Is there a Rule of Thumb for spread on new construction?

Question

Good afternoon folks,

I'm thinking in building an empty lot I own in Ellijay, GA.  Do you guys have a ROT to determine your exit strategy for new constructions? I am considering a quick sale to capitalize a bit and then build an STR to hold but I am curious of what typically investors look for as minimum ROI goes.  If your overall building cost are around 400K....what would you consider an acceptable after construction appraised value to make you pull the trigger?

Also (and maybe a silly question) is it possible to have a "pre-construction  appraisal" done to increase my confidence on the process?

Thank you!

George Marshall · Answer

I want to brutally simple, based on your market research or gut feeling about market price of your planned new construction will be, 1/3 land/property acquisition, 1/3 construction cost all-in, 1/3 gross profit.  Works for me every time.

Michael Eskenasy · Answer

@Allende Hernandez

When people talk about rules of thumb for new construction, they’re usually trying to protect themselves from the same thing: the number of ways a build can go wrong between the day you start and the day you sell.

The classic shortcut many builders use is essentially a 70%–75% of finished value rule for total project cost.

In simple terms:

Total project cost (land + construction + financing + holding + selling)

should usually be ≤70–75% of expected retail value.

So if you think the finished product would realistically sell for $600k, most builders want to be all-in around $420k–$450k or less.

That spread exists because ground-up construction carries risks you don’t see in normal flips:

• cost overruns

• timeline delays

• appraisal surprises

• market movement during construction

• buyer financing risk at exit

If the margin is too thin, one small issue can erase the entire project profit.

On your second question: pre-construction appraisals do exist, but they’re usually called a “subject-to appraisal.”

The appraiser reviews:

• plans

• specs

• comparable new builds

• projected finished square footage

Lenders use these for construction loans all the time. Just keep in mind they’re still based on comps, so if there aren’t many similar new builds nearby, the value can be conservative.

Personally, when looking at builds like this, I usually ask a slightly different question first:

Instead of “what ROI should I expect?” I start with

“how much margin do I need to survive the mistakes that inevitably happen during construction?”

If that cushion isn’t there, the deal tends to feel good on paper but stressful in real life.

Curious — are most of the nearby comps in Ellijay primary homes or STR cabins? That can change the resale math quite a bit.

Juan Cristales · Answer

Exactly. I would almost "mimic" something that has sold quickly in the 1/4 mile radius, low DOM and figure it's sold $/sf and work back from there.

On the builder's scope of work, ensure there is detail to explain a turn-key product... meaning: driveways, sod, landscaping, punch-list, interior and exterior clean up.

Some contractor builders I've met offer a VERY competitive $/sf built but then when I dive into the scope, they are only including the actual structure... no driveways, no sod, no landscaping, no cleaning... there is a bunch of stuff still left pending... INCLUDING a FENCE. So I would totally spend the time figuring that out before committing.

Best of luck and keep us posted!

Jason Wray · Answer

Allende,

You have a loaded gun question which makes it tough to answer without having some data.  Any time you plan on building on a lot "Construction Ground Up" you typically need to know current appraised value of land important to factor equtiy in land which can be used towards down payment if using a construction mortgage loan.

The value of the land is also important is it free and clear have a note to run a proper CMA/ARV and figure out your margins.  You also have to analyze the market are you building a single family, 2-4 units, mixed use, commercial, etc.  Then run comps in the market based on lot size, property type, number of units, sqft bed/bath count etc.

If you put all of the numbers together and have a blue print or build specs you can run a report on the LTC/ARV.  Then figure out if you are going to take the hit on the capital gains or 1031 exchange the boot of funds into another property equal in nature.

It's a lot to take in so, if you ever want to talk REI feel free to reach out or send me an email.

Ryan Arth · Answer

Another note, if you are paying a fixed price to the builder, he has built a large enough buffer into that such that he will still profit after the usual surprises through the build.

What is the minimum return required to do a build? That is a personal question, based on your other investment options, their returns, and whether you want to get into this long term or not. Just because you own the lot does not require you to be the one to build on it, sometimes selling it to the next guy with a dream is more profitable than taking on the risk.

In my opinion, a leveraged spec should have a bare minimum return of 20% just on the build, and that's if you are going to rent it out after and plan to make a good return over time, so you are willing to accept more of your profit on the back end.

Allende Hernandez · Answer

Thank you very much @Michael Eskenasy. My understanding is that STR are blooming in the area and is actually the better deal, as per the Realtor I am speaking to.

Factoring the cost of the land, that I purchased about 4 years ago, plus my tax and HOA payments since then plus realtor fees etc...I am starting to believe that the deal is coming out thin. Going STR is an option I could entertain but I prefer to have at least a couple of exist strategies that work for these lands.

Allende Hernandez · Answer

@Jason Wray and @Juan Cristales

Thank you for responding. I own the land free and clear. I will speak to the lender probably today but the assumption is that its equity can be used as downpayment and closing costs (or a portion of it)

I am using a fixed-price builder that seems to be reputable in the area, so unless something big happens, the construction price should be somewhat predictable.

What I am looking for is a guideline to quickly assess the risk level of these type of projects.

(Land Cost + Holding Costs + Costruction Cost + Loan Cost)/Retail

Thanks!

Juan Cristales · Answer

What is the cost to acquire the land?

Is the Build Cost just the construction for a turnkey product?

My Rule of Thumb is easy: The actual build, has to be around 60% of Value or LESS and the land maybe another 10% on the high end. Otherwise, any small bumps in the process and you could have a break even or losing deal.

Is there a Rule of Thumb for spread on new construction?

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