With demand outstripping supply, a considerable number of new builds are sold before construction even begins. CEO and Founder, Gavriel Merkado, investigates what this means in practice and whether buyers are getting as good a deal as it may first appear.
Read Time: 3 minutes
A large number of new properties are sold off-plan — i.e.: before the development has been completed. The market is such that these properties are often sold before construction has even begun. But what does this mean for buyers? Are they getting a good deal? And what would be a fair amount for a deposit on an off-plan property?
The deposit paid for buying a property off-plan acts in very much the same way as a European call option. Such a contract gives the deposit payer the right to purchase the property at a fixed price at a certain point in the future, but importantly not the obligation.
In this way it is possible to use standard financial tools to price the value of that option, namely the Black-Scholes-Merton formula:
There are plenty of downloadable spreadsheets to work this out (if you’re interested, there is a good one here). But in order to apply it to real estate you need to know the expected value of the property on completion (equivalent to the ‘stock price’), the number of years until completion, the standard deviation of returns for that property type and ‘risk free’ rate of return for that period.
In a simple example below, using data from Hackney and assuming that the property will be worth 5% more in two years’ time:
In this case, expecting a 5% price difference between the price paid and the value of the property on completion results in an option that is worth 7.18%. If the developer is selling deposits at 5%, this could be a good deal.
Testing this theory across a range of different values and completion prices gives the following sensitivity table, where the values shown are the equivalent % value of the deposit.
Using such a sensitivity table as the one detailed above, it should be possible for a savvy investor to understand whether they are overpaying or underpaying on their deposit on an off-plan property. For example, a 20% deposit for a property that may be worth 10% more in two years’ time and has an 8% standard deviation of returns, which would be too expensive (13%-20%). Similarly, it should be possible for a property developer to price their deposits more appropriately.
The question is then what the expected price/value will be on completion. This is open to interpretation and may be quite subjective, depending on the individual’s view on the market.
One other very significant factor remains, which is something not usually thought about in options pricing: the default risk of the issuer. Some academic work has been done on this. Though it is quite in-depth and beyond the scope of this brief piece, reports on option pricing’s exposure to credit risk and default risk may be of interest to investors out there looking to get their teeth further into the subject.
It goes without saying that factoring in the credit worthiness of the respective property developers and discounting the value of that option based on their probability of default during the construction period is essential.
Placing a deposit off-plan development works much the same way as placing any investment in the financial market. When taking on the risk of purchasing the option to buy a property before it is built, the reward could be substantial. However, as with any financial investment, it is vital to understand the risk before you place your deposit.
Knowing your numbers and doing your research is key to measuring this risk and determining whether the off-plan development is a good deal or not. Curious to see where REalyse could help you level-up on doing this sort of research? Request your free trial today.
© Treex 2020