More than the Developer’s Cost

The Edge, 24 July, 2006

The government’s recent move to introduce the build-and-sell concept in the housing sector should be commended, considering the numerous problems faced by customers in the present system, particularly with regard to abandoned projects and shoddy workmanship.

Recently, however, newspapers reported that the move means the prices of houses will rise by 30% to 100% in some areas. The Real Estate and Housing Developers’ Association of Malaysia (Rehda) was reported to attribute this to the fact that developers have to bear the construction cost and interest on bank loans that were previously borne by customers.

More than the Developers Cost

While it is fair to say the prices should rise because of the transfer of debt servicing from customer to developer, what surprises me is the range of increase. Computations show that even on the high side, the price increase should be much lower.

The rise in cost to the developer is due to the additional finance cost borne during the construction period. Interest is paid on the progressive payments made by the bank, which, in a typical case, are disbursed based on a 24-month construction period.

In current conditions, the first 10% is normally paid by the purchaser as down payment upon signing the sales and purchase agreement. The 90% is financed through a bank loan. The purchaser has to pay the interim interest on all the payments made by the bank until the house is completed.

In the build-and-sell concept, the developer takes the loan and pays the interim interest that was previously borne by the customer. This additional cost is inputed into the price of the house, thus pushing it up.

Consider the financing of a RM250,000 house at an annual percentage rate (APR) of 10%. If the RM250,000 were disbursed to the developer according to this schedule, the future value of the cash flow after 24 months, when the house is completed, is RM272,234.85. This should then be the new price for the house since the developer bears the financing cost. In percentage terms, this increase is 8.89%. Other costs, like legal expenses, should also be added, but are ignored here to show the increase was due to finance cost alone. The percentage increase does not depend on the original price of the house. In other words, instead of RM250,000, if it were a RM1-million loan, the increase is still 8.89%.

The increase, nevertheless, depends on three factors: the APR — the higher the rate, the higher the new price; the pattern of the cash disbursement to the developer — the earlier the disbursements, the higher the price; and the duration of the construction period — the longer the duration, the higher the price.

If the entire RM250,000 were given to the developer upfront, before the construction starts, the price rises about 22% for an APR of 10%. But then, this will not be prudent financial management. Funds should be taken only progressively, as and when needed as in present conditions.

Accordingly, if the pattern and duration are fixed, as in our example, the price increase for different APRs is a linear function, as the graph shows.

Even during times of high interest rates, with an APR of an about 12%, the price increase is only 10.8%. Nevertheless, at the current APR level of 7%, it should only be about 6.11%.

Price increases in the build-and-sell concept due to the higher cost of construction materials or the burden of unsold units are void for comparison purposes since these are encountered even in present conditions. Therefore, Rehda’s finding of price increases of 30% to 100% under the new concept could probably be attributed to other factors that affect real estate prices too, such as location, amenities and so on, and not solely due to the transfer of financing to the developer.

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