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What does it mean when the Steam Downloads screen says Preallocating?

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Steam reserves (allocates) the space required for the download in order to optimize disk usage by trying to minimize disk/file fragmentation and of course it checks the available disk space before the actual download.

This helps increasing the game's performance (like already stated in the comment by Ross Ridge) and saves valuable time, because the download won't start when the allocation fails (e.g. not enough space on your disk) and the files are written to the disk faster, because it already "knows" where to put them. Allocating each file separately can cause some delay on slower disks especially with downloads of several 1000s of files (download - wait - download - wait, instead of download - download - download).

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In addition to @dly's answer, preallocation is necessary when downloading files, regardless of optimization or performance.

By preallocating files, the OS already knows how much space will be occupied. If any other application attempts to fill that space, the OS will report that there is not enough disk space available.

This is especially important, because you don't want to spend hours downloading a file, just to realize that you no longer have enough space for it, just because another app was also writing. It gets even worse if that other app is also lacking space, just because your download occupied too much.

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