Are off-the-plan investments a bad financial risk?

Off-the-plan apartments are shiny, new and well marketed, and come equipped with all the bells and whistles that many of us would love to have in our own homes.

As a result, they may seem like good investments to add to your portfolio.

After all, there’s no need for repairs or renovating, warranties are in place covering the building, fixtures and fittings, and there are decent tax deductions to be had from the depreciation of new appliances.

It sounds great so far, right?

Don’t be fooled: off-the-plan properties have their own set of risks that established buildings don’t.

I could write pages on the topic but today I will take a moment to look at off-the-plan investments from a financial point of view.

Off-the-plan investments are not a bad financial risk; they’re far worse than that.

In my view, they’re a terrible financial risk as they effectively represent gambling with your money.

This is because you have so little control over the investment from the moment you hand over your deposit until you collect the keys – which could be anywhere from six months to four years away!

Of course, like most aspects of property investment, every opportunity has its own set of factors and variables.

If we look at the property market in Melbourne, we can see a dramatic increase occurring in the construction of residential properties.

An estimated 30,000 new dwellings are expected to be commenced or completed in 2016, most within the city boundaries and the rest in the outer suburbs.

When we see a sizeable growth in construction of housing in an area, we also see the effects of competition. Developers offer incentives to attract buyers and persuade them to purchase off-the-plan in a new estate or apartment complex.

Usually developers are required to sell a certain amount of apartments before they can commence construction, so they will wheel and deal to move their properties quickly.

This could work in your favour if you become interested in buying at the right time… Or it could be the very reason why you pay $50,000 more than your next-door neighbour for the exact same property.

There are other financial risks, too.

When you make an off-the-plan purchase, you’re buying the property at its supposed current market value. In general, the build time is between 24 and 36 months and in that time it’s possible for the market to shift upward.

I realise that in Sydney some investors have done very well over the last few years because on completion their properties were worth several hundred thousand dollars more than they paid a few years earlier.

This is a fantastic outcome – but it’s the exception, not the rule.

More often than not, you’ll pay a premium on today’s market price to cover the developer’s margin and marketing costs, so don’t count on capital growth of your new property as a strategy to generate a quick profit.

The opposite scenario – in which the property is valued at less upon completion than the price you paid – is a more common financial risk of buying off the plan, and it can turn ugly fast.

Towards completion, your lender will appraise the property to check that the current market is still in line with the purchase price.

If the property is valued at less than the purchase price (and that’s happening a lot nowadays, especially in Brisbane and Melbourne) it will result in you requiring a higher Loan to Valuation Ratio.

Best-case scenario? The bank could agree to lend you more money and charge you a higher Lenders Mortgage Insurance premium.

But over the last year or so, as APRA has made the banks tighten their lending criteria, very few will lend more than 80% of the value of your property on completion.

And worse, if the market shifts downward, or you only put down 10% deposit and hope capital growth will mean you won’t have to find any extra deposit, you could find yourself in real financial strife.

For example:

• You purchase a property off-the-plan for $600,000 with a 10 per cent deposit of $60,000.
• You expect it to be worth $700,000 at settlement in a few years’ time, allowing you to borrow 80 per cent against the end value without having to put in more funds.
• Upon completion it is valued at $550,000 (and that’s generous based on some of the real-life case studies I’ve seen).
• The lender limits your borrowing capacity to 80 per cent of $550,000 to minimise their risk… giving you access to just $440,000 in finance.
• You need to come up with a further $100,000 to settle the deal – or you lose your $60,000 deposit and the developer can still sue you for any loss they incur.

This scenario has stress written all over it and is happening to investors all over Australia.

When a new apartment complex is released to market, suddenly 20, 40 or 60 new dwellings become available all at once and supply often exceeds demand.

Finding a tenant, even in an area that had previously been a rental hotspot, can suddenly become difficult. This can mean you need to drop the expected rental price to bring tenants in.

In my mind there are many other risks to buying off-the-plan and all this uncertainty means you should only consider buying this type of property if you obtain a significant discount. Yet in reality, investors usually pay a premium on the market price, giving away the first 5 or more years’ capital growth to the developer.

In summary, off-the-plan purchases are not a bad financial risk – they’re a terrible financial risk. Steer clear.