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Developers typically require a minimum of 20-30% deposit. A portion of this amount may be used by the Developer for construction and is at risk should the Developer or Project fail.
First, you will find that most developers require a minimum of a 20-30% deposit. In some states such as Florida for example (Statute 718.202) prohibits the developer, in condominium projects, from accessing the first 10% of the deposit. Anything above and beyond the 10%, the developer may access for purposes of construction. Therefore, assuming Bob provided Joe with $300,000 on a $1mil unit and the project went bust, Bob would only be reimbursed $100,000 of his $300,000, thus losing 2/3 of the capital. Once again, this is assuming it’s a condominium project. In the example of a town home or single family home, Bob would lose ALL of the capital. This is significant because in the softening real estate market that we are currently experiencing, studies have illustrated that as high as 60-73% of projects are projected to go bankrupt.
Also keep in mind there are developers out there that will only require a 10% deposit or less. That can be a warning sign. More than likely the developer may be struggling for pre-sales. Generally in hotter markets developers can demand higher deposit amounts.
- No Price Protection – Developer can sell for less than Bulk Buyer’s purchase price, potentially creating a loss. (Uncertainty associated with the true fair market value of the unit)
When the real estate market was hot, developers would literally sell out within hours. Why? The power of leverage. With a $200,000 deposit, assuming the property appreciates as little as 10%, upon re-sale, one is recognizing 50% gross appreciation on $200,000 deposit, without having to close. However, in a soft market, leverage can have the exactly opposite impact. If the real estate market values decrease by 10%, this equates to a 50% loss. This does not account for the additional cost of real estate commissions. It is for this reason that the same developers that were selling out within hours are taking years to sell 50%. Investors are now very reluctant to participate with such high risk (developers must pre-sell 50% of their project to secure a construction loan from a lending institution).
- Most purchase contracts assess penalties for assignment prior to closing.
When the market was hot, investors were purchasing units for as little as $300,000 and flipping them for as high as $600,000, at times making twice as much as the developers without having to bear as much risk. There was so of that activity taking place that most purchasers had no intentions of closing. In the end, you had a purchaser seeking to flip, unable to flip, forfeiting their deposit, and leaving the developer holding the bag. In response, lenders and developers imposed one of two penalties:
· Assess penalties for assignment prior to closing. To flip one’s unit before closing may cost them a penalty fee anywhere from 50 basis points to 3% of the purchase price of the unit.
· Require that buyer close on the unit prior to resale. At which point in time, most mortgage companies impose prepayment penalties for attempting to immediately resell.
- You must close when project is issued a Temporary Certificate of Occupancy.
o Closing costs (ex: Title, etc.)
o Carrying costs (ex: mortgage, property taxes, condo association fees, etc.)
A traditional buyer must close at the time of Certificate of Occupancy (CO). CO is exercised when the city completes inspection of all units in the structure and deems them to be in “move- in condition”. As conveyed earlier, many of the pre-construction buyers had no intention of closing and as a result of surplus of inventory, many of them now are either forced to close or required to forfeit their deposit.
- The is significant time and effort involved when you negotiate and effect a transaction (ex. Must market property or hire real estate agent).
Most people do not have the opportunity to do the proper research and due diligence with prospective investment opportunities. Instead, they make the common mistake of trusting a friendly realtor or financial advisor. You should never take advice from people who have never been where you want to go. In addition, most of the best-performing projects are more than likely not going to be in your immediate area and are probably in a completely different region of the country.
