going for. This, he says, will give you the best guide as to what your potential purchase is really worth. You should bear in mind potential future capital growth, too.

We look at the current market and always add on a 5% ‘contingency’,” he says. “After all, when the banks look at the builders’ feasibility, they want to see contingency in there as well. If there is a ‘premium’ you need to ask yourself whether you’re happy to accept that to benefit from the potential capital growth you could achieve during the build phase, assuming you’ve bought in a growing market.”

However, there’s also scope to negotiate – especially in the current market. While developers are unlikely to shift on price, there are other ways buyers can negotiate. Developers are definitely receptive to negotiating. You can ask for incentives – furniture packages or interest payments on your deposit, for example. Another incentive is a rental guarantee – especially if you’re buying in a large block where all the apartments are coming onstream at the same time. In that situation, it might be handy to have six months’ rental guarantee in case there’s trouble absorbing the influx of properties.

Other considerations

The longer it takes to build, the more equity growth you should get if you’ve bought at the right stage of the cycle. To be honest, most builders are hugely optimistic. If they say two years, you can almost guarantee it’s going to take three.”

The benefit is that you’ve then got equity with which to leverage into further properties straight away. Even so, a long delay in completion is a risk you should make efforts to mitigate. One of the biggest risks is that the project is cancelled or that the completion date will be delayed for lengthy periods of time, during which you may be required to commence paying owners corporation fees without the ability to live in or rent out the property.

In the past, an off-the-plan apartment sale was only reported as ‘sold’ when a contract went unconditional, the full deposit was paid and all the necessary documentation was signed by both parties. Too often today a ‘sale’ is reported based on a holding deposit only – sometimes as little as $1,000. Often, and increasingly of late, mystery shoppers have been able to purchase ‘sold’ stock, and last year, close to a third of the sales claimed had not really occurred at all. It is advisable to interrogate the developers over sales, as well as issues like approvals, deposits and planned completion dates. You should also question the time period for the reported sales.

Often, developers will ‘soft launch’ their new project to interested buyer groups months before going to the open market. Many sales are made during this period, yet the sales spruiking is often based on the public launch date. Don’t believe the ‘50 sales made in the first two weeks’ or similar headlines. Fifty sales might have been made, but our experience is that they take many months, even up to a year, to make – not two weeks. Admittedly, should a project go well over schedule, off-the-plan contracts have ‘sunset clauses’ allowing buyer and developer to walk away from the original agreement at no cost, with the buyer getting his or her deposit back and the developer being able to put the property back on the market. This date is usually set a year or so from the expected completion date. While this provides some protection for both parties, there have been cases where developers have deliberately gone over sunset clauses in order to be able to put the apartments back on the market at a higher price.

If you think the developer’s deliberately gone over the sunset clause, you can sue for damages; however, there’s a cost associated with that, and it can be messy. Your best defence is to make sure you’re going with a reputable developer and builder.

Financing and cash flow

The financing process for off-the-plan is relatively straightforward: the buyer puts down a 10% deposit when the contract is signed, and then seeks finance for the remainder when the property reaches practical completion stage (about two to three weeks prior to ‘actual’ completion), based on a valuation carried out at practical completion. The reason for this is that lenders will not finance something that does not yet exist, unless it’s in the very near future (eg, a house and land package to be completed within four months).

The major risk here is that the bank valuation will come in lower than the agreed purchase price. In this situation, the lender will only lend up to 90% of its valuation, and you’ll need to ‘tip in’ the difference from your own pocket. Of course, you can always go to another bank for an alternative valuation, but if that also comes up short, you may have to negotiate your way out of the contract with the developer, which could be tricky, and you could even be sued if you default. Therefore, even if you’re confident a property will increase in value during the build phase, you should keep a buffer just in case there’s an unexpected fall in value.

Shortfalls are usually less than 5% of the purchase price, and the largest can be up to 10% – as seen in Cairns in 2009. A buffer of 10% of the purchase price should be adequate. That doesn’t need to be cash, it could also be held in a line of credit. You need to budget in contingency in case things go pear-shaped – although if you settle in a time of economic turmoil, interest rates may be lower which could mean your mortgage costs are lower.

Holding costs are another aspect of financing that investors should look at closely. WBP property valuer Brendan Smith warns that you should be clear on holding costs at the outset as these can blow your returns out of the water. This is more often the case if you’re buying in a larger development – the fees for these can be high, especially if there is a gym, swimming pool, tennis court, etc included. However, even smaller developments can suffer from high owners corporation fees, typically due to the presence of elevators, which are notorious for hiking fees. While Hosking Richards doesn’t have a preference for large or small developments, he often opts for projects with three storeys or less as this reduces the need to include elevators.

Deposit bonds and vendor finance

There are a couple of other quirks of off-the-plan finance that investors should be aware of. The first, deposit bonds, are a boon to any investor concerned about tying up large amounts of capital in an asset that doesn’t yet exist.

A deposit bond is essentially insurance. Instead of putting down the full 10% deposit, you go to a deposit bond company which will issue a guarantee to the developer that they will get the full 10% at settlement. You still have to put in the 10% deposit at settlement, but if you default, the insurance company will pay the developer the 10% – then come after you for the money.

The cost of a deposit bond varies, depending on how long it lasts – two-and three-year bonds are common – the size of the deposit and the value of the property. A three-year deposit bond for a $26,000 deposit cost around $2,100.

There are a couple of limitations: the developer has to approve it, and a deposit bond will never be higher than 10% of the property value. However, it can be an attractive option for buyers. Another finance option is vendor finance. Rather than going to a traditional lender to obtain a loan at settlement, vendor finance sees the developer lend the money to complete the purchase to the buyer, usually for two or three years.

Why does a vendor offer finance? More often than not, it’s because they know there are going to be problems with valuations and may not be able to sell otherwise. Relying solely on vendor finance is not a good idea. Should you go down the vendor finance route, you’ll be on the hook to the developer for the full amount of the property. If you can’t obtain traditional finance at the end of the vendor finance period, you’re stuck.

Vendors are not banks. Unless there’s a very good reason why you don’t want to go to a bank – perhaps you know you’re going to sell two properties before the finance period ends so you can finance this one, although that’s pretty risky – stay away from it. There can be great benefits to buying off-the-plan, but inherent in such purchases is great risk.

Investors with existing property are actually in a better place to manage the financial risks, as they may have equity to soak up the shortfall. This is somewhat ironic, considering that off-the-plan properties are often marketed to first homebuyers due to the low entry costs and government incentives available to them. First-time buyers should therefore check and double-check your figures to make sure you don’t get burned.

MoneyQuest
If you’re looking for a loan expert, you need to find someone you can rely on. Someone with experience and integrity. Someone who has your best interests at heart.

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