The finance geeks will love this post!  I hope…

For the rest of you, don’t let the math below dissuade you.  It’s complete gibberish to me as well.

I’ve always thought of pre-construction investing much like derivatives in the financial markets.  Let me give you my two cents on why the two are comparable, and perhaps you can poke a long list of holes in my theory…

Imagine what it’s like to be Robert Merton?

Anybody who has taken even an introductory finance course has been taught the Black-Scholes Model of options pricing, but naming the third person who developed the theory is like being drunk at a bar and being expected to name the third of the Three Tenors……”Domingo, Pavarotti, and…….the other guy.”

Fischer Black, Myron Scholes, and Robert Merton developed a model for pricing stock options back in the early 1970’s, but I’m not quite sure why Robert Merton got screwed over when it was named “The Black-Scholes Model.”  Maybe he gave up at the 11th hour and lost his claim to (potential) fame?

Whatever the case, Robert Merton lost an opportunity to be a part of what is debatably the greatest achievement in financial engineering, and likely has to sulk on the sidelines with that guy who left George, Paul, John, and Ringo after saying, “These guys suck….they’ll never accomplish anything!”

I’ve always thought there are parallels to options investing and pre-construction investing, but it wasn’t until this past weekend that I finally realized I need to write a blog post on the topic.

Consider that with most pre-construction projects in 2011, you need to put down a 20% deposit in order to keep your place in line.

I’ve always maintained that I would only ever invest if I could put down 10%, as I believe 20% is far too much money to tie up for the potential return.

This weekend, I was up in Pickering, again, as I have now likely solidified my role as “the number one Pickering agent….from Toronto.”

After a detour through Ajax, I couldn’t help but notice how many signs were advertising new homes under construction, and so I popped in to take a look.

Would you believe that these homes can be purchased with a meagre 5% down?

I took out a receipt from Pizza Nova and began scribbling down numbers on the back of it as fast as I could.

Five percent, you say?  For a house priced at $189,900 before construction?  Now we’re really making a comparison to options trading!

For those that don’t know what options trading is, or how it works, allow me to go through a very short tutorial.

First of all, let me say that options trading is how “most” people make “big” money.  I’m sure that your friend Nancy enjoys day-trading with the $5,000 in her TFSA, but the big money is made in options trading where the downside is limited and the upside is endless.

Options are divided into puts and calls, but for our purposes we’re going to examine call options.

A classic European call option is the right, but not the obligation, to buy an asset at a pre-determined price on a pre-determined date.

Simple enough?

That right, or rather that “call,” costs you a price – a fixed price.

Let’s go through an example.

Shares of DJF Incorporated are currently trading at around $50. 
On Monday, April 11th, 2011, you purchase 100 call options for $2.00 each.
The “strike price” is $55.
The “maturity date” is April 11th, 2012.

Your call option has cost you $200 – two dollars per share.

If on April 11th, 2012 (the maturity date), shares of DJF Incorporated are selling for more than $55 (the strike price), then you have a decision to make.

Let’s say the shares are trading at $65.  You can exercise the option, making $10 profit on each of your 100 shares, thus $1,000, and subtracting the $200 you paid for the option (the premium) you come out ahead with $800.

Conversely, if the shares plummeted and are now worth $30, you don’t exercise the option, and your losses are limited to the price you paid for the option – $200.  Had you actually purchased 100 shares, you would have lost $2,000.

Call options limit the amount you lose to the amount of your premium paid, and the upside is limitless.

Determining the value of the option, or rather the “premium,” is the complicated part of the equation.

There are many variables to consider, such as the length of the contract.  If the contract is for one month or one year, the price will differ considerably.

Obviously the strike price will affect the price of the premium as well.  If the strike price is something very high and very unlikely, then the price of the option will be smaller.

There’s the risk free rate, or basically the rate of interest at the current moment if you were to stuff your money into your mattress and do nothing.

And then there’s a little something called risk, or in this case, the volatility of the stock price.  During the dot-com boom of the late 1990’s, options pricing was nearly impossible since the market was so exceptionally volatile.  You’d see huge price swings – stocks going up or down 200% in one day!

To consider all these variables and come up with a market value for the call option, Robert Merton (and his two friends) gave us The Black-Scholes Model.

There it is – The Black-Scholes Model.

