Friday’s blog video was about the pre-construction condo marketand how I am of the opinion that there is no longer any money to be made.

One reader commented, “People keep buying because the market keeps going up!”

He’s completely missing my point…

Rewind to the spring of 2002 and I was an eager student business student at McMaster University.

We had just come out of the tech bubble and almost every kid I knew from the “Trading Centre” had lost all his money by swing-trading shares of Sun Microsystems et al, so when I stepped foot into my “Securities Analysis” course, I planned on ditching everything I knew about stock market analysis and “emptying my cup,” as Bruce Lee would say.

The course was nothing like I expected.

There was no real-world application, and it was nothing but math.

I was more of a technical analyst than a fundamentalist (Fundamentalists – now is when we argue.  You think I’m lazy and unintelligent, and I think you’re wasting time looking for the “why” when all you need is the “what”), and I was hoping to actually analyze stocks instead of just theorizing with x, y’s, and z’s.

I think I squeaked out a B- in the course, but I didn’t enjoy any of it.  I learned very little, but what I did learn was perhaps one of the most salient points I took home from four years of business school.

On the very first day of class, our professor asked us one simple question:

“Can you beat the market?”

I’ve probably told this story over and over during the last four years on my blog (I’m losing track after 756 posts…), but it’s worth repeating again.

Can you beat the market?

If you can, then bravo.  You’re in the minority.

If you made 27% on your stock portfolio last year, it means nothing if the TSX rose 29%.  In essence, you lost.

Oh sure – you made 27% more than the people that sat on the sidelines, but by actively trading your own portfolio, or by paying a financial planner to pick investments for you, the result was a loss of 2% from what the market bore.

You did not beat the market.

If the TSX composite and/or the Dow goes up 32.7% next year, and your stock broker makes you 22%, then he is a monumental waste of time and money.  You could have put your money in the index and you would have done better.

Can you beat the market?

My professor challenged us to beat the market, and of course, none of us did.  The TSX (back then it was the TSE) improved a little more than 2% during the four months that I took that course, and I believe my fantasy portfolio lost about 5-6%.

I did not beat the market.

In any market and with any investment, it’s all about beating the market.

“Consistent returns” is a term that is thrown around a lot, but it’s meaningless without context.

If you “consistently” return 7.5% per year, every year, for ten years, what does that matter if the overall market returned an average of 12% and may or may hot have included massive fluctuations during the same time period?

Real estate is no different, in my opinion, and the comment that was posted on my blog last Friday was the inspiration for this post.  That comment read:

“The reason ppl keep buying is because the market keeps going up. Have you ever seen the market go down in the last fifteen years? Nope! So ppl keep buying preconstruction because the market keeps increasing. Shouldn’t you know this?”

I didn’t respond on Friday because I thought this one comment needed an entire post to address.

This person is arguing that people purchase pre-construction condos because the market always goes up.

Let’s assume for a moment that this is true.  Let’s assume that the Toronto market will go up every year forever and analyze this comment.

Let’s assume that this reader, Mr. Reader, bought a condo today at “Pizzazz” for $385,000.  The condo is 700 square feet, and thus $550 per square foot.

If you fast-forward to 2014 when this condo is completed, the condo is worth $437,500, or $625 per square foot.

Mr. Reader, in his infinite wisdom, has made money.  He has made a 14% profit as the market has gone up.

He was right – “people keep buying because the market keeps going up.”

However, I fear that he missed my point entirely.

Rather than buying pre-construction, he could have purchased existing resale at the same point in 2011, and he still would have made that 14% profit that we see above.

He did not beat the market.

THIS is the point I’m trying to make.

We can get off onto a sidebar about how pre-construction condos can/will/might/won’t appreciate more/less over the next three years than that of resale, but we’re talking a couple percentage points in difference.

The major point here is that “the market” goes up 14%, and Mr. Reader had his money in pre-construction and made 14%.  He did not beat the market, he simply put his money in the equivalent of an index fund, and he took whatever the market gave him.

So how did pre-construction used to work?

Well as I said in my video last Friday, and as I’ve been saying for the past two years – there used to be an inherent discount in the price of pre-construction.

Just as you pay less for cake mix than you do for cake, you used to pay less for pre-construction than you did for resale.

