Deep Dive into Development of Duplex/Townhouse (New Construction)
Introduction
My intentions here is not to do a quick look at the numbers but a deep dive into the entire experience of doing my first development. I did break this down into sections so that you can skip to area of interest if you don’t feel like reading the whole thing. Before I jump into the details though, I am going to explain, briefly, my background as it does lend to understanding some of the decisions I have made along the way. Even though a lot of them did not turn out as planned.
Both my wife and I are currently non-licensed architects that work a full time job, in the same office (I am in the middle of my 6 exams to become licensed….it’s a really long and painful process). We’ve both been practicing for almost 10 years now and have lots of experience in residential design, as well as adding commercial and medical to our portfolios in the last several years. We’ve worked in large companies (300+ employees) and small firms (10 employees). There are plenty of pro’s and cons to both sizes, but the one thing that was consistent between both, that we get frustrated with was that the clients would too often take too much control over a project and would not allow the architect to do what we were hired to do. (I know that sounds a bit confusion but since this post isn’t about architectural practice, I won’t go further into that now. Feel free to ask about it in the comments if you’re curious.) So we have decided that to further both our desire to get into real estate and expand our architectural careers, that we needed to start down the path of Architect & Developer (A&D). So, this development project was done in a way that would give us the most experience possible as an A&D. So some means and methods that I will describe below might seem a bit odd or different and that is because we took the A&D approach to this project, even if there might have been simpler ways, because we wanted to expose ourselves to as much as possible, in as controlled of an environment as possible, so that we could minimize risk while maximizing as broad an experience as possible. Basically, we combined the knowledge that would typically be gained over several projects into one project…our first solo project.
I won’t go into any further detail on my architecture career or future goals, as an A&D, because I want to keep this about this specific project. I am going to get very detailed in how I ran numbers and the processes that got us to where we are. So this will be a long post….sorry no TL:DR at the bottom either. I have broken this up into sections so you can easily skip to areas you might be more interested in. Do note that this project is still on going. So, all numbers and expenses are all pro-forma based and not actual finished numbers. I do plan on updating this as the project goes on and will give updated number at the end of the project.
Project Conception and Feasibility Study
This project started back in the fall/winter of 2018 when my wife and I were trying to find our first rental property to buy. I was browsing Zillow looking at potential houses and just happened to click on a house that sat on a large lot. Way out of our price range though…like WAY out of our price range, they were asking $460,000 (for perspective our primary residence, at that time, we had bought for $235,000 less than a year prior). I quickly looked through the pictures and my brain just got flooded with ideas. I then figured out exactly where it was located, looked up the zoning codes, did rough measurements of the site and realized that this had absolutely huge potential. The reason I knew this had huge potential was because I knew that the city was going to be updating the zoning and design codes in 2019. Even though this was public knowledge and the city held public forums and workshops on this, very few people knew anything about it even though it had been in the works for nearly two years. The only reason I knew about this was because I am an architect. But because I knew about this zoning update, I knew that this house had way more potential than what it currently had under the original zoning code.
I spent the next 3 months running theoretical pro-forma over and over again. A dozen different scenarios. Playing with numbers and ranges that would show the best possible scenario. I had to do this because my wife was NOT on board with this. We had lots of discussions about these numbers. I ended up with having to show her 5 different pro-formas that showed all the different ways that this project could go. From the absolutely worse case scenario to a dream numbers scenario. That is what it took for her to realize, and more importantly, be comfortable with the risk we were about to take on. By this time the house had reduced it asking price though. Its was now down to a “reasonable” $430,000. It had also gone under contract once but that fell through. By the time we were actually able to put in a winning offer, which was another 2 month later, this house had gone under contract three times and each time the buyer backed out. Now normally this is a huge red flag but we were able to find out that it just happened to be that all the offers fell through because they all had contingencies of their house selling. Since we were keeping our current residence, we were able to get our below asking price offer of $420,000 accepted. We ended up closing in May 2019.
Now, how did we get a house that was almost double the cost of our current residence to work? I will just explain the pro-forma that we ended up working with and not every potential option we looked at because I looked at a lot.
We knew right off the bat that buying this house as an investment properly was out of the question. The 20-25% DP that would have been needed was not obtainable. That and the CoC rarely worked out and when it did, it was not really appealing. So, we had to buy this house as primary residence that would allow us, not only, a 5% DP but also much better interest rates. Since that meant we were moving we had to decide to either sell our current house or turn it into a rental. With the low purchase price and low interest rate and, the location of the house meant that it was too good not to turn it into a rental. I won't go into the numbers for the rental, but we ended up renting that for $1900/m. This helped offset the $2500/m mortgage of the new house to a manageable amount. Still not an ideal mortgage for our primary but because of our project plan we were not going to have to deal with that for very long.
