A reader emailed me the other day seeking my advice on pre-construction and its viability under the current market conditions both in terms of investment and as a principal residence.

I’ve been touting pre-construction as a fantastic investment vehicle for the last three years, but times change.

As I told my curious reader, “That ship has sailed, my friend.”

Hindsight is a female-dog, is it not?

I watched the people around me make money hand-over-fist through the purchase of pre-construction condominiums before I finally jumped on board myself.

I’ve made some lucrative investments, but I can’t help but look back and say, “If only I had bought in this building, or during that time frame.”  Really what I wish is that I had just bought MORE.

We’ve had a fantastic bull market in the last decade, and while house prices in many areas of the city have more than doubled, I think that dollar-per-dollar, pre-construction condos were the best investment during that time.

But just as all good things come to an end, I think the days of making six-figure profits inside of three years by purchasing pre-construction have gone the way of the T-Rex, the dodo-bird, and Britney Spears’ career…

Let’s go back in time about 6-7 years and look at why pre-construction was such a great investment.

More specifically, why were prices so low and so far below the current market?

I can think of two main reasons:
1) You were buying an intangible product; a condo that was not yet built.  Surely there needed to be some sort of discount, no?
2) Developers needed people to buy their product so that they could move ahead with the project.  Units are sold before financing is in place, so the more units that sell, the better the chance that a lender will finance the project.  Surely the developers needed to entice buyers in order to get their sales in place, no?

When both of these reasons ceased to exist, the pre-construction market died.

In my estimation, this happened about 6-8 months ago.

With the West Side Lofts fresh in my mind since they finally broke ground on the project last month, I’ll use this investment as an example of how units were priced back in the day.

I first walked into the sales centre in early 2005 and subsequently purchased a unit at West Side Lofts.

The unit was a 2-bedroom, 2-bathroom condo of 700 square feet, and it included upgraded finishes in the kitchen and bathrooms.  Once I purchased parking and a locker, my total cost came to just over $250,000.

I considered this to be “dirt cheap.”

West Side Lofts is being built right across from The Drake Hotel which is a landmark in Toronto.  The area of Queen West has already gone through it’s “up and coming” stage and is now officially “here.”

The project was scheduled for completion in August of 2008, and in 2005 I figured my unit would be worth about $350,000 once completed.  Actually, I figured that even in Spring of 2005 when I wrote my first cheque for a deposit, a unit like the one I was purchasing had to be worth at least $285,000.

In essence, I was being sold a $285,000 unit for $250,000.  I was being given a discount of about 12-15% simply because the building wouldn’t be ready for three years.

This is where investors made most of their money.  As long as you had good cash flow and were solvent enough to carry this project through the sales, construction, and occupancy period, you would make money due to the fact that you bought your unit for less than it would have been worth if the product was real.

But there was more to the equation: the market was red-hot!  Condos were going up in value 8-10% each year.  So not only did you get to purchase a condo for less than market value to make up for the fact that it wasn’t built yet, but you got to reap the rewards of the ever-increasing market.

Take this one step further: If you owned a resale condominium worth $250,000, and the market increased 8%, you’d be looking at a paper-gain of $20,000 on your principal residence worth $250,000.  However, with pre-construction, you are only required to put down 10% as a deposit.  So if you made the 8% paper gain and $20,000 on the value of $250,000, you’re really only calculating your profit on the $25,000 (10%) that you put down instead of the $250,000 that you own as in the resale example.  Your profit margin goes from 8% to 80% when you compare resale to pre-construction!

Confusing?  I hope not.  It’s very straightforward, but I didn’t feel like drawing graphs and counting beans…

So when did everything change?

Well, it started with the higher pre-construction prices.

I remember going to see the launch of King East Lofts last year and prices had risen to $300,000 for a 590 square foot, 1-bedroom unit with no parking.  I recall questioning aloud how this compared to what was available on the resale market.

At over $500/sqft with no parking, these had better be some pretty swanky units!  Sure, the units are new and never-lived-in, and will be of a current 2010 style (when ready) compared to a unit completed in 2000 and its ten-year-old design, colors, and features.  And I’d bet that the finishes (floors, counters, windows, trim, kitchen cabinets) would all be of greater value than that of resale, simply because people have come to expect more and builders have obliged.

But is that really enough to justify waiting three years for the building to be ready?

Is there enough of a discount for the buyer?

I didn’t think so.  In fact, I saw zero discount whatsoever.  I figured that if that building were actually complete and ready to move in, the prices they were asking in pre-construction were equal to what I would expect units to sell for on the resale market.

So out the window went one of the reasons why pre-construction was so attractive.  The market was so hot that builders didn’t see any need to discount their projects in order for buyers to purchase units.  Everybody was so caught up in the pre-construction craze, that buyers never stopped to compare their intangible units to what was actually available on the resale market.

Eventually, the public, media, and economists began to question the real estate market in general.  This put a damper on the second reason why prices were so good in pre-construction; if prices didn’t continue to climb by 8-10% per year, was it worth investing?

How about if prices were flat across the board – a year with zero percent growth?

You could net 3-4% interest on your money in a GIC or T-Bill, so why take the “risk” of the condo market not climbing at a higher rate?

Then we had the stock market collapse and the economic crisis in the past five months, and with the Toronto condo market down 3-4% in that time, it spells T-H-E E-N-D for the pre-construction craze.

But many people disagree with me, and buyers are still scooping up units every day of the week.

I just don’t see this being a viable investment anymore, for the two reasons I outlined earlier:
1) The pre-construction prices became level and actually began to exceed that of resale prices, and no “discounts” were available anymore.
2) The market has cooled off and has actually decreased somewhat in the last half-year, and there are no guarantees of an upward spiral like we experienced in the past half-decade.

There has never been a better time to buy resale and ignore pre-construction altogether.

All good things come to an end, and those who made six-figure-profit after six-figure-profit should be happy, and move on.

But as the market is cyclical, eventually there will come a time down the road when pre-construction becomes a moneymaker.

Will you be ready?