The Dangers Buying Leveraged And Pre-Construction Property

At a conference 20 years ago, an elderly gentleman came up to me after I’d presented a real estate investment opportunity to say he didn’t invest in real estate anymore.

I figured it was because, at his age, he probably wasn’t buying any green bananas either. Guy was in his late 80s.

He went on to explain that, decades earlier, he’d bought a lot on the island of Montserrat. It was located on the side of the island that disappeared when the volcano blew.

An act of God is one way to lose all of your investment in real estate.

The other is leverage.

In the run-up to the bursting of the global real estate bubble in 2008, I met several so-called investors who bragged that they controlled US$1 million, US$2 million, US$5 million, etc., of real estate.

They didn’t use the word “owned” because they didn’t own anything.

They’d put down deposits on pre-construction apartments… as little as 5% in some cases. You need only US$100,000 to “control” US$2 million worth of property if a 5% deposit is the threshold.

The guy with the US$2 million worth of apartments under contract expected to flip them, not before they were completed but before the next payment was due. He was speculating that he could find another investor to buy from him at a slightly higher price than he’d paid. He only needed someone to buy from him for 5% more than he’d invested to make a return of 100%.

In the financial world, this type of investment is called “options trading,” and it’s so speculative that many brokerage companies require you to have both a high net worth and experience before they’ll let you trade this way.

No such limitation exists for real estate.

The idea of buying and flipping pre-construction apartments is a valid one, but it’s a high-stakes musical chairs. Last man standing isn’t left simply with no place to sit down. He’s left with nothing.

You have to manage the risk and not overextend.

Buying pre-construction, typical terms are 10% down with at least another 20% paid over the construction period, either 5% four times or 10% twice. Usually a total of 50% paid is required by the time a building has been completed. Construction times vary, depending on the size (mostly the height), from 18 months to 36 months.

While you can find markets and opportunities where you can sell an apartment before completion, this is not as easy today as it was in the heyday of the pre-2008 boom. In today’s climate, you should expect to hold an apartment at least until a few months before completion if not until after the unit has been built, in which case you’ll have to come up with the total balance due either from your pocket or from a bank loan.

The fallback investment approach, if you’re not able to resell the apartment before taking possession and having to pay the balance, is to rent the unit while you try to find a buyer. For some, this can be the primary strategy.

Taking the leveraged time during construction to come up with the full amount of the purchase price can make sense depending on your portfolio’s cash expectations. The profit premise behind pre-construction buying is that you’re buying at a discount because you’re giving the developer use of your capital before construction has begun.

As construction progresses, property prices should go up, both because of the closing discount gap and thanks to general market appreciation. Of course, real estate markets don’t always go up, so make sure the discount you’re getting from buying early is enough to warrant the wait for the building to be built.

My first pre-construction purchase was textbook perfect.

It was a beachfront property on the Spanish coast. The developer had plans for multiple buildings, and I found the project just as they were launching the first one. The price was good compared with prices of completed projects in the area, but most important was the property’s location. It wasn’t ocean-view or oceanfront. It was true beachfront.

The payment terms, likewise, were perfect: 5% down and 5% every six months until the project was completed. A total of 30% due over two-and-a-half years with the remaining 70% upon possession.

And the developer agreed to list my apartment for sale within their sales department. This is rare.

At the time, Spanish banks were giving foreigners financing for up to 70% of the cost of an apartment. That was my backup plan if the apartment didn’t resell before completion.

However, I didn’t have to resort to my backup plan. About two months before the expected completion date, the developer wrote to say he had a buyer for my unit. The buyer wanted to be able to move in right away, so, even though the developer had cheaper units available in phase 2 by that time, my phase 1 completed unit was the winner.

The apartment sale closed a month before completion. The buyer paid me the original 30% deposit directly, plus my profit, less the 5% commission the developer charged.

I almost doubled my money in less than two years.

As I said… textbook.

Trouble is, this kind of buy doesn’t always work out so well. Indeed, I haven’t been able to repeat that level of leveraged profit from a pre-construction purchase since.

And I have another story I’ll tell you sometime about a leveraged pre-construction buy I made a few years later in the U.K. that went to zero. I had to walk away.

Leverage can get you excellent returns, but use it wisely when investing in pre-construction real estate. Don’t take on more than you can comfortably afford to close on if the property doesn’t resell before it is completed and you have to take possession.

Lief Simon