Academic journal article Real Estate Economics

Sale before Completion of Development: Pricing and Strategy

Academic journal article Real Estate Economics

Sale before Completion of Development: Pricing and Strategy

Article excerpt

The paper examines the risk-and-return characteristics of a popular development strategy, the presale system (or sale before completion), used in many Asian cities. We model a presale decision in a real-options framework and suggest that the use of presale is primarily for a risk-sharing purpose. That is, developers can reduce bankruptcy and marketing risks by selling (or leasing) their projects before their completion dates. Our model also indicates that, because of the presale system, there is a barrier for new developers to enter into a market, which helps explain the anecdotal observation that most real estate markets in Asian cities are oligopolistic in nature and dominated by large developers.

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Developers have to start construction based on a projected future demand and take the risk that the demand might not be realized when the projects are completed. Developers will be in a difficult financial position (holding vacant buildings and construction loans that are waiting to be paid off) if demand has unexpectedly fallen at the time of completion. Limiting the costs of such an outcome is important to the viability of developers.

An examination of the practices of development communities around the world indicates that there are at least three methods to deal with the risk associated with demand uncertainty. First, developers may delay the property development until they are more confident about the future demand. The seminal work by Titman (1985) explicitly models the value of this "option to wait" in the project investment process. Somerville (2001) also concludes that builders will obtain building permits first, but will only exercise them after the demand conditions become clearer. Quigg (1993), Bulan, Mayer and Somerville (2002) and Schwartz and Torous (2003) all provide empirical evidence that supports the "option to wait" theory.

While the first method deals with the identification of the demand curve, the second method is a strategy that works with the demand curve. This method is popular when developers have a multiphase project. If the state of the market is unclear when the development starts, a risk-averse developer might reduce the price on the earlier units to ensure that there will be sufficient demand for the product. Developers can increase the price level of the remaining phases if future demand conditions warrant it.

The use of this method has some empirical support. For example, Sirmans, Turnbull and Dombrow (1997) document that developers would be willing to sell the units in the earlier phases of a subdivision at a lower price because of the uncertainty about the future characteristics of the neighborhood. They will sequentially increase the price of the units in the later phases of the subdivision as more (positive) information about the neighborhood is revealed. In other words, when developers are uncertain about the success of their projects, they are willing to trade profit in the earlier stage for more certainty.

The third method is to presell a project. The presale method is to sell (or to lease) a unit before the completion of the project. (1) The presale approach is very popular in many of the cities in Asia (especially in China, Hong Kong, Singapore and Taiwan), and is also used in developments in North America and Europe. Compared with the other two methods, the presale method not only helps developers deal with the uncertainty of future demand (and potential bankruptcy costs), but can also substantially reduce (or eliminate) developers' inventory costs. Since a developer can have all units sold or leased before the project is completed, this method is particularly useful for large development projects (such as a 50-floor, 500-unit condominium project).

While the presale method has been very popular in Asia, little attention has been paid to the risk-and-return characteristics of this strategy for both developers and buyers of the presale contract. …

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