The mindset of making a fast and handsome profit from residential development poses risks for both inexperienced investors and buyers.
There is hardly a need for a long presentation of the real estate market in Sofia and larger cities at this point. A highly vibrant market, with a record number of transactions, weekly rising prices, thousands of housing units under construction and a significant number of building permits issued. Against a backdrop of rising inflation, rising prices of building materials and primary commodities, zero or negative interest rates on deposits, low interest rates on mortgage loans, affordable lending, a large share of the old building stock, coupled with people’s desire for new and larger housing. The list goes on.
At the onset of the pandemic in 2020, some sector analysts predicted a contraction in demand and a very imminent collapse of the real estate market. A year and a half later, we observe the very opposite. According to the data announced by the National Statistical Institute, in the first half of 2021 construction of 402 new buildings or 4,795 new housing units with a total floor area of over 550,000 sq.m. has begun in Sofia. To these we should add the building permits for 498 new buildings or 8287 new housing units with a total floor area of 942 000 sq.m. issued for the same period in the capital.
Is it getting crowded in the investor community?
The high demand and rising prices of residential properties in Sofia provoke interest in construction as an investment opportunity for fast and large profits. Being lawyers, we more and more frequently advise prospective investors who have decided to start building, even without experience in this field. The calculation is roughly as follows: we build a housing unit with a total floor area of 4000 sq.m. at a cost of 800 euros/ sq.m. VAT excluded, we then sell it at 1200 euros/ sq.m. VAT excluded and gain 1 600 000 euros. The bank will finance the project, and now the properties are selling like hotcakes. It sounds like an easy and certain profit. Nevertheless, if investors do not want to repeat the 2008 situation with bankruptcies and unfinished projects, they need to include some important additional factors in the calculations.
What are some inexperienced investors overlooking in the equation?
Investors who will rely on loans to finance their projects should read the signals that the Bulgarian National Bank has recently given in relation to mortgage loans. The scheduled from 1 January 2022 increase in the capital buffer on these loans obliges commercial banks to set aside more reserves. The purpose is that they can cover losses in the event that the borrower cannot service the loan provided. It is expected that the measure will restrict the loans to some extent, as for investors this would mean that their potential buyers would have more difficult access to loan financing.
This is relevant to certain clauses in investment loans between the bank and the building developer. They include conditions under which, in order to finance the next stage of the building process, the bank requires a certain number of preliminary contracts to be concluded. In the event of a contraction in mortgage loans, investors may be under pressure to reach the agreed sales for each stage at the risk that the bank will refuse further project financing. Reducing the price to stimulate more and more prompt sales could change the investor’s intended financial model and force them to seek additional financing to complete the site. The investor must properly calculate these features at the beginning of the project, especially because the investment contracts with the banks usually include clauses for a minimum sales price per sq.m. because of which the price cannot be reduced arbitrarily.
Another thing that inexperienced investors underestimate is deductibles. As a standard, the bank will require a 30% deductible from the investor, with some lending institutions even higher. To this amount should be added the fees and interest on the loan, the costs of surveying the property, the design, the fees and costs of establishing the building right, the operating costs, the marketing budget, brokerage fees and other so-called soft costs.
The investor also bears the risk of continuously rising prices of primary commodities and materials needed in construction. Cost planning is becoming uncertain and contracted building companies are increasingly demanding the ability to make adjustments to building contracts due to the fact that the cost of materials can rise significantly during the course of the project.
On the radar of there should be another topic, which is becoming increasingly acute globally. Indications of energy shortages in major exporting economies such as China could develop into a slowdown in the production and supply of some key construction primary commodities and materials.
It should not be overlooked that the bank will require all contributions from sales to end customers to be credited to the investor’s account at the same bank. In the beginning they will not be available to the investor as they will serve to repay the loan. The general principle is that the bank would want to be satisfied in the first place. It is likely that if the investor is not one of the big established names, the bank lending to the end buyer will pay on a completed building with a certificate of occupancy issued. This is why it is important for the investor to have the amount for the deductible because they will need it during the course of building.
Proper pre-calculation of the described costs and risks and securing financing for them beyond the bank loan would ensure the successful completion of the project.
What are the risks for buyers?
A characteristic of such a dynamic real estate market in Sofia and larger cities is that rising prices encourage buyers to take bigger risks. In their desire not to be overtaken by another for a given property, they do not carry out the necessary research – does the investor have other completed projects to date, how is the project financed, are there mortgages established. Buyers usually accept the investor-approved contract without thinking about negotiating payment schemes with the main burden on completion.
By trusting an inexperienced investor, buyers share with them the risk of a miscalculated investment project, which may lead to the inability to complete the building. Buyers should not forget that the bank will always have its interest protected and in the event of the investor’s inability to repay the loan instalments, it will be in a privileged position vis-à-vis them.
The real estate market is currently very dynamic. The global economic processes affecting the sector are also. In such an environment, it is crucial for investors to plan and secure every step of the successful implementation of their projects. This means setting aside additional reserves and negotiating favourable terms covering the risks currently indicated. The investor needs to protect its interest well both in the investment loan contracts with the banks and in the clauses with the building companies and suppliers that will execute the project.
Good planning and prudent actions and assessments by all participants in this market could refute the parallels analysts are drawing today with the market overheating and the real estate bubble of 2008.
Author: Teodor Todorov (The article was originally published in the 24 Hours newspaper on October 11, 2021 under the title – Is the Property Market Overheating? 3 Important Researches for a Buyer to Do.)