Ground up development is a high-risk and high-reward form of rental real estate investing. The process of ground up development involves taking raw land and building a completely new structure on it. While it may sound like a simple concept, the process is one of the most resource intensive types of real estate investing endeavors. Below we take a deep dive into everything you need to know about investing in ground up real estate developments.
What is Ground up Development?
Ground-up development, or ground-up construction, is the process of constructing a real estate property from the raw land, into a new income-producing piece of real estate. Ground up development real estate projects require raw land, which may require tearing down an existing structure, and capital to build the new structure.
How to Invest in Ground up Developments?
Investing in ground up developments is a high-risk and high-reward venture. Investors should be ready for their capital to be committed to the project for long periods of time, since the permitting and entitling process itself can take time (several years for larger projects). Below we take a look at 2 of the most common ways to invest in ground up development rental real estate projects.
Find Experienced Developers Seeking Capital
Experienced developers are always seeking out investors for capital to fund their new projects. This investment approach can be a nice way to passively benefit from the potentially high-rewards that ground up developments can offer. Investing with developers, or giving someone else money for any matter, should always be done with careful due diligence. Vetting out the developer’s previous experience, local market knowledge, business plan, and financial projections should be carefully considered beforehand.
Develop a Property Yourself
If you have sufficient real estate experience in all aspects of real estate such as construction such as permitting & entitling, sourcing contractors and tradespeople, and financial budgeting, then this investing approach could potentially be a good fit. The development process first starts with significant pre-planning such as architecture, engineering, contractor selection, building material sourcing, and obtaining city approvals. Following the pre-planning stage, funding the project and managing the budget throughout the construction process into completion is another challenging feat. Below is a general timeline of the common steps to develop a successful rental property:
- Market and Economic Analysis – Also sometimes referred to as due diligence (DD), this is the thorough assessment of a particular area and parcel of land, to determine what can be built there and its economic viability as a profitable investment. This can include everything from environmental concerns, to market feasibility studies, budgeting, zoning, local government approval, contractors and tradespeople selection, etc.
- Land Acquisition – Once there is sufficient confidence in the due diligence for the project, developers can purchase the land (or atleast get in under contract). While it may sound easy, this step can sometimes come with many surprises such as unrealistic asking prices, uncooperative tenants in existing structures set to be torn down, and unexpected changes in seller negotiations.
- Financing – If the project isn’t raising any outside capital, then this step can be skipped(i.e. you already have sufficient funding). If the project requires raising investor capital, then a project’s financials and offering memorandum (OM) should be polished and ready to impress investors. The type of real estate financing obtained from a lender or bank will depend on how the land is intended to be used as well as the soft-details such as developer’s track record and projected financials. Investors typically look at a ratio called loan-to-cost (LTC) that compares the amount of financing for the project, to its cost.
- Construction – Once all of the prep work has been completed, the exciting part of construction can commence. Throughout the construction process, which can take months or even years depending on the size of the property, the developer should be very mindful of the budget. During the construction phase is where inevitable issues will arise such as building material shortages, labor issues, weather delays, among many others. Projects also almost always go over budget during this phase, however, a well planned contingency fund should help mitigate any harm before it causes material issues. Contingency funds are usually 5-10% percent of the total construction cost.
- Rent or Sell – Once the project is completed, developers will often either sell the new building, or keep it to lease to tenants. This decision is typically made in the beginning planning stages of the project, to help better plan for the post-construction phase as well as financial budgeting and tax planning. Selling can be a great way for investors to receive back their entire initial capital contributions, along with any profits. Renting can also be a great option, as investors can start receiving regular dividends while maintaining their initial equity investments.
Build New or Renovate Existing Properties?
When deciding whether to build a new ground up development or renovate an existing property, the decision should be determined based on the factors such as market needs, local property availability, investor’s risk appetite. If capital is limited, then choosing to renovate will typically always be the lower cost option. If investors seek larger-than-average returns for their investment, then a new building will likely be the better option. If the neighborhood is older with many historical landmarks or if the local government is very restrictive, then a renovation will likely be the better option.
Pros and Cons of Real Estate Development Investing
While there are several benefits to investing in ground up developments, there are also some potential drawbacks that investors should be aware of. We take a look at the pros and cons of both below.
Pros of Ground Up Development Investing
- Greater Return on Investment – While the risk is higher, so are the returns. Ground up developments that have been property planned and executed can offer some of the greatest returns of any real estate investment strategy due to the immense value creation of bringing an entirely new product to market.
- Build Based on Demand – Markets and trends change over the course of a building’s lifetime. When you build a new construction development, you can build it to whatever is most in demand at the time by both renters and potential buyers. Furthermore, desirable designs and favorable amenities can be included as part of the build process with minimized additional efforts.
- Energy Efficient – As the world continues to go green, the push for buildings to follow suit has been growing from all directions. Renters now seek energy efficient buildings to reduce utility bills, while municipalities have been increasing the compliance requirements for buildings to increase energy efficiencies.
Cons of Ground Up Development Investing
- Requires More Capital – When comparing ground up development to renovation, the latter choice will almost always be the lower-cost investment. The pre-planning stage by itself (e.g. permitting, environmental studies, engineering, etc.) can be costly for projects big and small. Couple that with the building material and labor costs to actually build the project, and the costs can easily be in the hundreds of thousands or even millions.
- Longer Build Time – As previously mentioned, ground up developments require extensive pre planning which often includes zoning approval, environmental studies, building permitting, and more. This process requires the careful review and approval of various governmental agencies, which unsurprisingly can take quite some time. It is not uncommon for larger developments to spend several years on just planning and obtaining local government approvals.
- Greater Risk – What if you build a tract of single family homes right before interest rates spike upwards? What about building a new office building right before the Covid-19 pandemic fueled the work from home boom? Ground up development requires a substantial amount of effort and capital from the developer, but things aren’t guaranteed to always go in your favor especially when unexpected macro events happen.
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