The risks of buying off-the-plan and how to remedy them: Cameron McEvoy
With development proposal approvals and construction starts appearing to be on the increase in several states in recent months, I thought it good timing to address the investment option of purchasing off the plan.
There has always been a degree of risk associated with purchasing residential properties off the plan, yet for some investors, a well-researched off-the-plan purchase can present solid opportunity and make for a good strategic addition to their portfolio.
So today I’ve shortlisted some of the major risks associated with off-the-plan buying, along with ways you can remedy these before they become bigger problems further down the track. Key to this though is that all of this risk management can be executed before you sign off on any contracts with a developer.
Risk: High penetration of other developments, resulting in weaker-than-expected values at completion
You need look no further than markets such as the Gold Coast and Inner Melbourne for examples of how this can be a serious problem for investors. High market penetration occurs when too many large-scale development applications are approved by a council and are completed a few years later, resulting in an instant oversupply of housing stock in that area that flattens capital values and reduces rental rates achievable.
This hurts investors who purchased a dwelling off the plan at a certain rate, because when the market becomes oversupplied, almost overnight, values can drop sharply, as can the rental rates for such developments due to so much choice in the market.
Prospective tenants can become picky and this can leave some developments struggling to find tenants to occupy these buildings. This can significantly reduce the profitability of these dwellings and overall make for a bad investment.
You would think developers would try to avoid this occuring more often; and they certainly do not intend to pit themselves against so many competing developments in an area, but it is not always avoidable. Sometimes zoning restrictions enforced by councils can buck the trend of where the demographic data is ‘telling’ the developers to build their next block, resulting in developers having to pick their second, third, or fourth favourite site for a particular construction.
This occurance can often result in them being forced to develop in a very competitive area for them. Not really ideal for many parties involved.
Remedy: Research other projects in approval & construction in an area
This is a common risk associated with buying off the plan and a real problem for investors. The best practice here is to do your own research on the area where you are interested in a particular development.
Do not be lured or attracted by the developer’s ‘word’ that their opportunity is particularly unique; or their assurance that there is genuinely a limited supply or restriction to other developments appearing in your chosen area. Instead, contact the local council of this area to get an understanding of the area zoning.
Most councils in Australia have this information, along with a list of the pending development applications (and their approval status) readily available on their websites. If not, call them. This will give you a feel for the future use of the area where your desired block will be located. Additionally, investigate the surrounding dwellings in proximity to where the building is. Things to look for when doing this are:
- Hertiage listed sites. In a word, these are great. So your desired block is going up in amongst four parallel streets full of mostly heritage-listed workman’s semis/cottages? Great! This means that those little dwellings are not going to be bulldozed any time soon, potentially making your desired apartment block as rare as hen’s teeth in that area, which in turn could result in your dwelling holding its value or increasing in value faster
- Former-industrial areas going through gentrification. Be cautious here. If there are many old factories or industrial businesses surrounding the area, and some are already being bulldozed over, be weary. Often times, when an area gentrifies, it means the land becomes more valuable being used as blocks of apartments, than, say, it being used as a row of little mechanics, warehouses, storage facilities and so forth. This could mean your area is at risk of becoming an apartment ‘jungle’ in coming years. Proceed with caution in this instance.
Risk: Wrong property type for area
Another risk commonly associated with buying off the plan – but also for purchasing established dwellings – is the property type and its appropriation for an area. One would think that a developer would have a keen eye for ensuring they build the right property type for the demographic demand within a suburb or area, but they do not always get this right!
For instance, what good is purchasing a 3-bedroom, 2-bathroom, double-car garage unit off the plan, in an area where the strongest property demand is for studio and one bedroom apartments? Or conversely – and this is actually quite a common occurance – building little 2-bedroom townhouse or apartment developments in regional towns where the demand is more for detached houses on bigger blocks with good sized yards.
Buying the wrong property type off the plan for an area can result in poor re-sell values and/or a struggle to find tenants. You may find a tenant quickly, but they may not be willing to pay the desired rental rate, if the property is not their ‘first choice’ for that area.
Another thing to be mindful of is the more widespread trend of an ageing population and catering to their needs. Developments in regional towns and coastal areas where tree/sea-changes are likely to migrate to, in their later years, should be considered carefully.
Is a top-floor apartment in a three-floor walk-up building with no elevator, such a good idea, if it is in an area where every year; more and more retiree and baby-boomers are migrating to?
Remedy: Study your desired area before shortlisting off-the-plan developments
Get to know your potential area and do this in several ways:
- First, use online tools to study the demographic breakdown of your chosen area, to get a feel for the type of family (or single-person household), and develop a ‘persona’ of who is most likely to be living there. Is the off-the-plan unit befit for their needs?
- Actually take a walk in the area. Buy a coffee at the local cafe, and people-watch (one of my favourite pasttimes I picked up back in the day when I was a backpacker). You learn so much about the inhabitants of an area in this way. Get a feel for what they like and the lifestyle features that are valuable to them, and this will pave way to how they are likely to live.
- Look at recent sales on real estate sales websites. What kinds of properties are selling the fastest? Talk to agents in the area to get a feel for the things that buyers and renters demand the most, in an area. These people are your best resource in finding out what an area is like.
Risk: Wrong property features for an area
A similar risk to the above but altogether more subtle; where ‘property type’ typically refers to things like bedroom volume, whether it is a unit, villa, townhouse etc, and the parking situation; property features is more specific to the features that will make a would-be tenant, when inspecting the interior, say ‘yes – this place has everything I need’.
If the development is in a lower socio-economic area and the developer is keenly spriuking the ‘luxury’ features of the building, this should raise alarm bells in your head. Astute property investors are keenly aware of the risk of overcapitalising on a property, especially when it is off the plan.
