This is the maths facing the recent buyers of off-the-plan inner-city high-rises. There’s a lesson here…
I’ve been flying some red flags over inner-city high-rise developments for a while now. So far the market has been trundling along ok, but things could perhaps turn quickly.
So what would that scenario look like?
The key trigger to watch for takes the form of ‘settlement risk’. Settlement risk captures the things that can happen between commitment and delivery of apartment stock.
Let’s run through some numbers so you can see what I mean.
Imagine someone purchased a $500,000 unit ‘off the plan’ with a $50,000 deposit – say a year or so ago when the banks were happy to lend 90% of the value. They were probably thinking that by the time settlement is due, in like three years, that unit might have appreciated 10% or more (which is pretty reasonable over 3 years).
That would mean that their equity would have gone from $50,000 to $100,000. Happy days. Hopefully, rents and returns have been increasing as well.
And if you bought a property at almost any time in the past 20 years, this was the scenario you were looking at.
But things have changed.
First up, banks are no longer happy to lend 90%, especially on new construction in the inner city. They’ve started covering their arses a bit. So say the buyer’s bank now wants 80% of the valuation. They’ve got to come up with an extra $50K.
I could probably come up with $50K rummaging around in my cars, but not everyone has $50K just lying around.
But we’re also talking 80% of the valuation, and maybe the valuation has changed. Maybe the bank no longer thinks the property is worth $500K.
How likely is that?
Well, according to the Australian Financial Review, a study of nearly 2000 off-the-plan properties in Melbourne valued by WBP Property Group between 2014 and 2015 found that half are now worth less than their original purchase price.
According to the study, the average loss was about $40,000, or about a 10%, from their original purchase cost. Most of the properties studied were purchased between late 2009 to late 2015.
Only 1% of properties surveyed were deemed to be worth more than their original purchase price, with the remaining 49% now valued at the same price they were originally purchased at.
We’ve had an absolute truckload of high-rise construction coming on line in recent times. Check out the chart on 4+ storey building approvals.
That means there’s a lot of similar stock on the market, more sellers than buyers, and it seems that this has been depressing prices.
So a 10% fall in the valuation is not impossible, particularly if the banks start getting pushy about it.
So now our buyer’s bank says they’re only willing to lend 80% of $450K (=360K), but our buyer is down for the full $500. And so the buyer needs to somehow come up with the rest.
The loan of $360K + the original deposit of $50K = $410, so our buyer is $90K short.
Even I’d have to start going through my coat pockets to come up with that much.
So what can they do? They could walk away and lose their deposit, or they could try argue their way out of the contract, but both aren’t exactly appealing options. It’s a messy business.
They could try to sell the apartment, but the market has moved against them, and they’d be selling at a loss.
Say they sell and realise the $450K. Say that’s works out at about $400K after transaction costs. They pay off the loan of $360K and have $40K left over.
But they’ve sunk $140K of their own savings into the deal ($50K deposit, + additional $90K), so this deal has turned $140K into $40K.
Ouch.
And that’s not including any rental losses along the way.
Even if they decided to hold, if the rental market is soft, they might not be getting anywhere near the kind of returns they were expecting. Vacancies are high, which means greater holding costs and less scope to get a decent return.
And maybe their bank decided to increase rates as well. This has happened. So the gap between the rental income and the repayments widens. Most people still think negative gearing is a good idea, but there’s a limit to how negative anyone can go.
This is all a sad story for the buyer concerned, but there’s a macro-story here too. What happens if a lot of buyers find themselves in the same boat?
And what happens if they all decide they’re better off just to cut and run. Suddenly we’ve got even more stock on the market, prices are falling faster and realised losses are rising.
People could get crushed in the rush to the exits.
And this contagion could spread to the developers who now have no buyers for their stock, and the banks that funded the development.
And then chicken-virus would be in every school and kindergarten.
Ok, I’m painting the worst-case scenario here, but the point is, it’s not too hard to see it happening.
And given we had a tonne of development in 2015, we could be starting to see the effects of this in 2017-2018. It will be something to watch for.
Some folks (like the RBA) are relaxed about it, given how many apartments are being bought by foreigners. But with Chinese capital controls kicking in, I’m not sure I’d be hanging my hat on it.
I still don’t see any shake-out here affecting the broader market in a huge way, but for me it’s just another reason why high-rises are a no-go zone right now.
There are more than enough opportunities out there. I don’t need to muck around in this market.
Anyone hear any stories of settlement risk kicking in already?
ron says
no jon…not yet. i repeat what i have said about the american market though. GET OUT!! its drooling blood there..and will turn into a flood real soon. my info says usa is f***ed. in a metaphorical sense of course. in general i cannot get my head around that US$800 trillion debt hanging like a guillotine blade over the world economy. i don;t care how you say it i could never ever count to 800tn. my inclination is to sell everything and buy gold and silver and several nice juicy stocks that will always behave inversely to everything else. more billionaires will be made this time around then before. the 1% who make billions will take it off the minions who don’t know anything (99%). i say to you with tears in my voice, get rid of your debits quickly. with feeling, ron
Sunitho says
What stocks Ron! Have you watched the share market over the last few weeks ?
