Moving from the popular presale model to a build then sell model would provide additional funds for the builder, increase the quality of housing, stabilise demand, increase workplace stability and encourage labour retention, writes Andrea Sharam. So why are we not using it?
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In the previous article, we described how the design phase in apartment construction delivers less than optimal outcomes because developers trade off efficient construction against the potential of losing their equity due to the nature of procurement of design services and the risk of a downturn in demand.
Here, we discuss how market volatility determines the nature of the apartment product and how the risk of market downturns has been institutionalised into the apartment development process.
Build to sell apartment production is effectively a contract market, as financiers use presales to confirm demand and cover the construction loan amount. Purely speculative developments, in which apartments are only offered for sale after a building is completed, are very unusual in Australia, as the developer and their financiers are totally exposed to changes in market conditions.
By law, presale contracts can only be offered by developers once a planning permit has been obtained. Presales lock in project revenue. This means controlling construction cost is paramount, and the use of design and construct contracts shifts this risk to the builder. For various reasons, builders’ margins are very low, ensuring a focus on cost management means little capacity to invest in productivity.
Presales mean buyers take the capital gains (or losses) that developers would obtain if apartments were sold post-completion. In a rising market, precontracting thus provides the opportunity for buyers to make windfall profits with little outlay (presale deposits are 10 per cent or less of the purchase price and held in escrow). Buyers can cut their losses if prices fall below the purchase price by defaulting at settlement, as it can be challenging for developers to obtain a legal remedy.
The opportunity for lightly taxed capital gains and limitation of potential losses means buying off the plan is attractive to buyer. Apartment development has therefore become highly reliant on investors.
While presale contracts are intended to derisk apartment development, overreliance on speculative investors makes projects highly vulnerable to investor flight during market downturns
Consequently, most apartment products are “investor grade”; that is, of lower quality, amenity and design than owner occupiers typically seek. This dynamic reinforces owner-occupiers’ preference for houses over apartments, and apartment developers’ reliance on investors.
So, while presale contracts are intended to derisk apartment development, overreliance on speculative investors makes projects highly vulnerable to investor flight during market downturns. This risk means developers seek a higher return on investment.
For builders, there are two pools of funds in the development process that could be diverted to support investment in efficiency measures. The first is the capital gains extracted by presale buyers, and the second is the developer’s profit.
If market risk could be reduced, the rate of required return on development could be lower, easing pressure on contract prices.
Redistribution of capital gains, however, requires a shift of a different nature.
Shifting from presales to a build then sell model (not unheard of in the Australian context and not uncommon in the US) would transfer capital gains from presale buyers to the developer, providing additional funds that could be shared with the builder, for example, through early contractor involvement or cost and risk sharing contractual models. This would address many of the design problems that impede construction and result in defects, as well as the pressure to cut corners. Build-then-sell would also reduce customisation, which is another source of delay and defects.
Existing subsidies for speculative investment could be channelled towards institutional build to rent and community housing to support moderate and low income households.
Offering apartments only once they are constructed reduces the opportunity for speculation but also provides the opportunity for buyers to assess the quality of the build prior to purchase. This would increase pressure for quality assurance. Removing capital gains tax concessions, negative gearing and use of prudential levers could also be used to shift the market away from the current model to more stable models.
Existing subsidies for speculative investment could be channelled towards institutional build to rent and community housing to support moderate and low income households. By growing these models of private rental housing, owner occupiers would dominate build-to-sell apartment provision bringing much needed change to the nature of the product.
With stable demand, builders could move from inefficient due date production to rate based production. Stability would reduce the tensions in allocating construction risk. Workforce stability and greater direct employment would encourage investment in training and encourage labour retention.
The build then sell model obviously involves the risk of not obtaining sales at completion. There is evidence in Australia, however, that developers who self-fund projects, who are highly capitalised and do not exit the market when downturns emerge, ultimately achieve higher rates of return as they take the capital gain on unsold stock when the next upswing occurs, and until that time, they have rental income.