Don’t ask me to explain it because I’m going to be honest – I have no clue what any of that means, and I’m pretty sure I cheated on my third year finance exam anyhow.

So where are the comparisons drawn to real estate?

Think of buying a property in Ajax for $189,900, and putting down 5%, or $9,495.

Think of that deposit as “the premium” as it pertains to our derivative comparison.

Let’s say that the property will be completed in two years – on April 11th, 2013.  That is the “maturity date.”

And what is the strike price?

Well that’s what I’m trying to determine.

In theory, if the price of real estate in Ajax went down over those two years, you could walk away from your $9,495 deposit and limit your losses.  If the house you contracted to pay $189,900 for was only worth $150,000, then why would you pay $9,945 to take a $40,000 loss?

I say “in theory” because the developer has the right to sue you to complete the transaction.

When the real estate bust hit Florida, investors were walking away from pre-construction condos and losing their deposits.  I gave this example in a blog post the other day – if a condo that you were contractually obligated to pay $5,000,000 for dropped in value to $3,000,000, and you had put down a deposit of 10%, or ‘only’ $500,000, then why not just walk away and lose your deposit?  You’d be limiting your losses from $2,000,000 to $500,000.

Now I’ll be honest here and say that I’m not sure how or if the United States and Canada differ in terms of their laws for “walking away from a deal.”  I’m only working in theory here as it pertains to our comparison to derivatives.

But if that house in Ajax were worth $240,000 in two years when it’s completed, then isn’t the $9,495 you paid as a deposit a paltry sum in order to essentially “call” the option?

There are variables here, of course.

First of all, consider that you pay Land Transfer Tax when you close the deal, and you’d pay a Realtor a commission to sell the house in order to take your profit.

You’d also want to consider the opportunity cost of tying up that $9,495, or the “risk free rate of interest” that you could gain by putting the money into a GIC, for example.

And what are the chances that this property is never built?  Or what if it were delayed?  There is considerable risk involved, and you might want to look at the developer’s track record.

Consider how much more difficult the equation becomes when we look at pre-construction condos.  You have a monthly occupancy fee to pay, each month, until the building is registered.  This is not the case with a freehold home in Ajax!  You never know how long the occupancy phase will be; maybe six months, or maybe sixteen months!

So I have come to the conclusion that somewhere, someplace, somebody should take all these variables and ideas into consideration and come up with a Black-Scholes Model for real estate investing.

What we want to know is – how much should we put down as a deposit for a pre-construction condo?

Our variables that we can plug into the equation:
-pre-construction cost of the condo
-completion date
-expected value upon completion
-expected occupancy fee
-expected occupancy period
-expected/potential delay
-potential for project to fall through
-Land Transfer Tax
-Realtor fees
-risk free rate
-overall expected rate of increase/decrease in real estate market

Do any others come to mind?

So why isn’t some math genius working on an equation for us right now?

There are millions of real estate investors out there, and many of them (as we see in Toronto) are buying pre-construction condos.

The average Joe Investor in Toronto has no clue what he’s doing, and just says “I sure hope this condo goes up in value by the time I get it…whenever I get it.”  This is why, as I’ve alluded to before, developers now charge obscene prices for pre-construction – because the general public is stupid.

Experienced real estate investors in Toronto have shed away from pre-construction condos, and they’d be more likely to buy a freehold home in Ajax for $189,900 with as little as 5% down than put down 20% to pay $550/sqft for a pre-construction condo, being developed by a first-time developer, when prices of existing resale next door are only $500/sqft.

But I’ve talked about that enough…

If we had the equivalent of the Black Scholes Model for real estate investing, then we’d have some idea of what makes sense and what doesn’t – because right now, I keep saying “Buying pre-construction condos in Toronto makes no sense.  It makes no sense!”

Exactly!

And with all that said, I hereby invite all the finance geeks to:

a) add some value to my theory
b) poke some holes in it
c) quit your job, look up Robert Merton, and develop the Merton-Fleming Model of real estate pricing.  Although, I suppose if you put years worth of work into it, you can insert your surname in place of “Fleming.”

I have a feeling that option (b) will be more popular, as it usually is, but let’s try and remember here that this is only a crude example.

But perhaps if there was more clarity in the pre-construction investing world, then prices wouldn’t be where they are right now…