Now you know what you are selling the question becomes ‘when are you going to sell?’ There are three different stages of development when you can sell your subdivision down:
- Pre-construction (Pre-sales)
- During construction
- Post-construction (Spec Building)
Pre-Construction (Pre-sales)
Obtaining sales before you start construction helps to de-risk your project. It validates your estimated sales prices and provides collateral to secure funding from a lender for construction. However, the longer the time between pre-selling and when you start construction the greater the risk of costs blowing out and you have sale prices you cannot deliver on (as profitably). In a rising construction market, due to increased demand and a shrinking amount of available resource (previously decimated by the last recession cycle), construction costs can accelerate rapidly. It is common for developers to get excited and sell out product early in the development cycle. Unfortunately, when they find out construction costs have escalated, the project may no longer be profitable enough to secure financing. They either must go back to purchasers for more money, or if that fails or is not a contractual option, cancel the development.
Where sales prices are continuously rising, the developer may find in retrospect they have undersold their product and not made as much profit as they could have. In a red hot market you might sell 20 homes out in one week, then have to wait six months for consents and to arrange contractors and funding and then another two years to complete construction. If the market continues to rise, you could have made more money by staggering sales throughout the development period.
The flipside is you may not want to miss the market and have product left unsold once construction is complete. If prices stay flat or go down then you are in a better position by having your product pre-sold. However, if the market continues to deteriorate and the value of the home becomes less than what purchasers paid you will start to see settlement risk. This is when purchasers are no longer willing or in a position to obtain their own funding when the time comes to settle. If the value difference is greater than the deposit held then this puts the developer’s profit at risk.
So there are positives and negatives to presales. Nevertheless, the ‘pre-sell or not?’ question is often one the developer has no control over anyway. An external lender may require pre-sales before advancing construction funds. Therefore, without pre-sales there is no project. For example, in the middle of a rising market the lender may require 50% of the sections or houses pre-sold. So the developer works as quickly as possible to secure those pre-sales so they can tie up financing and contract with a builder to commence construction. Only once pre-sale numbers are satisfied does the developer have the option to consider whether to pre-sell the remaining product or sell it down during construction or hold it until construction is complete.
Experience shows that after a prolonged rising market where lenders become increasingly nervous, or at the start of a rising market where the pain of the last downturn still hurts, then lenders may require an even higher pre-sale percentage. The requirement can be as high as 120% of the amount borrowed. That means the developer must achieve enough pre-sales to cover the entire loan amount — this could be 80% or more of your sections or homes.
Andrew Crosby
+64 21 982 444
andrew@xpectproperty.com