Let’s assume that things worked today in 2011 the same way they did back in 2006, and let’s assume that Mr. Reader looked at existing resale condos, which were trading at $550 per square foot, and decided to put down a deposit on a pre-construction condo next door for about $375 per square foot.

The condo cost him $262,500, which seems ridiculously low, but he realizes that he’s not buying a condo – he’s buying a piece of paper that says one day he will trade it in for a condo.  He’s buying the risk that this condo will never be built.  He’s buying the ten months of occupancy he has to endure before the condo is registered and he can sell it.  He’s buying the constant construction zone he’ll live in.  He’s buying the unfinished amenities, the broken promises, the material defects, and the disappointment from developers in Ontario.

Shouldn’t he receive a discount for all of this?

That’s how things used to work.

Fast forward to 2014, and the condo is worth $437,500.  He’s made a profit of 67% – a whopping amount of money when you consider that the market only increased by 14% in the same time period.

He has beaten the market.

So why did he make so much money?

Because pre-construction properties were being sold for a discounted price relative to comparable resale available at the same time.

The discount was the entire reason for buying pre-construction.

It was, in essence, a built-in profit.

You, the buyer, the “risk taker,” were being compensated for waiting three to four years to take possession of this condo, rather than getting it in thirty days like with resale.  You were also taking on the headaches mentioned above, and thus you were offered the unit at a price substantially lower than what was readily available on the market.

Doesn’t that make sense?

Today, pre-construction prices are equal to that of comparable resale.  This means that you are tying yourself to the market, and your pre-construction condo will be worth whatever the market has to offer in 3-4 years.  There is no reward; no compensation.

So let’s address the one issue we’ve never talked about before; the elephant in the room, if you will.

The market has done nothing but go up for the last fifteen years, but what if it went down?

What if you bought a pre-construction condo for $500,000 and the market started to drop?

Well, if you had bought a resale condo, you could sell it for $490,000, or $475,000, or whatever the market has to offer when you finally decide to dump it.

But if you have tied yourself to pre-construction, you’re stuck with this for the long haul.  When the condo is finished in 2014, and it’s worth $420,000, you close the deal and own something that is worth less than what you contracted to pay for it.

You can’t sell what you don’t own, let alone what hasn’t been built!

Take the case of Floridian luxury condos that plummeted in value.  Investors contracted to pay $5,000,000 for condos and put down $500,000.  Four years later, those condos had plummeted in value and were worth $3,000,000.  Rather than close the deals and take the $2,000,000 losses, those investors walked away from the deal and said “goodbye” to their $500,000 down payments.

We’ve only ever seen an up-market!  If the market were to decrease during the time period that you’re pre-construction condo is being built, you’re going to lose.  Pre-construction condos are illiquid since you don’t own them until 8-12 months after you’re given occupancy, and because, well, they haven’t even been built!

At least existing resale properties are liquid enough that you can sell them at any time!

As a final thought, there was a discussion about Friday’s blog video on one of my favourite real estate forums, www.buzzbuzzhome.com.  The comments posted about my video were very astute, as one reader essentially said that pre-construction condos will out-appreciate the resale condos during the same time period, which is why people keep buying them.

He raises a good point.

As I alluded to above, we can’t paint the entire market with the same brush, and it’s entirely possible that pre-construction condos will increase 17% in the same period that the market increases 14%.

But in my opinion, the entire reason we used to buy pre-construction condos and take on the risk (that the project will fall through, that the market will drop, that there will be material changes, etc) and endure the lengthy 8-12 month occupancy period when we all bleed money is because of the “built-in profits.”  When we were paying $375/sqft for something that would have sold for $450/sqft if it was ready today, we were being rewarded for our our risk.

Now, we’re looking at “out appreciating the market” as our risk, and it’s not enough, in my opinion.

I have stopped selling pre-construction condominiums altogether because I don’t sell what I don’t believe in.

Call me an idealist if you will, but I think there are far too many Realtors in this business, and far too many with less than one year of experience who will sell anything, anytime, anywhere.

As long as that continues, we’ll see pre-construction condos continue to rise.

After all, where else other than a pre-construction launch party can you get such amazing crab cakes and chicken skewers?