What good is having expensive Smeg appliances, spa baths, plush Persian fibre carpets, and intricate feature wall designs in each room, if your target tenant is not the type to pay extra rent to have such features? Even worse, if your would-be tenant does not value such things, it is likely they will not take particularly good care of them.
Conversely, if you are eyeing off a development in an inner-city, high renter-to-owner ratio, ‘commuting executive’ kind of area, it would be risky to buy off the plan in a development that does not cater to the needs of these people. So, a modest development with no gym, cheap fixtures and fittings, and poor security, might not be the best investment for this demographic.
Remedy: Study your desired area before shortlisting off-the-plan developments
The remedy here is exactly as above – research your demographic ‘persona’, before buying off the plan. Who is most likely to be living in it? What kind of features would they need or want? Cut out the ‘noise’ of the developer’s pitch, and assess what features, fixtures, and inclusions your target audience would truly want.
Take yourself out of the picture. Unsuccessful investors will assess a development based on their own personal desires and likes. They may really like the kitchen colours, or the floor plan works for them personally. But this is not about you.
You will not be living there, so start thinking of whether your desired tenant, or owner-occupier that you’ll be reselling this property too, will like it. Go to open-house inspections on near-new dwellings in the area and get a feel for how these places look and the features they have.
Risk: Trusting a developer’s numbers without checking figures yourself
When buying off the plan, developers will present capital growth projections, forecasts of rental growth, and may even have a third-party industry expert provide assurance of future growth figures to hand. Nothing really is assured, though.
The reality is that there is no way to know this for sure, particulary if the developer is basing their metrics on flawed or missing data sources to begin with. Trusting only their figures (however knowingly or unknowingly skewed or biased these may be) is a road to failure for off the plan buying.
Remedy: Seek out independent numbers and see if these correlate
There are a number of resources you can seek council on, to verify numbers or refute a developer’s forecast:
- Sources like RP Data will identify recent sales; mid-long term growth patterns in terms of values, and actual historical vacancy rates for the area
- If you have collected numbers and statistics from elements I’d mentioned earlier, these will also help you here to verify the likelihood that the developer’s ROI numbers stack up
- Ask for references from this developer on previous completed projects, and request to see an ‘end-to-end’ case study of success stories from their last development. If they cannot provide these, or refuse to, alarm bells should be going off
- Google the developer’s name and their company name too. Add in the word ‘Somersoft’ into your search term bar and you should be able to find chatter on the Somersoft forums about this developer, their reputation, and (hopefully not) any horror stories from previous purchasers from them. Developers often settle extreme cases in and outside of the courts, and in either instance will likely impose silence clauses in these settlement terms contracts, so investigating the blogs and forums can be a great option to hear real stories and accounts
Risk: Agreed fixtures, fittings, and inclusions are not honored at completion
I am conscious that I am painting a negative picture of developers in some of the risks identified above. Though many in the industry regard them with little high regard, developers are not ‘bad’ people. Well, most of the time. Just like buy-and-hold investor types; developers are in the business of making high profit volumes.
And so they should, really, considering the degree of risks these companies take on, in executing these projects. However, most of you will be aware of horror stories where developers promised quality/luxury appliances, lighting, flooring, and any other features, yet at the end of construction these were replaced by inferior alternatives. This becomes a problem when valuers assess the market value lower than expected at the end of the project
Risk: Get your solicitor to approve the contract that details precise inclusions, precisely!
As you move closer to contract stages with the developer, get in writing as part of this; every single inclusion and feature/fixture/fitting that is to be part of your property purchase. Have your solicitor cast his or her eye over it before signing off. Be particularly weary of developers that give you grief for requesting such levels of detail. This can be extensive but worth it.
Even go so far as to name the brands of the toilets, dishwashers, ovens, and so on that the developer is saying they will use in the finish. On items where brand name is not possible, you need to ensure that the category is detailed. For example, if floating floorboards are to be laid, this must be specified, or else cheap carpets could wind up there in the end.
Another one is double-glazing on windows; particualry in inner-city developments; be sure to have this as a contractual inclusion if they’ve mentioned it; and if not, agree a price for their inclusion at point of delivery. Things like floor-plan adherence, ceiling heights, and voltage of lighting fixtures , should all be specified contractually.
Risk: Developers pitching future success of an off-the-plan purchase on the ‘promise’ of future infrastructure
Sometimes developments that are not as initially profitable for a developer as once desired, need to be marketed in different ways. Another investor-buyer trap that one can fall into is being sold the idea that because there is new school/hospital/railway station/employment hub ‘planned’ for an area; the future demand for the development is a sure thing.
This is dangerous territory. Some buyers will purchase properties off the plan in a development because they are told by the developer that the future use/growth of that area is guaranteed because all of these great plans ‘have been approved by council or state’.
After buying, and said future infrastructures are scrapped and never even built, the property may not hold its value very much nor produce much rental demand due to the area never really growing.
Remedy: Do your homework with the local or state government on the actual progress of these infrastructures
Most state governments in Australia sadly seem to be in a perpetual state of near-bankruptcy. For this reason, infrastructure and planning developments regularly get delayed or even worse, scrapped. Take Sydney’s north-west rail link, which was in various stages of ‘planning’ since the late 1980’s, but took until 2013 before actual construction sites started appearing to lay the rail line foundations and diggers commenced ripping up the dirt.
Perhaps my perspective is ever-skeptical, but you would be wise to not believe that any state government infrastructure development will go ahead – no matter if it has been given an ‘official approval’ – until you actually start to see soil being penetrated by machinery. As for non-state enterprises, like new private schools or business parks in close proximity, you need to conduct extra due diligence to be assured that they will go ahead.
Cameron McEvoy is a NSW-based property investor and maintains a blog, Property Correspondent.