Invest With Passion!

By Karen Kusumakar

What is preconstruction? Preconstruction is pur-chasing a house or condo after it has been planned, but before it has been built. If you listen to the hype, you will earn more than 100% on every preconstruction deal that comes your way and you are missing the boat by not investing right now. While realizing profits of more than 100% are certainly possible, preconstruction deals have their pros and cons just like any other investment method.

Why should I invest in pre-construction?

There are many reasons to invest in preconstruction deals depending on if you are buying it to live in, to rent out, or to sell. But the common  reason to all types of borrowers is instant equity. Because most pre-construction deals are offered at below market value, the buyer has equity in the property at closing. This is extremely advantageous for the buyer. Another big reason for investing in preconstruction is appreciation. If you would have invested in a good preconstruction deal in Las Vegas or Florida in the last few years, for example, you would have seen a return on investment of at least 100%.

Why is the developer selling at below market value?

Typically, developers plan subdivisions as opposed to just building a house here and there. The financing for such projects is in the multi-million, if not the multi-billion, dollar range. Lenders don’t like to lend that kind of money without some sort of reassurance that the developer is planning a project that will sell. Most lenders require developers to have a certain percentage (usually half) of their units under contract BEFORE the lender will loan them money. This means they have to sell their product before they break ground. It is difficult to sell, and risky to buy, a property that has not been built yet. In order to make the deal attractive to a buyer and make the risk worth taking, the developer will lower the price.

How much money is required?

When it comes to preconstruction deals, the possibility of a no-money-down deal is extremely difficult if not impossible. Developers are not in the market of holding property. They want to know that you are going to close when the time comes. Therefore, developers will require a sizable earnest money amount…anywhere from $1,000 to 10% of the purchase price. Also, expect to put money down during the construction phase. For example, the developer may require you to put an extra $5,000 down when the foundation is poured and the frame is up.

What are the steps and the timeline for a typical pre-construction project?

1)  Developer purchases land or owns option to purchase land.

2)  Developer plans the project with engineers, architects, excavators, etc.

3)  Developer gets approval from the local government. Steps 2 and 3 may be repeated a few times.

4)  Developer applies for financing.

5)  Financing approved contingent upon developer pre-selling a set percentage of the units.

6)  Developer markets (or hires someone to market) the project at a below-market-value price and gathers the necessary number of reservations.

7)  Developer purchases the land if not already owned.

8)  Developer finalizes everything and gets the necessary legal paperwork done.

9)  Developer converts the reservations to actual purchase contracts and, at this time, may choose to sell more units at a higher price.

10)  Developer breaks ground and begins construction. At various stages of this step you will be asked to put down more money.

11)  When completed, developer obtains a Certificate of Occupancy from the local government.

12)  Final closing takes place.

The timeline can run anywhere from a few months to a few years. It depends on the type of project, how much work needs to be done, and how experienced the developer is. You may have heard of a project being in “phase one” or “phase two.” At certain points during the process mentioned above, the developer may raise the price of the remaining units and sell them. This is usually referred to as a phase. The point during the process in which this happens is completely up to the developer. For example, let’s say a developer is constructing a new subdivision of 100 homes in Illinois. When completed, the homes will have a market value somewhere between $350,000 and $375,000. At step 5, the developer needs to pre-sell 50 homes to get financing. They are put on the market at a price of $300,000. This is phase one. The developer successfully pre-sells 50 homes and obtains financing.

The developer decides, at step 9, to sell an additional 10 homes. But now the price is $315,000 per home. This is phase two. The developer decides to sell the rest of the homes after the first few

homes are completed and closed. This would be phase three and would have a selling price very close to market value.

Or the developer could decide not to have a phase two or three at all and just wait until completion to sell the rest.

Are there limitations on buying, selling, or assigning preconstruction deals?

That will be decided by the developer. Be sure to read the reservation agreement and the purchase contract carefully. Remember, the developer wants to make as much money as possible. A homeowner will typically pay more for a unit than an investor and will be more serious of a buyer, so the homeowner will be preferred. The developer may want homeowner buyers only or may allow investor buyers but require them to wait a certain length of time before selling their property. The reason for this is if the developer decides to have a phase two or three, he will not want to be competing with those investors to sell his units.

Assignments may or may not be allowed. Do keep in mind, though, that you are on the hook if you assign your right to purchase the property and the new buyer does not close.

What are the risks of investing in preconstruction?

Because EVERYTHING about preconstruction is in the future (completion date, market value, rental market), all of the information you have gathered or have been provided is speculation. That means the developer can claim a project completion date of six months, but the project will be delayed if there were a hurricane that destroyed all of the wood needed to build.

Market value is the most important figure and, ironically, it is also the most volatile. The good news is you can generally see a trend in market values. While you may not be able to predict market value exactly, you can generally tell if values are going up or down.

What are the potential pitfalls?

Pitfall #1:  The biggest potential pitfall is the case where the developer does not complete the project. If the developer goes bankrupt or skips town, you may lose all of your money.

Pitfall #2: During the reservation phase, either party can back out or change the terms. If the property increases in value more than the developer expected, he may decide to increase the purchase price. You have a choice to accept the price change or get your earnest money and walk away. If you walk, he sells to another buyer at a higher price.

Pitfall #3: Time comes for closing and you do a walk through of your property. You notice that the quality of work is not up to the standard you thought it would be.

Pitfall #4: You close and are required to hold your property for at least one year before selling it. During that year, the market tanks and the value of your property drops by a significant amount. If you sell before the year is up, you most likely will face significant financial penalties.

How do I protect myself when investing in preconstruction?

The most important thing you can do is “due diligence”. This means don’t trust what anybody says, especially the people on the other side of the closing table. Research everything from the developer’s license and zoning permissions to his previous projects and finances. Research the (speculative) “facts” and come to your own conclusion based upon your ability to take risk. Check what’s for sale in the market. Get second and third opinions on the value of the property in the future. If possible, check out the construction site and make sure the quality of work is up to par. While good deals are definitely out there, not every deal you come across is a good one.

Another important issue is the money you put down. Make sure ALL money you put down is held by an escrow agent and not by the developer. If the developer can’t finish the project, your money is safely tucked away where he can’t touch it.

Finally, be prepared for all situations. Make sure you are able to hold the property for the specified amount of time after closing, if necessary. If you can’t sell it, have another strategy prepared.

How do I invest in preconstruction?

Preconstruction deals are in high demand. This means you are competing with a lot of other investors for the same units. A lot of developers don’t have to go outside of their network to find buyers. And if they do, they use the network of a few good realtors. This means you need to get in with the right crowd. There is power in numbers. Become a part of an investing group. A developer will give a group of 100 investors a better price than if each of the 100 investors came to him individually.

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About the author: Karen Kusumakar specializes in preconstruction deals. For currently available preconstruction opportunities, go to www.LocateRE.com.

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