Reader’s Write: Options Trading vs. Pre-Construction

I’m blown away!  I received three responses to my blog-challenge, and one was absolutely fantastic!

Thanks to Derek for submitting this response, which reminds me I know nothing about finance…

I’m not an options trader but I do work at a Toronto investment bank in the bond department.  I too haven’t really discussed options since school, but for me that was only a few years ago as I’m a bit younger than David! (haha, gentle ribbing).

I see the comparison David is drawing and its a good one.  I’ve been reading David’s thoughts on the pre-construction condominium industry for a while but never really put two and two together and come up with the comparison myself.  But I do agree that the comparison puts the lunacy of pre-construction “investing” into perspective, if you can call it INVESTING at all.

DEFINITIONS first.

An OPTION is a contract that gives the buyer the right, but not the obligation, to buy or sell an asset at an agreed-upon price on a specific date.  An option is a security like a stock or a bond.

There are two types of options: PUTS and CALLS.

A PUT gives the buyer the right to SELL an asset at an agreed-upon price during a specific time frame.  The owner of a put hopes that the price of the stock will DECREASE.

A CALL gives the buyer the right to BUY an asset at an agreed-upon price during a specific time frame.  The owner of a put hopes that the price of the stock will INCREASE.

I think for the purpose of David’s comparison of options trading to pre-construction investing, we should only focus on CALL options.

The price at which the asset can be purchased is called the STRIKE PRICE and the date that the option expires is called the EXPIRATION DATE.

The cost of the option is called the PREMIUM.

The simplest form of options trading is probably in the stock market, so let’s say that shares of Toronto Realty Blog Inc. are trading at $80 today, and you want to buy a call option.  You buy a call option for $3.50 per share, where the strike price is $90, and the expiration date is one day from today – August 1st, 2013.  You buy 100 total options, for a total of $350.

If the price of Toronto Realty Blog Inc. is “IN THE MONEY” on August 1st, 2013, ie. it is $90 or more, then you exercise your option (things can get very technical here, ie. you can sell your option versus exercise the option and immediately sell the shares, but let’s keep this simple for the purpose of comparison to pre-construction investing.  I know my coworkers would be all over me and picking apart this example with errors, but it’s mean to be simple).

Let’s skip over the idea of exercising versus trading out and just look at the profit.

Keep in mind, that the option cost $3.50 per share, so technically the stock has to be above $93.50 for you to take a profit.  Let’s say the stock is trading at $100, and you close your position.  You’ve made $10 x 100 shares, for $1,000, minus $350 for the option = $650 profit.  We could run this example over and over, but you get the idea.

The underlying idea behind options trading is threefold:

1) There is a cost associated with the purchase of the option.
2) You determine the strike price in advance.
3) You have the ‘option’ of going ahead with the purchase, or not.

If shares of Toronto Realty Blog Inc. were trading at $70, your option would be worthless, and you would lose $350.  Consider that your loss is limited to the $350 you paid for the option.  Had you actually BOUGHT 100 shares when they were trading at $80, and you were forced to sell them at $70, you would lose $1,000.  If shares were at $50 and you sold, you would lose $3,000.  But when you buy an OPTION, your loss is limited to the cost of the option – in this case, $350.

I think this is what David is getting at with the comparison to PRE-CONSTRUCTION CONDOMINIUMS.

As David said in his video: the real estate market has done nothing but go UP for years and years.  Pre-construction condos were always a simple way to make money, since you could effectively buy anything and make money, as the market was always advancing.

But what if the market stays flat or goes down?

If you bought a pre-construction condominium today at an agreed upon price of $300,000, and in four years, the market had declined and the unit was worth $250,000, you would have to take that loss.

There is no OPTION when it comes to buying pre-construction condominiums, even though you are playing the futures market!!

With stocks, you can buy today at a KNOWN price, and sell at any time.  When you play the futures market with stocks, you have an OPTION, and you can limit your downside.

The same cannot be said for pre-construction condominium investing.

The major difference here is that there is no OPTION PRICE, but you do put down a deposit on the unit – maybe 15% up front?  So if you pay $45,000 up front, and the condo decreases from $300,000 to $250,000, you’ve lost the potential interest you could have had on that $45,000 over the four years (or other opportunities), and you’ve basically made a downpayment on a $50,000 loss.

The comparison to OPTIONS TRADING is if you were to walk away from your deposit (I don’t think this is legal, but people have done it in the United States when the market was really bad).  If you put down $45,000, and you were set to lose $50,000 when the property closed, you could walk away and “save” $5,000.

In this case, the option cost is HUGE!!

In the example above, the option was only $3.50 for a share trading at $80 – or 4.375%.  In the pre-construction condo example, the downpayment is 15%, or more than three times as much!

But the biggest problem with pre-construction condominium investing is that there is no OPTION!  You’re blindly throwing money into the market, with no way of getting out if you make a bad investment.

You don’t know the price of the condo in the future, whereas you know the strike price with options trading.  And you have no way of getting out of the deal, unless you want to forfeit your deposit.

Also consider that CLOSING COSTS play a role in condo investing.  You have to pay levies from the developer, land transfer taxes to the government, legal fees, and other costs.  These might add up to as much as 7-8% of the asset’s price.  You pay commissions to trade options, but those costs are nominal in comparison.

I’ve been reading David’s blog for a little over two years now and I have read all his posts on pre-construction condos.  The conclusion I drew was that developers are crooked, they deliver a sub-par product, and the delays and occupancy periods are nightmares (is there anything else???).  But when you look at the costs associated with buying pre-construction and the UNCERTAINTY it makes it look even worse.  The fact that you can’t predict the future is perhaps the biggest issue, and with options trading, you can pay a small price/premium either get in, or get out.  A pre-construction condo buyer is better off playing the options market, and avoiding the downside.

 


Excellent use of CAPS LOCK, Derek! 🙂

Thanks for the explanation, and I whole-heartedly agree with your assessment.

One more point to add, if I might: buying real estate without knowing the future value is true for both resale and pre-construction, but you could sell an existing house or condo in a week and close in a month; but with pre-construction, you’re locked in!  You have nothing to sell except a piece of paper, and you’re often not permitted to do so because the developer won’t allow it.  And if you actually can sell it, how hard/easy is it to move paper?

4 Comments

Post A Comment

Your email address will not be published. Required fields are marked *

  1. […] today’s episode, I’ll share one of my favourite analogies about buying a new or resale home… it’s all about the cake versus the cake mix… coutesy of my friend David Fleming.  We […]

  2. Chuck says:

    awesome article! I agree with moonbeam, it should be required reading… and the last paragraph is SPOT ON.

  3. moonbeam! says:

    This should be compulsory reading for anyone looking to buy preconstruction… cautionary words. Thanx for explaining in simple terms. My neighbourhood has several enticing condo developments looking to attract preconstruction buyers. The locations are tempting, but buyers beware.

  4. Vlad says:

    This is excellent stuff. Just a month ago I talked a colleague out of buying into a 1-bedroom pre-con condo that would be closing in about 3 or 4 years. She was going to use a line of credit to help her with the deposit and take on a second job to save for the balance. Yikes! Great location aside (Yonge & Eg), she would have been spending the foreseeable future having sleepless nights while watching her untouchable “investment” turn to turd.

TWEETS