Have you seen how many billions of dollars have been wiped off the Australian Market?
And the world markets? In the last two days alone?
petespace73 says
$800 Trillion Ron? Nah mate, it’s only 19 T. (see below)
http://www.usdebtclock.org/
Cath says
Hi Jon! Yes…..my husband and I lost our $61,000 deposit on our Melbourne unit when our contract was rescinded in September last year (bought of the plan 2 years ago through a large property marketing firm). The bank valuation on the finished unit came in way under the purchase price so the loan was not approved (and this was the case for 80% of units within the development). The property marketing firm worked with us for 9 months trying to sell the unit for the purchase price but were unsuccessful. The developer rescinded the contract and kept our deposit. The property marketing firm refused to answer our emails or take our calls after that.
We have since found out that the developer had already paid the property marketing firm 6% up front to sell the unit. We were the only ones who lost out…..and with two young children, it was money we couldn’t afford to lose. We have had to sell our house because of it. Lesson learnt!!
You are “spot on” with your advice and I am sharing here (something I NEVER do!) to confirm that what you are saying is correct and in the hope that it will save others from making the same mistake we did. We thought we were going through a a group that had immense expertise and experience. We still love property and will reinvest when we get back out of the financial hole we are currently in, but we will never invest in off the plan units again that are sold on mass.
Jon Giaan says
Thanks for sharing Cath.appreciate you taking the time to share your story.
Mark says
That’s sad to hear Cath. And sadly, Jon is spot on!
I got out of my Eureka apartment in June 2014 – I just felt the tide was turning and there were too many approvals in the pipeline for the next 3 years alone – 35,000 new apartments! Crazy stuff. Now if I buy off the plan, I hassle the developer for a 10%-15% discount on the retail price so that I have covered the initial hit of the marketeers costs etc. Bought an apartment in Brisbane using that technique and you have to be willing to walk away. It is business. Good luck for the future. Hope you get back on your feet again soon!
OffThePlanSucks says
Off the plan is really bad. If the value goes down, you lose, and if the value goes up the developer invokes the sunset cause, cancels your contract and resells it for more to someone else. Either way you will lose.
huge trouble says
I disagree. The demographic has changed. In the old days we would get a few mates together and rent a big run down old house and share the expenses. These days the kids are staying longer with their parents and saving money the parents are helping the kids buy their first home. Kids today want independence. They don’t want to live in a shared house if they can help it. If you buy off the plan for a short term capital gain then this is not the product for you. If however you want to minimise tax and buy for long term capital growth inner city apartments are still a great investment.
Kathy says
Could not agree more, except I think this will happen sooner than 2017-2018, more likely this year. This glut is mostly investor stock in the form of tiny dog kennel one or two bedroom flats and represents a finite and small market. There are not many that have been designed for owner occupiers.
The largest Australian demographic is still families with children, making up half of home residents, and household sizes are increasing, not decreasing. Of the other half of singles and couples not all of them necessarily want to live in a flat. According to Matusik the demand for this type of property represents a much smaller percentage than that for detached, semi detached (with a garden) or small lot housing suitable for families with children and/or pets. And not a great deal is being built for aged care or people who want to age in place with single level, no stairs, no lift dwellings, although this is changing slowly.
I can see a time very soon when even those who have managed to purchase and settle on these flats will get tired of getting no or negative capital gain, low rental yields and longer vacancies due to the glut but still having to put their hands in their pockets every month to pay for it. They will sell, and those who have existing properties, even if they are only a few months old will be competing with new stock that is also not selling.
It doesn’t help that our greedy and lazy Councils and state governments are only too happy to keep this gravy train rolling on as it represents the biggest return for them.
I believe we are reverting back to the norm of capital gains in line with inflation, as it should be. The parabolic capital gains seen over the past 45 or so years are a product of the huge expansion of credit after the US dollar’s link to gold was severed. This was never going to continue indefinitely. In this low inflation, low interest environment, it is now starting to pull back.
Jarad says
I have a slightly different story. My Dad bought an apartment in Melbourne off the plan via a marketing company. He’s not an inexperienced investor, but used the company as he was time poor. When it came time to settle he happened to be on leave so he took the time to go through his contract with a fine tooth comb. He found a clause that stated that ANY variation between the purchase price and the valuation would be covered by the developer. Neither the developer or HIS solicitor (who were provided by the marketing company) were going to mention this clause at settlement. My Dad instructed his solicitor to enforce the clause in the contract and saved ~$45k on the settlement. It wasn’t life or death to my Dad but how many people settled on that development and just covered the difference out of their pocket?