So this was going to be a short couple of paragraphs on some common pitfalls around financing ‘’off plan purchases”, mostly to help a client understand the transaction they are currently contemplating… but here we are now and it’s almost “War and Peace”.
You’ll be forgiven for wondering what I’m on about as a finance / mortgage broker who gets paid through the process of helping client raise finance, as most of what follows will read like the equivalent of a bucket of ice cold water… Bear with me, firstly (shameless plug – I’m much more than a mortgage broker, think of me as your personal finance strategist) I like to be able to look my clients in the eye year after year when we do their reviews and I really want to make sure that if it is a path you’re going to walk, you are able to make informed decisions and build in solid buffers or safety margins.
Here we go..
Buying a property “off the plan” is the purchase of a property that hasn’t yet been built, the decision being made on the basis of the planned construction. The most commonly bought off-the-plan properties are apartments, units and townhouses.
The second type of off plan purchase, which is becoming more common due to concerns around the inner city apartment markets particularly in Melbourne and Brisbane, is the purchase of unregistered land.
An unregistered land purchase is when a developer subdivides a larger block of registered land through an unregistered plan of subdivision. The plan of subdivision must be approved by the local council and registered before settlement can occur. When you sign a contract to buy an unregistered land, you are buying a “Lot” in an unregistered plan of subdivision. Your actual lot doesn’t yet exist, so there is the potential that there could be changes to boundaries, easements etc.
There has always been a degree of risk associated with purchasing residential properties off the plan, such as the end product finishes not meeting expectations in an apartment or unexpected easements or changes to the size of a lot with unregistered land, with the result that you may end up unhappy with the property you have purchased.
There are potential upsides to these purchases, particularly in rising markets where you may be able to lock in the purchase price of a property which may go up in value before settlement.
In almost all cases, unless your purchase is very close to completion of the building or registration of the land (ie within 90 days), as a purchaser you will be required to commit unconditionally to the purchase without being able to secure your finance until settlement is almost due.
Having lived through a number of these contracts and seen a few disastrous ones from a distance, my focus here is to help you understand the finance process and the risks you will need to consider so that an informed decision can be made.
These risks are real and a mistake or a miscalculation could and often does prove extremely costly. (I know, icy cold water… very negative, aren’t I?)
So, why all the concern?
Firstly, your finance clause probably isn’t worth the paper it’s written on…
Most contracts include a finance clause, however it is usually only between 14 and 28 days. However, in the early stages of marketing a development or land release, registration and therefore settlement can be anything from 6 months to 36 months away (even before the inevitable delays).
If settlement is more than 90 days away, it is highly unlikely that the developer will be in a position to allow a valuer access to inspect the property. In the case of a new building, there may well be nothing to inspect as construction would not have commenced.
Under these circumstances, the best your broker or bank will be able to do for you is a pre-approval (be very sceptical of anyone who promises you more than this, there will be a catch). A pre-approval is a long way from the comfort of an unconditional finance approval. I’ll explain more in detail later on.
Even if the valuer can gain access, the vast majority of lenders require that a property settles within 90 days of the date of valuation, if this doesn’t occur due to delays, even an unconditional approval can lapse!
If you decide to proceed with an off plan purchase before a formal or unconditional approval is possible, you will essentially have to sign off the finance clause, giving up your right to use the fact that you can’t raise finance later when settlement is called to cancel the contract.
So, you’ve got a pre-approval and signed the contract anyway, what happens next?
Whilst you wait in anticipation for the settlement date, and the magical date 90 days prior when the property can be valued (with the most accommodating lenders, some want to wait for registration to actually happen), the property market will move. It may be in your favour and rise, it could be static, or in the stuff of nightmares it could fall, a lot.
When the valuation is done, if it comes in at less than what you contracted to pay for the property, the lender will base the loan amount on the lower of the contract price or the valuation.
As an example, if you had contracted to buy a property for $ 500 000 and were planning to borrow at 80%, you would have paid a deposit of $ 50 000 and assuming you got some half decent advice, you would have locked in access to funds for the remainder of your deposit plus your stamp duty already in place – so $ 70 000. This would either be cash, or a loan raised against another property (at all costs avoiding cross-collateralisation, which you can read more about here). Plan A is that the bank would lend you $ 400 000 to complete the purchase.
If the valuation comes back at $ 450 000, the bank will now only loan you $ 360 000, leaving you to find the remaining $ 40 000, usually at very short notice.
If you can’t come up with the cash, then if lending policy allows, you could try to borrow the additional $40k taking your loan up to 90% of the valuation. This will cost you lenders mortgage insurance of around $ 8 000 in this example. Due to a very recent policy change across the industry, you may also now be forced to make principal and interest repayments rather than interest only repayments (which could hurt if this is an investment property and you haven’t planned for it in your cash-flow).
If you can’t do either of these, you may have no choice but to cancel the contract. This could result in the loss of your $50 000 deposit and possibly being sued for more if the developer struggles to resell the property for what you were going to pay, which he will because the valuations are coming in short.
Assuming you’ve found a gem, you’re confident the valuation won’t be an issue, and you’ve got a pre-approval… does this take away the risk?
Like my earlier comments about the finance clause, unfortunately a pre-approval (especially the variety obtained over a quick conversation in a branch or without heaps of paperwork), is also worth little more than the paper it is printed on under these circumstances.
