Buying too much real estate? A unique dilemma

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Andy Dufresne
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Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

Facing a unique and major housing dilemma and would appreciate your thoughts and criticism!

Real estate in my neck of the woods (this is outside the US and Europe) is very expensive, both relatively and absolutely and is now in bubble territory. 

Since my portfolio return has generally been better than RE rental yields, I have always rented, never owned (a very costly mistake on my part, but that is water under the bridge now). However, several things are making me reconsider. 
 
First and foremost, I have the option of purchasing any apartment I want to in a certain building (total of ~150 apartments available, ranging from ~850 to ~2000 sq feet) in a new neighborhood in a good location for anywhere between a 35 and 50% discount to market price - the larger the apartment, the larger the discount. 

Why I have this option is irrelevant, but this is a one-time shot and I will need to make my choice by the end of the year. I will likely be able to move into the apartment in about three years. Further, I anticipate that in 10-15 years this neighborhood, given its many nascent advantages, will increase in value faster than the general housing market.

Second, DW and I are tired of moving every couple of years (there is a lot of stress involved and it can take months to find something). Now that we have a child, and hope to have more, DW's nesting instinct has become much stronger and she wants a place to call home.

Third, the current economic situation has a few levers pointing me towards real estate.  First, ZIRP has pushed equity valuations to levels I am highly uncomfortable with so I am over 80% in cash and do not expect the markets to provide a real return of more than low single digits in the next decade. This, coupled with the likelihood of significantly higher inflation rearing its ugly head in the mid to longer term future (say 3-5 years from now) given the printing orgy governments are currently partaking in, makes me think that real assets are crucial and while some stocks are OK inflation hedges (most of my PF has such stocks), real estate can be just as good and perhaps better. 

I have run the numbers and assuming a future sale in 13 years' time (i.e. 10 years after moving in), the IRR on the project - assuming no appreciation over inflation and no leverage is between 5.5 and 9.5%, depending most of all on the initial discount which is larger for larger apartments. Were I to take a significant mortgage (say 60% LTV) this figure would naturally be far higher (about double once you account for the interest expense). I do not anticipate getting such returns from the equity markets in the next decade or so, and this would be a substantial base sum compounding (~120 JAFIs), and perhaps more importantly, compounding outside the more volatile equity markets.

In terms of wants versus needs - I am not sure this is relevant because the ongoing costs of the additional square footage I can purchase (were I to buy a larger apartment) are negligible compared to their current and future value, especially considering the much larger discount to fair value for larger apartments. A larger apartment might potentially force me to take a mortgage, but I have no problem paying such a mortgage off from future incoming cashflows. I may, however, choose to purchase a smaller apartment that I can easily rent out and continue to rent myself - this would be especially relevant in the first few years while the neighborhood is being built and is less pleasant to live in.

Thanks!

Peanut
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Re: Buying too much real estate? A unique dilemma

Post by Peanut »

I can’t really judge your assessment without knowing where it is you’re talking about. On the face of it, it sounds too good to be true. My biased opinion is that people want established neighborhoods, not new ones. A lot of people do want new homes, but yours would no longer be that in ten years’ time. I imagine buying a place that isn’t built yet carries its own risks. I don’t consider real estate that one buys to live in an investment but rather a liability, or at best, a place you like to come home to that is cheaper than the equivalent rental.

ertyu
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Re: Buying too much real estate? A unique dilemma

Post by ertyu »

Real estate is really dependent on location, so Im not sure how much help we can be without more info. Let's assume you are right, this investment really does have the specified rate of return and the neighborhood is indeed on its way up. Things to still consider:

- a common shady practice: get people to contribute the initial amount by making it look like an incredibly good deal. Then, in the middle of the project, go, oops, ran out of money, you guys need to contribute more. people are already invested so they cough up the money.

- the builder takes the cash and is nowhere to be seen. or: something happens to the builder and the project is embroiled in legal drama. regardless, the end result is the same: the project is just abandoned in the middle and you've just sunk your cash.

The tl;dr: here is that there are many and varied ways to scam people when buying new construction, so you should make sure to research everything if you decide to pursue this.

rube
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Re: Buying too much real estate? A unique dilemma

Post by rube »

I like real estate, but real estate is local and it sounds like you would be betting on one horse. What is the outcome of your IRR and your overall financial situation it turns out the market does not develop as expected but goes sour?

