As a follow up to last week’s insight article about condo prices stagnating, I want to now open the curtains and unveil how developers of pre-construction projects set their prices.
You should understand that, depending on the length of tenure and private equity support (silent money partners) of each developer, each scenario is always different. However, I will highlight the most common scenarios.
Most of the time, in the world of real estate financing, mortgages and construction loans, you provide a down payment to your lender, usually a bank, before they will finance the balance of your purchase or project. When buying a house, traditionally you need 20% down payment and the banks will give you the balance of the 80% in the form of a mortgage.
For developers, they need to go to the bank and get construction financing. Basically, this means that developers go to the bank for money to build these massive 50-storey skyscrapers. Trust me, they ain’t cheap! Scary fact – in the last 7 years, construction prices have almost doubled!
Most of the time, in order for developers to get construction financing, they require about 70% of their project to be sold – that’s a lot if you think about it.
Many developers will sell their first lot of units (phase 1) at a competitive price (varies by location and project) in order to meet the target requirement for obtaining the bank’s construction financing. However, some projects (which I won’t name here) are not so successful with getting construction financing, and unfortunately will be left sitting there in a perpetual state of… nothing-ness. That is, they are paying the carrying cost to own the land, but are not able to build as a result of the lack of financing; not to mention the buyer’s deposit money is also still left just sitting around.
Now you may be thinking, “Then why aren’t new build condo prices going down if all of the developers need to hit a certain target to build and could potentially be in competition with one another?”
Deep pockets – This is where having a big chunk of change comes in handy. Developers who have been in the business for quite some time have deep pockets and often can finance or partially finance their own construction. So their quota, if you will, for units sold before construction tends to be less. Another instance where deep pockets come into play are private equity lenders for developers, or the so-called “silent money partners” in the back that nobody knows (who secretly finance the project for a high return on investment).
When there is no stress for financing, developers will hold back units to sell later on when they can get more money for them; I know many developers who implement this protocol. This is why a lot of people want to buy pre-construction in the earlier stages because units may be less expensive during this early phase.
The Controller of Supply and Price – Developers who are not strapped to sell units to get financing have the edge in their marketing strategies as well. They are able to control supply and price. If the supply that the developer has put on the market is not being fully absorbed (i.e., demand is lower than supply), they won’t release anymore units until the current ones sell out. However, if demand is high, developers can increase the price and satisfy the demand with better profit margins.
Essentially, the developer can adjust the supply according to the demand. With such a commanding force over supply and price, that is why you very rarely see the cost of pre-construction condos go down in price – this is an unfortunate fact.
Pre-construction involves a bunch of developers who talk amongst themselves to control the supply and price in the market. The resale market, on the other hand, is more of an open market than pre-construction because it consists of many individual homeowners selling their property.
These developers are similar to the Canadian wireless companies. From the eyes of the consumer, they are “conspiring” against everybody. However, I’m not here to paint a bad picture for these developers because at the end of the day, it is a business and if there is demand, then there will be price increases – just like how it is in the resale market right now.
Passing the Cost – The other factor impacting pricing of pre-construction condos right now is the cost of construction. When the cost of goods sold increases, in order to continue making the same profit margins in any business, they must increase the price of the product sold.
Here’s a prime example illustrating this cause-and-effect situation: The minimum wage increase in Toronto just came into effect, and as a result, the cost to run a business will increase. All of this will inadvertently affect the end consumer because businesses will raise the price of their goods and services to offset the higher costs of doing business.
The Wrap – So what does this all mean? Does this mean you should never buy pre-construction then? Of course not. This is me being transparent with you and sharing how everything works in the industry. As long as the developer makes their margins and continues doing business, while you make good returns on investment when the project completes, then everybody wins! No harm nor foul.
Until next time,
Happy Real Estate-ing,