Introduction:
Investing in real estate is a superb way to develop long-term wealth. However, several investment opportunities are available, notably in commercial real estate. Find out the real deal between investing in existing assets vs. ground-up development.
Possessing real estate is a rewarding and promising financial idea. Unlike stock and bond investors, prospective real estate owners can utilize leverage to purchase a property by paying a percentage of the total cost and then repaying the remainder, plus interest, over time.
Though a traditional mortgage often demands a 20% to 25% down payment, in some situations, a 5% down payment is all that is required to purchase an entire house. This capacity to own the asset as soon as the documents are completed empowers real estate flippers and landlords, who may take out second mortgages on their residences to finance down payments on more properties. Here are five major strategies for real estate investors to profit.
Investing in real estate is an excellent way to develop long-term wealth. However, several investment opportunities are available, notably in commercial real estate. On the one hand, ground-up developers turn the vacant property into income-generating properties. On the other hand, some investors prefer to buy existing properties (e.g., a fully-leased apartment building). Both techniques have advantages and disadvantages. Therefore, we’ll use this post to compare ground-up creation vs. investing in existing assets.
We’ll go through the following subjects in particular:
- Development from the Ground Up
- Investing in Existing Real Estate
- Last Thoughts
Development from the Ground Up
As the name implies, ground-up developers focus on converting unimproved land into working real estate. In other words, these developers make new property improvements out of previously unproductive (or less productive) land. Depending on the terms of the transaction, ground-up developers may choose to either A) sell the newly built building or B) lease the newly built building to tenants.
Let us begin with an unimproved tract of land. A developer from the ground up may look at that land, make a plan for improving it into a series of townhouses, figure out how to fund the construction of those homes, obtain municipal permitting approval, and then oversee the construction of those townhomes. Following the completion of the development, this developer might rent the homes (build-for-rent), sell them to real estate investors, or sell them to individual homeowners.
Customizable.
Ground-up developers create initiatives that are tailored to their specific ambitions. A vacant property is, in many ways, a blank canvas, with a developer’s design plans constrained only by structural, zoning, and financial issues. This adaptability appeals to many real estate investors because it allows them to align their unique vision with the highest and greatest use of the land.
Higher potential returns.
These development projects carry a large degree of risk (as discussed below) but offer the biggest profits. A well-planned and performed ground-up development yields the best returns of any real estate investing strategy. It’s not uncommon for a developer to achieve annualized profits in the 15-to-25 percent range, depending on the contract (or higher).
Adaptable exit strategies.
Ground-up initiatives also provide a more flexible deal exit strategy, which appeals to many investors. Some developers choose a fee-only model, which has little to no equity in the transaction and charges a fee for development services. Alternatively, others choose a develop-to-sell approach, assuming full ownership risk until the property is completed. At this point, they advertise it for sale to another investor. Finally, some developers seek the develop-to-lease approach to generate rental income after construction.
Risks of sunk costs.
Developers must make large financial investments before breaking ground on any building project. Before gaining municipal clearance, developers must pay for feasibility studies, legal fees, zoning applications, and architectural designs, among other things. If that approval is not granted, which is very likely, developers will lose all of their initial costs.
Experience is required.
As previously noted, ground-up development efforts are fraught with danger. A great deal of experience is required to mitigate this risk and complete development. Commercial financing, municipal zoning, building, design, accounting, and legislation are just a few of the activities that developers must comprehend and supervise. While developers may not be geniuses in any of these domains, they must have enough knowledge to grasp how these professions fit into the larger picture.
Time constraints.
Larger developments may require several years to obtain zoning approval and finish construction. The properties do not generate money at this time. This means that ground-up developers (unless they charge an ongoing development fee) may spend several years on a project before producing any revenue, which can generate substantial cash flow concerns.
Investing in Existing Real Estate
This technique comprises purchasing an existing, stabilized property and then leasing it to tenants indefinitely. When developers construct something from the ground up (for example, an apartment complex), they must “stabilize” it before qualifying for long-term financing. Stabilizing a property entails receiving a certificate of occupancy and leasing it out over a particular level, which is often 95 percent for multifamily properties. The property is claimed to have been stabilized at that period.
When you invest in existing properties, you avoid the entire development, building, and lease-up process. Instead, you buy an income-generating property and focus on the day-to-day operations of that property or you might hire a management company to take care of the day-to-day operations on your behalf. Investing in existing properties is equivalent to purchasing an established firm rather than creating your own from the beginning.
There is less danger.
When you buy an existing asset, you face less business risk because the property already provides income. Furthermore, thoroughly examining an existing property’s previous operating results might enable investors to forecast future results reasonably.
Returns are available immediately.
About the above, owning an established home lets, you earn revenue immediately. When it comes to attracting investors, this trait is frequently appealing. Rather than waiting a couple of years, you can begin making cash distributions as soon as a deal is closed (typically after the first quarter).
Less experience is required.
As previously stated, ground-up developments necessitate a great deal of skill to complete successfully. While purchasing an existing home still necessitates strong underwriting abilities, this technique necessitates significantly less. Buying an existing property becomes more of a financial analytical problem than an all-encompassing development task, especially if you intend to engage third-party organizations to manage the property.
Disadvantages
You are paying a higher price. While purchasing an existing asset provides ease and reduced risk, investors will almost certainly have to pay a premium for those benefits. Depending on the geographic location and general market conditions, exit (i.e., sale) valuations are frequently much higher than prices obtained from appraiser-assigned cap rates. But, if you want the ease and lower risk that an operational property provides, you must pay for it.
Design freedom is limited.
Existing assets are finished paintings, whereas unoccupied parcels are blank canvases. When investors buy a stabilized property, they usually do so to keep the property operating as the developer planned. For example, if you buy a 100-unit apartment building, you are unlikely to convert those 100 flats into 20 huge offices.
Existing leases are assumed.
This final feature could be an advantage or con for investing in current assets. On the one hand, when you buy a stabilized property, the lease assumption implies that the property will continue to generate similar revenue as it did previously. On the other hand, these current lease arrangements may be too restrictive on the new owners, limiting their power to raise rents, shorten terms, and so on.
Last Thoughts
While we designed this essay to compare new development vs. existing assets, the two approaches are not mutually exclusive. Many investors explore both choices throughout time, depending on their skill level and the specific business. We can assist you with both.
Whether real estate investors apply their assets to produce rental income or to wait for the perfect selling moment, it is feasible to construct a solid investment program by investing only a tiny portion of the total value of the property upfront. Like any investment, real estate has profit and opportunity, whether the overall market is up or down.
We’d love to discuss other real estate investing opportunities for your specific scenario! Send us an email, and we’ll schedule a meeting to discuss available passive real estate investment options – both new construction and existing assets.
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Come join us! Email me at mark@dolphinpi.us to find out more about our next real estate investment.