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Alphaville
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Re: Buying too much real estate? A unique dilemma

Post by Alphaville »

Andy Dufresne wrote:
Fri Jul 17, 2020 7:41 pm
A larger apartment might potentially force me to take a mortgage

i don’t know the laws where you live, but i don’t think you can get a mortgage on an unfinished unoccupied construction project. a mortgage requires an existing property as collateral.

to build a place you’d want a construction loan, except you’re not the builder... so here you’re lending the money to the builder, not buying an existing home.

you’re lending the money to the builder, and they’re promising to pay you back with a finished home.

so you’re not in the home buying business—you’re in the commercial money lending business.

even if you can afford the thing, you should go to the bank and ask if they’d be willing to lend you money for this project and hear what they have to say. just as a data gathering exercise.banks are pretty good at assessing risk.

thanks @ertyu for pointing out the risks, which got me thinking along these lines.

rube
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Re: Buying too much real estate? A unique dilemma

Post by rube »

A construction loan is in my location possible as a mortgage, but with some special conditions (loan is taken in phases and paid out to the constructor after finishing i.e ground floor, 2nd level, roof etc.). Might be the same where the OP lives.

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Seppia
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Re: Buying too much real estate? A unique dilemma

Post by Seppia »

Unless you’re talking about Singapore’s housing projects that are backed by the state, or something similar in nature, I’d also suggest caution.

If you’re 100% sure, I would go for a mid size two bedroom, as they are the most common style of apartment for families in large urban areas and are usually liquid.

Andy Dufresne
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Re: Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

@everyone - thanks for the response and cautionary advice. I'll try to provide as much detail as I can while maintaining some anonymity ...

@Seppia - you are closest to the mark :)

@peanut this opportunity comes from a government backed housing plan and the reduced cost is because the contractor got the land for cheap, so I am not too concerned. While such projects have had their problems, overall the program has worked quite well. This is, I know, far removed from the reality in the US, so while being skeptical and incredulous is completely understood (and I should have made things a bit clearer from the start), there is nothing "shady" about this ...

@ertyu The contractor is reputable and under local law, any money I pay for the apartment while its being constructed would be paid directly to the bank financing the project (NOT the contractor, although the contract will state explicitly that any payments made to the financing bank are deemed as paid to the contractor on account of the apartment)). Furthermore, I will receive a state-backed bank guarantee for these funds from the financing bank, so I am also not too concerned that the contractor will run away with my money.

As for location and this being a new neighborhood - the location is excellent - basically think of a plot of land belonging to the government smack in the center of everything important that up till now has been filled with trees and now the government has repurposed it for housing. I agree that in general people prefer established neighborhoods; in my experience, where I live the "new" phase lasts about 5-7 years when the massive building projects take place, and in any case I intend to live there for at least a decade (if not more), so by then it should be well established.

Some further pluses: first, the school system in this small municipality is top rated and the new neighborhood will have K through 12 schools (this is a huge plus where I live - not having to bus/drive your kid); second, since the land currently has trees, the landscaping for parks will be very easy. Third, the neighborhood sits close on the main highway and in a decade both the light rail and underground will be within 200 yards of the building and enable one to get to the central office district / entertainment / beach (if CV doesn't kill off any of these concepts) within 25 min or so.

@Alphaville - in my locale, you can get a mortgage for an unbuilt apartment with no issue, but your rates will be slightly higher as the bank will still price in additional risks like non-completion/delays etc. The differences are not huge and you can easily refinance once the apartment is built. No need to get a construction loan here ...

@Seppia - a two bedroom is indeed the most popular and liquid here as well, but closely followed by a three bedroom as a large percentage of people have larger families / like their space. Given the fact that both DW and I work from home, I would tend to go for a 3 bedroom, with one room serving as our home office.

