Last Updated: February 2024
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 Real Estate Development Investing?
Real Estate Development Investing Definition
Investing in ground-up real estate developments entails purchasing undeveloped land and constructing new properties from the ground up, a strategy distinguished by its potential for high returns due to value creation from scratch. This investment approach requires significant capital for land acquisition, construction, and navigating regulatory hurdles. While it offers the opportunity for substantial profit, it also carries higher risks and demands a comprehensive understanding of market dynamics, construction processes, and long-term project management.
Ground Up Development Investing Strategy
The strategy behind ground-up development real estate investing involves identifying and acquiring undeveloped land in locations with high growth potential, where new construction can meet emerging market demands. It requires thorough market analysis to forecast future demand and trends, ensuring the development aligns with local needs. This approach often focuses on creating value by transforming raw land into profitable real estate through well-planned construction, considering factors like sustainability, community impact, and architectural design.
Important Development Terms
Entitlement – The legal process of obtaining necessary approvals and permissions from government authorities to develop a property for a specific use or project.
Due Diligence – The comprehensive investigation and analysis of a property, including its legal, financial, and physical aspects, to identify potential risks and ensure a well-informed decision beforehand.
Cost of New Construction Investing
The cost of ground-up construction can vary greatly depending on factors such as location, building materials, labor costs, project complexity, and the type of building being constructed. On average, ground-up construction costs in the United States can range from $100 to $500 per square foot or more. It is essential to obtain detailed cost estimates from contractors and consider additional expenses such as permitting, architectural design, and engineering fees when budgeting for a ground-up construction project.
How to Invest in Ground up Developments?
Investing in ground up developments is a high-risk and high-reward venture. Investors should possess a solid understanding of rental real estate finance and 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:
The Development Process
1. 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.
2. Land Acquisition
Once there is sufficient confidence in the due diligence for the project, developers can purchase the raw 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.
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.
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.
5. 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.
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Real Estate Development Investing Tools and Resources
When investing in a ground up real estate development, it is a good idea to utilize real estate data software tools to research and verify data. Various tools are available to review property records, calculate potential costs, and more.
Countless amounts of building materials go into making a new construction property come to existence. Understanding commonly used building materials in the development process can help familiarize what is normal and what is potentially a special addition.
If investing in a construction development, it is a good idea to familiarize yourself with the various topics surrounding construction and development. In addition to the physical construction, various professionals will work together such as architects, engineers, contractors, and regulatory authorities.
Real estate investor tools, such as real estate software and choosing the right building products, can greatly aid investors in new construction development investing with everything from pre-acquisition and post-construction tools.
Pros & Cons of Ground Up 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 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. Since newer building materials tend to be more efficient, newer buildings are typically benefit by being more efficient. 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 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 – Ground up developments require extensive pre planning which often includes zoning approval, environmental studies, building permitting, and more. This process requires careful review and approval of various governmental agencies, which 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.
Ground Up Real Estate Development Investing FAQ
How Does Development Investing Compare to Other Real Estate Investment Strategies?
Ground up development investing in real estate is a unique strategy with distinct characteristics compared to other investment methods. Understanding how it compares to various other real estate investment strategies can help investors choose the approach that best aligns with their goals, resources, and risk tolerance.
|Comparison with Development Investing
|Buy and Hold
|Typically involves lower risk and longer-term returns compared to ground-up development, which requires substantial initial investment and offers potentially higher returns.
|BRRRR (Buy, Rehab, Rent, Refinance, Repeat)
|BRRRR focuses on renovating existing properties for rental income and refinancing, while ground-up development involves building from scratch, usually with a higher initial capital and risk.
|House hacking is a low-barrier entry strategy involving living in part of the investment property, whereas ground-up development is a more capital-intensive and complex process.
|Fix and Flip
|Fix and flip involves shorter-term investment in renovating and reselling existing properties, contrasting with the longer development timeline and higher capital needs of ground-up projects.
|Wholesaling involves quick transactions without owning the property, whereas ground-up development requires long-term commitment and significant financial and management involvement.
|Investing in mortgage notes is a more passive form of investment focusing on debt rather than property, unlike the active and hands-on nature of ground-up development.
|Turnkey rentals offer immediate rental income with minimal involvement, contrasting with the intensive involvement and delayed returns in ground-up development.
|NNN (Triple Net Lease)
|NNN involves long-term, lower-maintenance leasing with tenants covering most expenses, offering more predictability compared to the variable and high-involvement nature of ground-up projects.
|Syndication allows for investing in large projects without direct involvement, unlike ground-up development which requires active participation and management, especially in solo ventures.
|Real Estate Stocks
|Real estate stocks provide a way to invest in real estate markets indirectly and with high liquidity, as opposed to the direct, tangible, and less liquid investment of ground-up development.
How Do I Assess the Financial Viability of a Ground-Up Development Project?
Assessing the financial viability of a ground-up development project involves a multi-faceted approach. Initially, investors conduct a detailed cost analysis that includes land acquisition, construction, legal fees, and marketing expenses, while projecting potential revenues from the sale or leasing of the property. Additionally, evaluating market trends and economic indicators helps in forecasting future demand and pricing, thereby estimating the potential return on investment (ROI) and determining if the project aligns with the investor’s financial goals and risk tolerance. This comprehensive financial assessment is crucial in deciding whether to proceed with a ground-up real estate development investment.
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