Risks built into big condo deposits
The same paradigm shift that’s making condo developers less reliant on lenders by changing the way they finance construction is also generating new risks, observers say.
Hefty deposits from buyers who pay up to 80% before a project’s completion are allowing developers to finance early-stage construction without help from banks.
It’s good news for an industry that stalled as lending sources dried in the economic downturn.
But industry leaders say some dynamics merit closer scrutiny.
“The good thing is that developers don’t need to go to the bank until the last part of the project, if they even need to. They’re able to reach the shell without any bank financing. This saves the developer soft costs, which should be and often is passed down to the buyers,” said Jeff Morr, a 29-year real estate veteran whose Majestic Properties has helped develop emerging neighborhoods such as North Beach, North Bay Village and Miami’s Biscayne corridor.
“That’s where the benefit is to the buyer and the developer,” Mr. Morr said. “The risk is that you run into an inexperienced developer or a dishonest developer who delivers a shell of a building and never finishes, so the buyer is stuck holding the bag. There is risk – a lot more than there was when buyers were just putting 20% down.”
Deposits of 50% or larger are among the most significant changes in the industry in recent years, altering the dynamic for developers who, as late as about four years ago, got only 10% to 20% down.
“You needed construction financing. Today you don’t,” John Sumberg, managing partner at Bilzin Sumberg, told attendees of the Urban Land Institute’s condo market symposium last week.
As a result, several projects under construction have no financing, as developers use deposits and wait until later to approach lenders, he said.
Before 2010, buyers typically paid 10% deposits for pre-construction condominiums, then another 10% about 90 to 180 days later – for a total of about 20%, compared to 50% in today’s market.
“Buying pre-construction is reserved for the affluent,” said Mr. Morr, chairman of the Master Brokers Forum.
Today’s buyer is likely to deposit 10% to reserve the right to purchase a condo, then additional down payments within 60 to 90 days, again when the developer pours the foundation, again when construction reaches their unit’s floor and finally when the builder finishes the shell.
“The benefit for the marketplace is that we have a non-leveraged boom. Someone who has 50% down is not going to have a problem coming up with the other 50%, so we don’t have the same risks that we had with the 20% model,” Mr. Morr said.
It protects from a repeat of the trend at the start of the recession when some buyers who had had already paid 20% couldn’t secure financing and so ended up defaulting on their deals.
But the risk: some developers are avoiding the screening process in which banks would evaluate their financial strengths and their project’s true feasibility.
On the other hand though, observers say, with higher deposits, developers have been able to overcome restrictive lending practices and resuscitate the industry.
And the strategy has helped create security for reputable developers, as buyers now have a vested interest in each project.
“We have changed the paradigm of how real estate is sold in South Florida,” said Philip Spiegelman, founder and chairman of ISG World. “Essentially buyers are replacing the bank as the method by which developers are financing their building. If things get bad they are less likely to walk away from their investment.”