@rube Thanks for the pressing on the issue of downside. Since I intend to live in the apartment and will be under no pressure to sell, some of the downside is covered, as I currently pay rent. However, I agree that in a scenario where I end up renting it out the risk is higher. Some of this is mitigated by the fact that the location is good and there is a University with 30,000 students across the road, so I shouldn't lack for renters, even if I need to accept a lower ongoing return. In terms of the neighborhood not developing well, this is a risk I cannot control for easily but in my calculations I have been careful not to assume any real price appreciation at the lower end, and I still get a 5.5 to 6.5% return (unlevered) in this situation. Leverage can be seen as additional risk or a way to diversify - I am nor clear on which way applies for me. Finally, the general location is one that has always suffered from undersupply and overdemand so the chances for a complete "Screw-up" are quite low in my estimation.

ertyu
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Re: Buying too much real estate? A unique dilemma

Post by ertyu »

looks like you've covered most bases and that you'd like to go for it. so go for it :). i agree that the way macro seems to be aligning, a portfolio would benefit from a RE component.

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Alphaville
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Re: Buying too much real estate? A unique dilemma

Post by Alphaville »

ah with all clarified sounds like a golden opportunity and you seem to have the right legal framework for prepayment.

however, one last consideration perhaps: to avoid tying up the cash, and to hedge risk, maybe a mortgage is worth considering anyway? especially if there’s no penalty for early payment (again not sure about your bank/jurisdiction) and with a focus on the phase before completion.

sure it would cost you a few points, but it’s a kind of insurance/stop loss.

eta: this regardless of size

Andy Dufresne
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Re: Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

@ ertyu I probably will, but it's great to have this forum for some honest feedback. I am not blinded by the opportunity, although it will likely be a 7 year wait from when I first got it until the apartment will be ready ... The Millionaire Next Door teaches you that most US millionaires have much less "house" / McMansion than they could afford, and make most of their money work for them in making more money ... but where I live, owning RE makes it, almost by default a very large part of your portfolio (at best) or just a dead-money liability as some see it.

@Alphaville I am most seriously considering a mortgage. The prepayment penalty exists here for some types of mortgages (we usually combine 2-4 "types" of mortgages in one mortgage, some fixed, some variable, etc.), but let me challenge your thinking on this. Assume I take a fixed mortgage which in NOT indexed (i.e. a nominal mortgage) for 15 years @ around 3.25-3.50%; while there is (potentially) a prepayment penalty I am happy to assume it because if we get even modest inflation, over a 15 year period this may significantly eat away at my mortgage, and if we get even 2-3 years of 10% inflation it would be great for me. Also, over the longer term I believe (based on my historical returns) I can at least match this return - e.g. YTD without having touched my 100% equity PF (I trimmed it back in late 2019 before CV but did not add to it), I am up ~6% versus an essentially flat S&P500. Finally, my incoming cashflows can easily support the mortgage, even if I am still renting (it will just lower my savings rate by the interest component). The only issue I have to be careful with is the rate - despite the fact that the central bank rate here went down to almost zero, banks increased their mortgage prices .... let's hope I can still get one in time (econ situation here getting worse).

Riggerjack
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Re: Buying too much real estate? A unique dilemma

Post by Riggerjack »

I'm not a city guy, let alone a city guy with expertise in cities abroad. So maybe this post is me just displaying my ignorance. But:

1). The ways that condo sales can go wrong prebuild are many and varied.

And 2). Your investment assumptions don't seem to take C19, and especially the economic fallout from C19 into account.

It very well could be that a construction project to expand housing in a growing city, with government backing works as advertised.

But will your city continue to grow/prosper under the new normal, whatever that becomes? Are you vulnerable to reduced international trade? To dropping real estate values, if office space gets converted to condos? How much demand will a commuting distance condo have, if people are working from home?

How will C19 and the economic fallout affect the budget of your country? How good will those guarantees be, if existing trends reverse? If budget shortfall meets housing surplus, during construction?

I'm not trying to discourage you. I am just seeing projections similar to what I would have expected last year, with no update for recent events.

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Alphaville
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Re: Buying too much real estate? A unique dilemma

Post by Alphaville »

Riggerjack wrote:
Sat Jul 18, 2020 10:42 am
I am just seeing projections similar to what I would have expected last year, with no update for recent events.
i don’t know his situation either, but city or not you make great points.

just wanted to clarify here what i meant mortgage as a stop loss: in case of some great catastrophe he could let the bank(s) foreclose, and lose the down payment plus whatever he put in—but not the whole sum. a sort of insurance on the unfinished project (for which the bank would charge intesest of course).

some people might not be willing to risk even the down payment, but that’s up to each person. it’s just better than risking all.

