Real estate development in Georgia has experienced significant growth, attracting many developers and investors. However, in our view, there is a critical need for the sector to better understand the financial risks involved in selling apartments before construction is complete. By engaging in early stage sales, developers are essentially entering into financial futures contracts that are inherently both risk-insurers and bearers. The good news is that these risks can be managed with the right approach.
Understanding Futures Contracts:
When developers pre-sell apartments, they essentially enter into futures contracts with buyers. These contracts oblige the developer to deliver a predetermined quantity to the market at a specified price at a future time. While such practices insure sales risks, provide developers with a predictable revenue stream, and facilitate project financing, it also exposes them to significant financial risks.
Risks related to pre-sale of apartments:
- Increase in construction costs: Pre-construction home sales fix the sale price at the start of the contract, while construction costs are subject to market fluctuations and can increase unexpectedly during the construction phase. If costs rise significantly, developers may face severe financial stress, which may even lead to bankruptcy. For example, in recent years, international macroeconomic events and the outflow of labor from the country have significantly increased the cost of construction materials and labor, which has hit builders who had sold most of their apartments at the beginning of the project. It should be noted here that there is an illusion of high margins in the sector. Actually it is not so. The point is that high prices generated by demand are always accompanied by land appreciation that fills the gap between prices and construction costs. It is very naive to think about high margins in a sector where there are more than 200 competing suppliers in one small market, while even 3-4 suppliers are enough to create a fierce competitive environment.
- The effect of the whip: the so-called The whiplash effect further exacerbates the need for proper financial risk management. This effect describes the observable phenomenon when a change in demand/prices for a final product has a greater impact on a change in demand/prices for raw materials. An increase in housing prices subsequently causes construction costs to increase by a greater percentage than the increase in housing prices. Consequently, in the face of rising demand, developers must keep unsold apartments available for sale at higher prices to compensate for rising construction costs.
The effects of the mat in this sector are particularly strong on land prices, and most often the developers make a mistake when they pay an illogically high price in the ground in the hope that they can provide profitability by rising prices.
Advantages of parallel sales and construction processes:
- Equity transfer of risk in the market: Implementing parallel sales and construction processes allows developers to effectively mitigate financial risks. By gradually selling buildings throughout the construction phase, developers can more or less adjust selling prices so that any changes in construction costs are reflected in revenues. This approach helps to transfer part of the financial risk to the market, which ensures a fair distribution of the potential financial burden.
- Flexibility and adaptability: Parallel sales and construction processes give developers more flexibility to respond to market changes. If construction costs increase, developers can change the design of the project or financial model and/or adapt marketing strategies based on market feedback during the construction phase, thus enhancing the prospect of a successful and profitable development.
- Higher prices: A timed sales process, other things being equal, means higher prices because the more units you sell in a shorter period of time, the lower the price. Depending on the scale of the project, developers can choose the optimal sales speed themselves. Correct price management is responsible for at least a third of project profits.
p.s.
The other side of the medallion:
Suppose there was not an increase in demand, but a decrease, and the developer had apartments left for sale? Is this also a risk?
Yes, there is a risk that reduced demand can reduce revenues, which is why a "build first and sell later" strategy is not recommended if the project duration is too long. That is why sales in parallel with construction is a relatively optimal version of risk management. Thus profitability becomes more stable, predictable and manageable.
However, reduced demand affects construction costs, as reduced demand for housing later leads to reduced construction supply, which reduces demand for construction materials and labor. And the whiplash effect leads to more significant cost reductions…
Thank you for your time,
Flatmarket wishes you good luck
