Concerns Growing Over Off The Plan Purchases

Are you consider buying an apartment off the plan?

The ­Reserve Bank has been issuing warnings since at least October last year about the possibility of a ­severe contraction in the amount of Chinese money coming to Australia for apartments.

The apartment market is looking at approvals of about $65 billion. If it cracks it will spread to other parts of the residential market, boost bank bad debts and probably mean bank dividends must be cut.

To understand the ­potential crisis, you have to look at just how this apartment building boom is being ­financed. While some apartment developers such as Meriton have strong balance sheets, most have weak balance sheets and rely on forward or off the plan sales to Asian and local buyers to gain their funding.

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Residential and comercial buildings under construction in Sydney’s CBD (AAP Image/Joel Carrett)

The Asian buyers are by far the majority of off the plan ­buyers. If the developers are using Australian bank financing, they get their money to build the apartments first from the 10 per cent ­deposit made by the off the plan buyers, then from banks, which usually will lend between 45 per cent and 50 per cent of the cost of the completed building. The balance is borrowed by the ­developers on second mortgage. If the project is funded by a Chinese bank then different ­arrangements are in place.

[Tweet “There is an apartment over-supply in many of our capital cities.”]

On the off the plan buyers’ side, most of the Chinese buyers have had conversations with our local banks. While some may have been funded using Chinese banks, our local banks are the main source of funding for individuals finalising the purchase when the apartment is completed.

Clearly if Chinese (or local) apartment purchasers can’t raise the money to complete the purchase, it will cause huge losses by the apartment developers and their lenders because they will be left with unsold apartments.

The Reserve Bank says the volume of the apartments being built in Sydney and Melbourne is pushing up costs and a downturn in apartment markets “could weigh on developers’ financial health”. That comment from the Reserve Bank will increase pressure on vulnerable developers.

But in terms of financing the purchasers, the Australian banks feel safe because their arrangements with off the plan buyers have escape clauses. The Reserve Bank endorses that feeling of ­safety but the situation facing the banks is far more complex.

In the recent past, with a rising apartment market, these escape clauses have not presented a problem for the buyers because the apartments were worth more than the purchase price. But this year three events have taken place:

• The big rise in supply has caused the Australian apartment market to slip. It is generally ­believed that apartment prices in Sydney have fallen by 6 per cent to 7 per cent, though rents are still strong. In Melbourne the value of a “used” apartment is a lot more than 6 per cent to 7 per cent below purchase price value, so a second-tier “used apartment” market is pushing down bank valuations markedly.

According to the Reserve Bank, in Brisbane developers are having increasing difficulty gaining presales and the market in Perth has deteriorated. And in Brisbane lower profit margins mean developers have borrowed a much bigger proportion of the building cost.

While most settlements are proceeding smoothly but the change in the value of apartments is an ominous sign.

[Tweet “The over-supply means that the value of the apartments is falling prior to settlement.”]

• APRA is concerned that banks are too exposed to the dwelling markets and they have leveraged it too far, so it has demanded extra equity be raised by the banks, which is also in ­accordance with global rules. But it also has warned at least some banks that if they allow their investor lending on dwellings to grow by more than 6 per cent or 7 per cent then extra capital will be required.

So the banks are restricting their lending, creating a credit squeeze. When the banks were agreeing to back Asian and local purchasers there was no sign of a credit squeeze. It is not now a serious problem but the huge avalanche of apartments coming forward will make it a serious problem for the economy unless the APRA credit squeeze is eased.

• Finally, while most of the Chinese can raise 30 per cent of the apartment purchase price, the rules governing money leaving China are much tougher. The Reserve Bank emphasizes the difficulty of taking money out of China is increasing, so if the Australian banks reject loan applications from Chinese, many simply will not be able to get the extra money required out of China.

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There is strong apartment buying demand in Sydney and Melbourne’s population continues to grow, which underpins ­demand. But if buyers of off the plan apartments can’t raise the money that they counted on from the local Australian banks and/or in China, there are estimates that apartment prices will fall by 20 per cent to 25 per cent.

Are you thinking of buying off the plan?

Here are some of the more common risks associated with buying off the plan?

Over-supply 

This hurts investors who purchased a dwelling off the plan at a certain rate, because when the market becomes oversupplied, almost overnight, values can drop sharply, as can the rental rates for such developments due to so much choice in the market.

Prospective tenants can become picky and this can leave some developments struggling to find tenants to occupy these buildings. This can significantly reduce the profitability of these dwellings and overall make for a bad investment.

Do not be lured or attracted by the developer’s ‘word’ that their opportunity is particularly unique; or their assurance that there is genuinely a limited supply or restriction to other developments appearing in your chosen area. Instead, contact the local council of this area to get an understanding of the area zoning.

[Tweet “Make sure you do your research and get independent advice before signing anything.”]

Trusting the developer’s figures

When buying off the plan, developers will present capital growth projections, forecasts of rental growth, and may even have a third-party industry expert provide assurance of future growth figures to hand. Nothing really is assured, though.

The reality is that there is no way to know this for sure, particulary if the developer is basing their metrics on flawed or missing data sources to begin with. Trusting only their figures (however knowingly or unknowingly skewed or biased these may be) is a road to failure for off the plan buying.

Always seek independent advice and do your research before signing anything!

Promised inclusions not honoured at completion

Most of you will be aware of horror stories where developers promised quality/luxury appliances, lighting, flooring, and any other features, yet at the end of construction these were replaced by inferior alternatives. This becomes a problem when valuers assess the market value lower than expected at the end of the project.

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Check that the developer honours their promises about inclusions.

As you move closer to contract stages with the developer, get in writing as part of this; every single inclusion and feature/fixture/fitting that is to be part of your property purchase. Have your solicitor cast his or her eye over it before signing off. Be particularly wary of developers that give you grief for requesting such levels of detail. This can be extensive but worth it.

No reputable developer will have a problem with you seeking advice from an independent lawyer. We are experienced in dealing with property contracts of all kinds.

Contact us today for your free, 10-minute phone consultation.