Buying real estate off-plan? Be aware of the risks.

Real estate is the world’s most important and largest asset class, and is purchased both as a utility as well as an investment.

It is largely perceived to be a safe investment, ostensibly due to its tangibility but also historically, at least here in Malta, the downside risk appears to be contained, although not necessarily so in the future. For instance, the global financial crisis of 2007-8 has revealed the correlation between real estate performance and credit cycles, and the systemic risks that arise when debt obligations exceed anticipated returns on real estate investment.

When purchasing real estate off-plan (or “on plan”, as it is sometimes referred to in Malta), purchasers are not only assuming market risks associated with the asset class, but are heavily exposed to other risks which they ought to be informed about before parting with their savings.

Purchasing a property off-plan refers to the instance where a purchaser agrees to acquire a property that has not yet been developed, or is currently in the process of being developed.

When purchasing off-plan, developers typically offer attractive prices in order to incentivise them for the additional risk they are assuming in the transaction.

Perhaps the most pronounced of all such risks is referred to as “counterparty risk” or, in other words, the probability that the vendor may default on contractual obligations which would typically be set out in the promise of sale agreement.

For instance, the vendor may default in delivering the promised specifications in respect of the structure or finishing of the property. The vendor may also fail to deliver the property within the promised time frame.

In both such instances, it is common for purchasers to engage in non-contentious negotiations with the vendor in order for any default to be rectified.  Where such negotiations fail, however, purchasers may be left with no choice but to rescind the promise of sale, or to keep on extending the promise of sale until the property is delivered in accordance with the promise of sale agreement, thereby losing critical time and incurring additional expenses.

Another risk, no less critical, associated with purchasing real estate off-plan is “insolvency risk”, that is to say, the risk that that the vendor becomes bankrupt or insolvent during the period in which the property was being developed or finished.

In the best case scenario, where the deposit is kept by the notary or an escrow, purchasers may elect to obtain a refund. The situation is, however, radically different where deposits are paid directly to vendors, who later become bankrupt or insolvent.

In this scenario, purchasers may find themselves in the position of an unsecured creditor of a bankrupt or insolvent counterparty. Not only will they have to pursue costly litigation in order to obtain redress, but the probability of recovering the deposit in its entirety becomes very low.

This is due to the presence of other creditors, such as banks, employees and other secured and privileged creditors who will have a right to be paid first from the liquidation proceeds of the bankrupt or insolvent vendor.

For this reason, purchasers must be extremely careful when paying deposits directly to vendors in an off-plan property acquisition because the reduced price rarely compensates purchasers for the actual risks they are assuming.

The practice of using deposit money to part-finance real estate projects should be closely monitored by lawmakers and regulators, and careful considerations should be made on whether to regulate such practices.

This is because the risks of using deposits to finance the development of real estate can be associated with the investment risks arising from offering securities to the public, which latter endeavour is otherwise a heavily regulated practice.

In general, companies offering securities to the public (be it bonds or shares) must go through a rigorous approval process before the Listing Authority, and any such offer must conform with all requirements laid out in the Prospectus Regulation, as well as specific regulations applicable to public companies.

One of such requirements is that investors are made fully aware of the risks they are assuming in the investment, and this is done through full disclosure of financial and commercial information. Such requirements do not arise when developers use deposits to part-finance the development of real estate.

Looking at off-plan real estate transactions in isolation may not lead to particular concern in terms of systemic risks, but collectively the situation can be critical, especially in an unanticipated market downturn.

And with emerging stories such as that of the potential collapse of Evergrande in China, perhaps it is time to re-think policies around such practices.