This demo was made Climax Solent before development really got going at Climax LA (before shifting to the UK). It is from before the game was announced, and really was meant to get a foundation going that would serve as a guideline for the rest of the game's development.
Well the thing to remember is that this was really a vertical slice to have something to show and to build off of. It predates the games announcement at e3 2006, so its about as early as something resembling gameplay can get (bar the earlier builds leading up to this ).
That said, Im sure Konami was thinking "If it worked for RE, it could work for us!" The idea isn't a terrible one, but I think the psychological aspects of Silent Hill make it far more difficult to pull off well.
This lol. In fact even in "alpha" and "beta" stages, a lot of games either look horrible or are barely/unplayable, sometimes both. It can be this way even in the final months of development, because of the very nature of game development (shit can change drastically at any moment, so fine-tuning and performance optimizations are usually the last things to happen.) Usually when you see a preview build or a trailer or public demo, it's pretty much a special build meant to be as presentable as possible for obvious reasons, which is why lots of trailers and commercials since the 80's at least were "bullshots" as they were called -- representations of gameplay which weren't 100% faithful and accurate.