A year ago, I wrote an article that focused on increasing construction material costs and availability and the direct impact this was having on new construction in the Cayman Islands real estate market. In that article, I quoted a chief economist at Moody’s Analytics who projected “by the fall or the end of the year prices will be coming back to earth.”[i]
Unfortunately, this has not been the case, and in part, the war in the Ukraine has added to these current challenges along with many price increases that we are seeing with the current inflation we are all dealing with.
The three critical challenges facing global supply chains are labour shortages, equipment availability and the ripple effect of global bottlenecks.
As prices for materials continue to increase, the cost of building continues to rise. The biggest challenge developers are now facing is how to manage cash flow with the constant change with material pricing.
I thought I’d take this opportunity to delve into this situation as well as how some developers are handling this as well as the direct impact this is undoubtedly having on consumers who have purchased these pre-development residences.
Escalation clause
In the simplest terms, an escalation clause is a clause in a new construction contract between the buyer and developer that enables the developer to increase the sale price of a property due to an increase in the costs of labour or materials due to inflation.
The developer’s challenge
Demand increased. Prices increased across the board and the price of lumber, as an example, also was increasing at a rate that the construction industry has never seen. Let’s say you enter a contract for a certain sale price, the developer begins work on the project, but in order to purchase the lumber, cabinets, and trim, they are now facing prices that are up from 30 to 50% more than they originally budgeted. Suddenly the developer is in an unfortunate situation.
Increase sales price
To continue to build, a developer can choose to increase the sale price accordingly, exercising the escalation clause in the contract. Depending on the original sales price this could be in the thousands, tens of thousands or in some cases hundreds of thousands of dollars.
An extra $5,000 on a $200,000 residence may see completely reasonable for many buyers, but there will be those potentially faced with an extra $20,000 or more, which could mean the difference between moving ahead and walking away.
Although many new development units in the Cayman Islands are bought as investment properties or second homes, there are a lot of people buying these new construction residences as their primary residence. They took advantage of pre-construction pricing, signed a contract and in many cases have already given the developer 10% of the purchase price as a down payment to secure the unit and could have made additional payments throughout construction.
Keep in mind that even before the pandemic, many developments were taking several years to be built. Now with the slowdown in the construction industry on a global basis, it is not uncommon for a development to be delayed a year or even more depending on its scope and size.
At the time a purchaser signed a contract for their new development residence, they would have most likely worked with a bank to determine how much they can afford to buy. It is also not uncommon for people to “stretch” when buying with the understanding that a real estate purchase such as new construction is a good investment.
A year or two ago, this buyer had a good idea of what they could afford, made the commitment, and based their decision on where the economy was at the moment and potentially the future to anticipate their monthly mortgage payments.
The domino effect
Of course, all of this has changed, and it is having a huge domino effect on buyers in new developments. Interest rates are climbing and continue to climb as the year progresses as the world’s banks try to bring inflation down.
Additionally, if this buyer is now burdened with an extra $20,000 on their original purchase price this has a huge effect with financing. Also, when the property is reassessed from a valuation standpoint the stamp duty increases. In short, the purchaser will need to bring more cash to the table to even close the deal.
Coupled with that, in rough terms, $20,000 adds approximately $100 a month to a 25-year mortgage when calculated at an interest rate of 3.5% which was not unheard of a year ago, but if you change that to 5% that extra $20,000 equates to almost $120 a month. The real issue here is that a 1.5% rate increase is on in the total amount of the purchase plus the additional cost of the $20,000. When all of this is factored in, does the purchaser even still qualify with the new sales price?
Investors
As escalation clauses become more prevalent with new development, investors will also be impacted by this potential increase in cost. An investor who is purchasing in a new development has undoubtedly looked at how much they will be able to charge to rent it out long term or as a vacation rental. With the final purchase pricing potentially increasing, this then has a knock-on effect from an ROI perspective.
Assignment of contract
In the case of an assignment of contract, the assignor’s existing contractual rights are transferred to the assignee, but the contract remains the same and the assignor remains a party to it so far as obligations are concerned.
Most developers want people who buy into their developments to feel that they are making a good investment and that their property will appreciate. They see an assignment of contract as a benefit. Developers often sell to repeat buyers who trust not only their build and quality but return on investment.
An assignment of contract also enables buyers to get out of a contract due to unforeseen circumstances such as a family medical emergency. In this scenario, an assignment of contract enables them to claw back their deposit and go and help their family.
Traditionally in Cayman, an assignment of contract will not unreasonably be withheld, and this has been commonplace but now I’ve started to see the odd developer moving away from this practice. If a developer decides not to allow an assignment of contract (in reasonable circumstances), they will face some challenges by being seen as inflexible and restrictive which will lead to less sales especially from investors both now and with their future developments.
The downside
The reality is that as of right now most developers in the Cayman Islands are honouring their original prices or exercising the escalation clauses legitimately, but some are now dragging out construction, letting the purchase contracts expire and then re-selling them at higher prices to the previous or new buyers.
Fortunately, this is not a common practice in the Cayman Islands, but it has happened in other parts of the world where developers’ pre-sold larger developments and can no longer afford to build them at the price they originally sold them at and are in some cases just walking away. In other parts of the world, many pre-construction contracts allow developers to cancel sales agreements, require more money and delay projects if there are “unavoidable” reasons, like a pandemic.
The future
Although a lot of this might sound quite dire at the moment, I believe that the market will correct itself with respect to this dilemma we are currently facing with new construction.
The housing market in the US and Canada is starting to slow down, prices in some places are levelling out and inventory is beginning to increase. As for the Cayman Islands real estate market, I will explore this, along with providing an overall analysis of the changes in the housing market, in my next article at the beginning of July when all of June’s numbers are in.
We are already seeing price changes in construction materials in the US. Lumber prices are falling in the US as housing starts fall. “Housing starts dropped 14.4% in May 2022 from the prior month in the US.”[ii] Many believe this is a direct correlation with increased mortgage rates. “The average 30-year fixed-rate mortgage climbed to 5.65% for the week ending June 10, the highest level since late 2008.”[iii] But, as I will explore in my next article, all of these stats need to be taken into context.
As new construction projects slow down, supply chain issues get back to normal and the prices for construction materials comes down, buyers who signed purchase agreements for projects that may not be build for another year or two may not be faced with increased sale prices.
The reality is we are still in a time of change with respect to the global economy which undoubtedly effects the housing market. The good news is that what makes the Cayman Islands so special and such a great place to live, vacation and own property hasn’t changed. The Cayman Islands have many attributes that people from all over the world are continuing to seek, including a lifestyle pretty much unparalleled elsewhere in the world, with first class amenities, education facilities and healthcare services all set against a backdrop of stunning beaches and almost year-round sunshine.
This compounded with Cayman’s financial services and the influx of qualified labour, family offices and private wealth who are relocating to our islands contribute to the overall stability and growth of our country…and of course, Caymankind.
If you have any questions about any of the subjects addressed in this article or have questions about a pre-construction contract you have entered into, please do not hesitate to contact me at +1 345 945 4000.
[i] Associated Press, June 10, 2021
[ii] Markets Insider, June 17, 2022
[iii] Markets Insider, June 17, 2022