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Weekly UpdatesABSTRACT. Use of forward contracts for pre-selling uncompleted properties is becoming popular in many countries. However, there have been limited researches investigating the risks arising from asymmetric information specific to buying a presale property and the critical factors required for the development of an effective forward property market. Hong Kong is one of the largest forward property markets in the world and it has been getting mature after half-a-century long development. This paper therefore aims to study the asymmetric information problem found in the forward property markets in different areas and explores the set of factors that are critical to the development of a forward property market by referencing the development of the Hong Kong forward property market.
KEYWORDS: Asymmetric information; Forward property market; Presale properties
1. INTRODUCTION
For the past two decades, developers in big cities like Hong Kong, Singapore and Malaysia have been involved in building large housing estates to meet the growing demand for residential properties. The increasing popularity of self-contained condominium particularly in North America, Canada and the U.K. in recent years, with provisions of better management such as central managed garden, swimming pool and self-sustained recreational facilities, has created a competitive edge in the forward property markets. Since financing for these large-scale real estate projects is a major issue faced by developers in exchange for the significant profits they can generate, there has been an increasing use of forward contracts for presale of uncompleted properties at planning or construction stage by developers to release their financial burden and to enhance the value of their real estate assets (Leung and Hui, 2007; Lindholm et al., 2006). This kind of financing means is also commonly adopted in developing countries. For example, the pre-contract sale law is being used in Morocco which allows developers to get prepayments from buyers before completion of the construction works (AbanaReview, 2004). However, the finance for condominium construction in Moldova and other Eastern European countries is yet to explore (ECE, 2002).
For developers, pre-selling uncompleted properties can, on one hand, help secure the upfront capital for the construction; on the other hand, they can transfer the market risk of the project during the construction period through passing the equitable ownership of the presale properties to the buyers (Chau et al., 2003; Lai et al., 2004). For the buyers, although they have more choices in acquiring a property with the features that they desire in the forward property market, they have to bear the risks arising from the asymmetric information problem specific to a forward property market. Once a forward property contract is signed, the buyer becomes the principal of the uncompleted property and has to rely on the specialist knowledge of the agent, i.e. the developer, to finish the construction work. But this principal-agent relationship has an inherent asymmetric information problem that the agent knows more about the situation than the principal. Because of the lack of knowledge and technical expertise in the construction work, the principal cannot be sure whether his best interests are served by his agent of up-keeping the quality work after the agent has collected the money (Farrell, 2003). As Holstrom (1979) stated, the "actions taken by agents are not directly observable and therefore complete monitoring is not generally possible." It is not uncommon that when the presale buyers collected their properties upon completion, problems such as inaccurate size of the properties, mismatch of fittings and finishes were found. The problem of default in the middle of construction was also serious in some countries (Esha, 2003; Kalifa, 2005). Figure 1 shows the risks transferred from the developer to the buyer in a presale of an uncompleted property which include both the market risk and the capital financing risk during the construction period, and also the additional risks that the buyer have to bear which arise from the asymmetric information problem embedded in a forward property market.
[FIGURE 1 OMITTED]
Despite many failures of pre-selling uncompleted properties in different places, there have been limited researches studying the problems specific to forward property markets. As a purchase of a presale property, very often, takes a substantial amount of the life-time saving of the prospective buyer, the study on the asymmetric information problem embedded in presale property markets and the means to correct the imperfect information problem deserve serious attention. Hong Kong has been a pioneer in using forward contracts to pre-sell large-scale housing developments since the Fifties and hence many lessons can be learnt from it. By referencing the development of the forward property market in Hong Kong, the study identifies the set of factors that are critical for the development of a forward property market. The following section reviews the risks arising from asymmetric information problem in pre-selling uncompleted properties in different countries. Section three examines the development of the forward property market in Hong Kong and the measures taken to correct the imperfect information problem. Section four draws the set of factors that are critical for the development of a forward property market.
2. REVIEW OF FORWARD PROPERTY MARKETS
Many countries have their own presale systems of uncompleted properties. In the U.S., a presale (1) of off-plan uncompleted properties commonly represents a pre-construction sale programme carried out by a condominium (condo) developer who is required to sell a certain percentage of the flats before a lender will commit to financing construction of the project. The lending threshold on the number of flats pre-sold to the total number of flats could be as high as 40%. On the other hand, the buyer is able to secure an uncompleted property by placing a deposit, usually at 5%, and will either pay the remainder upon completion of the project, known as 5:95 system; or according to the development schedule, known as progress payment method (2). This kind of mixed practice is also applied in Canada and Australia, just the deposit required in Australia is 10%, and thus it is called 10:90 concept (Buang, 2006).
When the deposit is submitted, the developer usually ask the buyer to get pre-approval for a mortgage loan to secure the finance of the purchase. Many mortgage companies will not allow the buyer to close his purchase unless sales of 50% to as high as 70% of the flats of the project have been placed in order to insulate the lender from the risk that the project cannot be completed. But the downside is that a number of presale projects have been abandoned as a result of the developers not being able to secure the required presale threshold and so as the financing. Despite the rules, records showed that with the condo-boom in recent years, many lending companies were willing to take the risk by relaxing the presale threshold requirement in order to get a competitive edge in lending business in the forward property markets (Tribune, 2005).
Mixed practice of presales similar to that of Australia is also adopted in Greece and Dubai. Usually, 10% deposit is required and the remainder is paid either on completion or in multiple stages during the progress of the construction. If progress payment method is used, a discount on the purchase price is usually offered, and the completion of each stage must be certified in writing by the Architect before payments are made. The terms contained in the forward contracts include the timetable for the property's completion; stage payment dates; the completion date and penalties for non-completion; guarantees for building work; details of the builder's insurance policy (3); and a copy of the plans and drawings. The floor plan and technical specifications signed by both parties are also attached to the forward contract to ensure that the size and standard of construction are adhered to. The contract also requires to withhold at least 5% of the purchase price for six months upon completion as retention money in case the builder fails to correct any defects (Homesgofast, 2006).
In Mainland China, the presale system is used as a means to secure the upfront capital for financing the entire construction project, and thus it requires the buyers to pay 100% upfront far in advance of completion. As such, it poses a very high risk to the buyers. If presales of the project are not as good as expected and cannot meet the total financing cost, the project will very likely be defaulted and the buyers stand to lose all their money put into the presales. According to the record of Liaison Office of China, up to June 2004, there were 240 defaulted property sites left unresolved just within the Guangtung Province. Some of the housing estates were even repeatedly sold or mortgaged due to absence of proper regulation. The problem was so severed that in the Real Estate Financial Report 2004, the People's Bank of China questioned whether the current presale policy should be continued or replaced by a system in which developers may only sell completed projects (Kalifa, 2005).
The case in Malaysia is not much better under the "Sell-then-Build" Scheme in which progress payment method is adopted. It has been the objective of the Malaysian Government to promote real estate products as a popular investment instrument. However, 526 housing projects in West Malaysia were abandoned from 1966 to 2001. Just in 2004, the government was working hard to revive 97 abandoned housing schemes affecting more than 30,000 buyers (The Star, 2004). Besides defaults, the problems of "housing scam", late completion and building defects were so severe that there were strong calls for the reversal of the "Build-then-Sell" method. In June 2006, the government came to a decision to introduce the 10:90 system, in parallel with the progress payment method, which allows buyers to pay 10% first and the rest upon completion of the property with issue of the permanent certificate of fitness. It is believed that with the use of 10:90 system, buyers would be insulated from the fallout should the developer abandon the project. However, there had been heated debates on whether the new system would shrink the construction works so as the overall economy of the country (Property Times, 2006).
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