Reader’s Write: Options Trading vs. Pre-Construction (BONUS!)

I just received this submission as I awoke in a Montana hotel room, and it’s hilarious!  Too funny not to share!

Derek’s post this morning was rather technical, but Garreth has left me cracking up laughing…

A real estate broker I know has been trying to get me to buy pre-construction condos in the city for years, we’ll call him Not David Fleming.  Or, as he is known in parts of Toronto, Bizarro-David Fleming.  So Not-Dave (“ND”) or, the Anti-Dave (as I like to call him), says to me, he says “Dude, you work in Finance –buying one of these units with barely anything down is like buying an option on Toronto’s condo market. You can’t go wrong.”

As I choke on my Crystal mimosa (spitting about $30 worth onto ND), I say “How can you say that Man? A contract to buy a condo is decidedly not the same thing as buying an option.” For any faithful reader of this blog, you know this to be true –but let’s pretend that dear reader has stumbled on this prose looking for the Toronto Reality Show Blog (“Whatever happened to Toronto’s version of Jersey Shore? Will Ben Mulroney host a Celebrity Big Brother featuring  Maestro?”)…

The key characteristic of a true option, a derivative security (which means its’ value is derived from something else),  is the right but not the obligation to purchase a security at a predetermined price, within a certain amount of time. That’s right folks, options have an expiration date –and when they expire, the holder of said option has lost nothing but his or her premium, the cost of the option.

In contrast, if you’ve put a down payment on a pre-construction condo, you have contracted to buy said condo when complete, at a pre-determined price. And if you try to walk away from that obligation, don’t be surprised to find Brad Lamb tapping your screen door with a Louisville Slugger –okay, that’s an exaggeration, he wouldn’t do it himself, he has hired goats, I mean hired goons (AKA lawyers).

Sure, you might be able to slink away, losing only your deposit –but don’t count on it. Condominium developers need pre-sales to secure development financing and letting you walk away from a deposit (even if they could resell the unit at a higher price) sets a dangerous precedent  – suggesting to banks that a fistful of purchase agreements isn’t enough  to warrant the advancing of construction funding.  You do always have the option  (there’s that word again) of reassigning your obligation to someone else, but the onus is on you to find that buyer (or “greater fool”) –there is no liquid market in pre-construction condos.

So if buying pre-construction isn’t akin to buying an option, then how would you characterize it?

Buying pre-construction actually represents a transference of risk from the developer to you. You are now a participator in development risk, cost-overruns, financing risk, natural disaster etc. As I wrote earlier, developers take your obligations and spread them out on a table in front of their bankers and say “see, all these people are obligated to buy our units, so now you can release the funding.”

Some of you may disagree, suggesting “nah dawg, I am not a participator in risk –I have contracted to buy a certain unit, of certain specifications, at a certain price, in a certain time –what risk is there?” –I laugh, and yet admire, your naivety if you believe that.

The fine print of these agreements usually allow the developer to extend the construction period indefinitely and to drastically alter your unit. Of course, you do –at this point –have the option of walking away with your deposit if your unit specifications have been altered but if you already had your heart set on this unit, in this location –are you really going to take your ball and go home if after 2 years, the developer tells you that the ceilings will be 9 feet high instead of 11?

So if that’s the case, why the H-E-Double-Hockey-Sticks would I ever acquiesce to such an agreement? Well I would if –and only if – I were being paid to take on that additional risk.

And how does a developer pay me to take on the additional risk (vs. buying an already-constructed unit with exactly the characteristics that I’m looking for?)By discounting the price. If you want me to contract to buy your un-built unit tomorrow instead of the exact unit I’m looking for today, I want some compensation. If you tell me –as developers are telling buyers these days – “well you should be willing to pay the same or more for pre-construction, because whenever this new unit is completed –be it 2, 3 or 4 years from now – the condo market will have appreciated by much more than that” -then you may as well be selling me magic beans because this is not the way finance works.

The return should be commensurate with risk. And there is a time value associated with money –if my money is tied up in your illiquid development, I expect the return to exceed what I can earn by investing it in an existing unit today.

Bottom line, the economics of buying a pre-construction condo have swung away from what made this option attractive in the first place (in days of yore).  And with more cranes in Toronto and more units under construction than anywhere else in North America, now is exactly the time when a buyer needs to be paid for taking on the incremental risk. I leave  you with this anecdote – I did buy one pre-construction condo. My current home.

When I signed on the dotted line, I requested several specific things: his-and-her kitchens, parking for 1 (one) blimp, zero ghosts or poltergeists, an infinity pool (sounds common –but I meant a pool that has no bottom), and walk-in sub-zero fridge/closet (I like cold socks).

While I received almost everything I asked for (scientific analysis suggests that my pool has a bottom), I was shocked to learn that no one else will ever likely be interested in my unit at any point in time. And the 5-figure monthly condo fee, associated with the maintenance and security of my blimp and that crazy fridge, is another disincentive for a potential buyer.

The lesson I learned is that unless I plan to make my condo my permanent forever home (unlike most buyers who will trade up within 2-5 years), I did myself a disservice by paying up for a customized home, delivered years in the future, when I could have purchased a decent unit at time zero, for the same (or better) price per square foot.

 

4 Comments

Post A Comment

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

  1. Ralph Cramdown says:

    I think buying pre-con is closest to WRITING a put option. You’re selling the developer the right, but not the obligation (read the fine print and consult a lawyer) to deliver you a more-or-less specified unit at a more-or-less specified price on a not very specified date. If it doesn’t work out for him, he’ll just refund your deposit, or give you first crack at buying the new thing going up where your thing was going to go up, or lower his overhead by lowering your ceilings and daring you to cancel.

    Anybody want to explain the greeks as applied to writing a condo put?

  2. moonbeam! says:

    Great post Garreth, you made me chuckle into my morning coffee! informative & entertaining — give this guest blogger a prize, DF!

  3. Alex says:

    Great article!:-)

    I agree that developers have gone crazy with the prices, there is no good excuse right now to buy a pre-construction at the price of already built home with same specs. They better have an A-team in their marketing department:-)

  4. Devore says:

    That’s pretty good. As David has made the point before in his chocolate cake video, pre-construction buyers are no longer getting a discount on their purchase, but are actually paying a premium. The (uncertain) future price increases are now fully priced in on high profile projects, as if they were zero risk. Even if that were actually the case, investors should still be getting a discount due to time value of their money, ie, opportunity cost.

TWEETS