Andy Dufresne
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Re: Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

@Riggerjack I agree that many things can go wrong, but this isn't a condo sale - this is a project with five 30-story residential buildings. Everything about the project is/will be scrutinized and approved by the relevant government ministry (this intrusive concept of govt is easier to understand if experienced directly, e.g. if you have lived in Singapore / Europe), so it's actually the lowest risk (except for existing buildings of course). This specific contractor (company) has been around for decades and has built numerous buildings in this govt project where people already live, so it's not as "pie-in-the-sky" as it sounds.

As for CV19 - you are absolutely spot on that I have to think deeply about it and update my assumptions (although its hard to do so with so much uncertainty). Our economy, like all economies, has taken a hit and I think recovery will take 2-3 years after they find a vaccine (which I don't think is happening before 2021, likely in the second half), however, I do intend to live in the apartment, so resale price does not bother me in the short term. In the LT, the country will do OK (its an OECD member with a strong high-tech industry - this alone should narrow down where I live LOL). If anything, people will require housing even more if they work from home rather than the office.

Will prices go down? It's possible, but I don't think even under an extreme scenario they'll go down more than 20%, and the discount I can get is, on average, double that figure, so it means I will earn a lower return but it will still be positive. Finally, there is a very large supply/demand imbalance that has caused prices here to more than double in a little over a decade, and the underlying demographic dynamics won't, IMHO, change because of CV19 .

@Alphaville One big difference is that in my country there is no such thing as a non-recourse mortgage, so in this sense there is no hedging the risk directly. If the value of the apartment goes down, I'll still be on the hook for every penny of the mortgage. One thing that mitigates the risk is that there is a fixed, govt approved payment schedule, so it's more or less pay as the building advances over time (this will take 2-3 years), with the final 10% being paid when you get the keys to the apartment.

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Alphaville
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Re: Buying too much real estate? A unique dilemma

Post by Alphaville »

ok no doxing....seems legit lol

but yeah why not. only thing i can see getting on the way of this would be total societal collapse and in that case your keys would still be your keys no? so might as well have them.

the other issue is the ability to borrow money at rates below inflation. since you HAVE the money and the loan is optional, then why not.

see article + comments here: https://jlcollinsnh.com/2013/05/29/why- ... nvestment/

(first comment by brett doyle. might need to be “transposed” to your situation but appears similar? please note article date though)

Andy Dufresne
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Re: Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

@Alphaville - I will read it carefully, thanks!

Andy Dufresne
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Re: Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

Just updating this thread and again thanking everyone again for their advice & perspective :)

1. DW and I ended up buying an apartment in the project. The best apartment available when we chose was larger than our current needs, but it is one of the very few apartments that ticked all the boxes - facing in the "desired" direction, with a lobby-level storage unit (i.e. not one in the parking floors) and two great separate parking spots (which is super rare for some strange reason).

2. We decided not to take a mortgage. While I originally thought I would require a mortgage (for a larger apartment), and had taken steps to secure one; however, we received a large sum that, together with us scrapping and saving for the next 30 months (by that time we should be getting the apartment) we ought to be able to pay it off without taking a mortgage.

While this means we need to put most of our savings into 4 walls, it does give us peace of mind. We are well aware its highly irrational but the value of the peace of mind exceeds the dollar cost (for us). Also, since this is a larger apartment, we will basically be getting it for ~50-55% of the market price, so we should still do OK return-wise, esp. if we end up selling once the neighborhood is set up in 10 years' time (should be in the 7.5-12% annual nominal return range). Another option may very well be to rent it out (we won't be able to sell it until 2025) and continue to live where we currently reside (where prices are roughly more than double per sqft) and then sell it ... this is too far into the future to contemplate.

ertyu
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Re: Buying too much real estate? A unique dilemma

Post by ertyu »

Congrats on your new place!

Andy Dufresne
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Re: Buying too much real estate? A unique dilemma

Post by Andy Dufresne »

ertyu wrote:
Mon Mar 08, 2021 6:44 am
Congrats on your new place!
Thanks! Will only be getting it in late 2023, but still happy :)

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