Risker Times For Precons! Risk & Returns Comparison For Preconstruction & Resale Condos
Introduction
We’re starting to see cracks on the new builds side lately and a Mississauga developer bring the latest to file for creditor protection.
In case you don’t know, when you buy a precon you are entering into an agreement to buy something that hasn’t been built yet and you probably won’t see it done until a few years down the road. Because of higher level of unknown, precons are inherently higher risk compared to resale condos and so, historically, precon offer a slight discount over resale condos after adjusting for expected appreciation by closing.
Nowadays, I would say that precons now are even higher risk compared to before and perhaps not everyone fully realizes this yet. So in this video, I’ll dive into this more and show you how precons look like as an investment today, when you should consider a resale condo, and when precons might make sense.
Precons: Then & Now
In a nutshell, here is how a developer would price a precon. They would look at the fair market value of a similar condo today and then factor in an expected appreciation by closing, minus a varying discount based on supply and demand.
Precons were not always a very hot commodity where you would feel like you won the lottery if you got one. There was a time when precons did see less demand because of the higher risk involved, and so developers would offer a decent discount for those who were willing to take on the adde risk for potentially better returns.
2015 to 2020 was Toronto condos’ big moment, and they saw amazing double-digit annual price growth, which was far better than what was expected. So, even though there was no rental appreciation, precon investors made most of their money from the fact that actual appreciation was higher than the priced in appreciation, which doesn’t always happen.
Fast forward to 2022, and we’re now in a pretty different condo world today. Right now, condos are less desirable post-COVID, cash flows just aren’t there for investors as a long-term rental, and you’re not allowed to Airbnb your condo anymore in order to bump up your rent yields.
But perhaps because precons did so well in the past, a lot of people still remember the amazing performance and are driven to precons because of the stories from friends who made a lot of money from precons. Remember, that precon discount that I talked about is really driven by supply and demand. When there’s less demand, the could be a bigger discount but these days, demand for precons is still high, so that precon buying discount is pretty low.
Instead of a discount actually, it seems like precons are now factoring in an extra premium because developers are trying to protect themselves in case building costs continue to shoot up.
Toronto Precon Risks 2022
This leads us to the fact that yes, precons are riskier these days for both the developer and for you as the buyer.
First of all, even if precon builders add in an extra price buffer for building uncertainty, they might still ask you for more money if inflation gets ugly. We’ve seen this happen a few times already over the last year, and it’s very possible that this will continue to happen.
The second one is completion risk, and it’s getting pretty real. Most recently, a Mississauga developer just asked for creditor protection and when you dig into it, it’s not that they don’t have demand for their condo units – they’ve actually sold most of their units already. But the problem is the much higher than expected building costs and now rising interest rates end up making the project not sustainable anymore.
Next, let’s talk about delays. We know that precons are notorious for delays, even before COVID started. With COVID delays being a very common excuse these days, you can expect an even longer completion time, so this is another elevated risk.
Then we have the higher expense risk. In an inflationary and rising interest rate environment, your financial projections can change drastically if the assumptions you use end up being significantly worse than expected.
And the final thing is mortgage risk. Right now, investment properties require a 20% down payment, but we are seeing news that investment properties might be subject to higher down payment requirements starting in Q2 of 2023. If this is the case, it’s possible that you might end up needing more downpayment than you anticipated, which you may or may not have, and this will also change your return on investment in your property as well.
Resale & Precon Returns
The expected returns on a precon are a lot lower than on a resale condo until closing. At the same time, you are faced with much higher risk these days. So from a risk and reward standpoint, precons make a lot less sense these days and so we wouldn’t recommend them if you have enough money to invest in a resale condo today.
Here’s how returns compare. When you buy a resale condo, you get stable rental income on day 1, a better chance for gains from appreciation, and you’re also not subject to an extra premium because of uncertain building costs. With precons before closing, you only make money if actual appreciation beats the price in appreciation by more than the premium you paid, which is a coin toss these days.
This might not be what you wanted to hear, especially if you’re thinking about buying a precon soon. It’s definitely a more speculative short term move, but in the long run, they can still a decent investment if you can’t afford to buy a resale condo right now.
The big plus with precons is that they allow you to save up for the down payment over a longer period of time so that you don’t need all the money upfront. Eventually, you will still end up owning real estate, which is a good investment in the long run. Given the higher developer risk these days, I would only recommend that you be wise and choose reputable builders in urban centres that benefit from a COVID recovery like Toronto when you are picking projects.
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