In an effort to shore up their already not insignificant profits, most banks don’t actually have a human with the authority to approve a loan assessing pre-approvals. Often they are system generated based on whatever has been entered (you’ve no doubt heard the term garbage in, garbage out) and are subject to a list of conditions as long as your arm.
If your pre-approval is done properly and fully assessed (which takes some manoeuvring through the system by a broker who knows what they’re doing), it is valid for 3 months. In some instances, lenders will honour the pre-approval for up to 6 months subject to you providing proof of continued employment. It will always be subject to a valuation when the property is complete, and there being no change to your financial position.
Until recently, some lenders allowed for pre-approvals to be extended, but in many instances, because of how often and materially credit policy is now changing, most will require a new application after 90 days. Ironically, the process of continually re-applying for a pre-approval for peace of mind could result in your application eventually being declined because of too much activity on your credit file.
If during the period from the expiry of the pre-approval until settlement of the loan, your personal circumstances change, or lending policy changes which it almost certainly will, this is where things can start to get exciting for all the wrong reasons.
Here are some examples of the types of issues that can and do come up:
Changes to your circumstances:
- An unexpected job loss, or a reduction in hours of job, lowers borrowing capacity.
- A job change comes with a probation period which is a problem for some lenders (and most LMI providers)
- An unexpected addition to the family brings about both maternity leave and higher living expenses, again – reduced borrowing capacity.
- New loans/commitments taken on reduce your borrowing capacity. We advise clients to avoid this, but if the off plan completion timeframes blow out (which they almost always do) and the family car dies, sometimes you have little choice.
- You forget to pay a telco or utility bill and pick up a blemish on your credit file, even a little one of these can be a show stopper across the majority of banks and lenders. (If you can get it done after one of these the rate will usually be horrible)
Changes to lender policy or appetite:
- Interest rates rise and with that the qualifying rate is higher, which reduces your borrowing capacity
- Lending policies have changed and the LVR is now restricted further. Examples include lenders deciding overnight that they won’t touch new builds, or will only finance up to 70% LVRs in some areas.
- Your lender has reached their maximum growth in investment lending and stops all investment lending for a period. A very recent example is a lender dropping their LVR on all investment lending to 50% overnight (talk about saying no without actually saying you’ve closed your doors for that type of business)
- Lenders reduce their lending appetite against the property you purchased off the plan, as a result of a saturation of properties in the block/suburb/area where you purchased. This most commonly happens in large buildings where they may already have significant exposure. Lenders mortgage insurers also have tight maximum percentages that they will fund in any one development. If you’re not in early you could get a no just because there were too many applications for the same building in the queue ahead of you.
- Your preferred product or loan structure is no longer available to you. As an example, overnight in June 2017, most lenders have changed their policy with regard to interest only loans, these are now only available up to 80% LVR, if you need to borrow more than this you’ll have to pony up the principal repayment too each month, which may not be tax effective.
We’ve had these overnight changes from both the big banks and the smaller lenders – no lender right now can with any credibility say that their lending policies are stable.
It is one thing to make your own contingency plans for a change in your circumstances, which we always recommend clients do, but quite another to have the rug pulled out from underneath you because the lender who you thought would be on board no longer is.
When is off plan less risky?
As you may be expecting this ties back to the magical 90 day number and when a valuer can gain access. If you can find a development that is close to completion or land that is due to register and settle within 90 days, you can obtain full finance approval upfront and avoid all these headaches, even if it is technically still an off plan contract. This is my favourite option as it essentially becomes a normal contract where you can ensure your finance is locked in before you are committed.
So, after all this doom and gloom, where do we stand if we can’t find anything that is complete or near complete and still want to go ahead with off plan?
Congratulations, you’re made of tough stuff!
This is where we fall back on the advice of the “Oracle of Omaha”, Warren Buffet. Always, always have a safety margin far larger than you need.! “The core idea is to protect yourself from unforeseen problems and challenges by building a buffer between what you expect to happen and what could happen.” I highly recommend reading the article written by James Clear http://www.businessinsider.com/apply-one-investment-principle-to-your-everyday-life-2017-5?IR=T
So what safety margins do I recommend for my clients if you’re going to commit to a contract without full finance locked in?
- Have access to enough funds, locked in and correctly structured upfront to get you through a valuation shock of at least 10 to 15%, preferably 20%.
- Look forward all the way to the sunset clause * date in the contract and take into account any other finance you may need to take out as well as any likely or possible changes to your living costs.
- Taking 2 above into account, make sure that this transaction doesn’t take you anywhere near your maximum borrowing capacity.
- Make sure that your application would be acceptable, with a large safety margin, to a number of different lenders. If you only have one option and they change policy on you, you’ll be up that proverbial creek without a paddle.
- Consider how secure your job is, or your ability to replace your income at a similar level in a short space of time.
Even these won’t guarantee that you won’t have issues, but they should leave you better placed to deal with how the transaction may play out.
In short, work with a finance specialist (me) to make sure you have plan A, B and C in place before you walk through this door.
Contact me to discuss your personal finance strategy:
Tanya du Preez
B.Com Chartered Accountant (SA & AUS). Dipl. Financial Services. MFAA Credit Advisor
Mobile: 0430 383 996
Office no: (07) 3205 4888 Fax: 3020 3851
Office: 22/1344 Gympie Rd, Aspley, QLD, 4034 Postal: PO Box 377, Aspley, QLD, 4034
*This is the date at which you can cancel the contract if it still hasn’t registered, if the contract doesn’t have one, don’t sign it!