Project Planning and Execution
With getting the house under contract we were finally able to work on the design of the project. What made this house have so much potential was the amount of land that came with it, the location, and the up-zoning density that it was about to receive. This house is a 1926 farmhouse that had had all its farmland subdivided years ago and is now in the hear of a medium density residential neighborhood and is located directly across the street from the hospital. During the original subdivision, the owner had made the majority of the lots about 6000 sf (0.14ac) but he had kept his lot over 21,000 sf (0.49 ac) in size. So it is about 3.5x larger than the surrounding lots. It was a rectangular lot with the house at one end which gave it a huge backyard of over 12,000 sf. The backyard was a perfect for a size for a Duplex. Under the original zoning code all duplexes had a minimum lot size of 10,000 sf. This meant that I could easily do a short plat and create a new lot (more on the short plat process later). The new zoning code gave a major up-zoning that I new I could capitalize on and was what really made this project possible. The new zoning code reduced the minimum size of a duplex lot to 6,000 sf. What made this perfect was that the house has a detached two-car garage. The 10,000 sf lot would put the property line right down the middle of the driveway and between the house and the garage. So, the garage would actually be on the new lot. That doesn’t sound very perfect but when I measured out where the property line would be at 6,000 sf lot size….it ended up being just behind the garage. So, even including setback, the 6,000 sf lot would not encroach against the garage. The base zoning also made the minimum lot size, in this zone, 3,000 sf, which meant that I could actually do a Townhouse instead of a Duplex. With the Project Plan finalized the process of getting the ball rolling became a self-inflicted complicated mess that, in hindsight, ended up not being worth it at the end. Fortunately, most of it was out of my control and would have happened regardless of what I had planned.
My intent was to get the Townhouse/Duplex permit reviewed and the short plat approved under the original zoning code. The new code wasn’t supposed to go into effect until Dec 2019. So I thought that 6 months would have been plenty of time to get the plans permitted and the short plat finalized. So that I could start building in the late fall of 2019 and finish in the spring of 2020. The city gave me a 1-2 month review time on the plans and a 3 month review time on the short plat. I was able to get the building plans and the short plat plans in for review in a timely manner that would still allow me to ample time to at least get concrete in before the weather changed. The building plan review went smoothly but oh boy did the short plat review take forever. There is a reason that there are so many cliches and horror stories about dealing with city permit reviewers and boy does this fit the mold. I won’t go into all the details but it took until April 2020 to get the short plat approved and June of 2020 for it to get its final recording. Since this took so long to complete, my idea of submitting under the old code to save time, was completely useless. I could have submitted for it to be reviewed under the new zoning code, which would have allowed me to do a short plat for 6,000 sf instead of the 10,000 sf lot. So now I will have to pay for a BLA (Boundary Line Adjustment) as well as another short plat for the Townhouse. Because as it sits currently, I have a 10,000 sf lot with a Duplex on it (that is designed as a Townhouse but is not a Townhouse…yet). This also caused havoc with the bank appraisal for the construction loan, which I’ll explain later. The second short plat was originally planned for but both could’ve been avoided if we had just gone in under the new zoning code with the intent of a Townhouse from the beginning. But there was nothing I could do about the city taking for ever to review and of course….Covid-19, which just made everything take even longer. But I happy to finally be under construction. The slab-on-grade floor should be poured Friday, weather permitting. It’s a bit painful to imagine that the original timeline had a completion date of Oct 2020 and when Oct 2020 rolled around, I was just pouring foundations.
Picking a General Contractor
I can’t stress enough that you need to get as many bids as possible on your project. It will give you a more realistic expectation of both time and costs of a project. It will also tell you who is serious about work and who isn’t. I got 5 bids for my project and I’m glad I did. I wouldn’t do less than 3 unless it’s a very special circumstance. Of the 5, the build price ranged from $470,000 to $780,000. The construction time ranged from 6 months to 18-24 months. As you can see that is a $290,000 spread and an 18 month spread. With being an architect, I was at an advantage here because I knew how much the building should cost and how long it should take to build. I didn’t tell any of the bidders this as I wanted to see who was going to be the most honest up front. My intent wasn’t to try and find out who was lying or being greedy with their numbers but to find out who really wanted the job. When GC’s are not hungry for work, or are overworked, they will inflate their numbers and timelines to try and push away those that are not serious. They will also do this to see who is desperate to get their building built and at any cost. Two of the bidders gave me honest numbers for me to choose from. They also where in my own bid range. I ended up picking the person who had the shortest build time but a higher build price. I cant imagine trying to build during this covid debacles with a 12-15 month build schedule that the other guy gave.
Only time will tell if the GC I picked ended up being the right choice but right now I am happy with who I chose, mainly because he is technically a construction consultant and not a general contractor. Alongside the short build schedule of course. What makes consultant different than a GC are two main things. One, he has removed himself from paying any of the subs. This reduces his overhead, which lowers his fee, and also lets me have more control and knowledge of the budget. This does add extra time, commitment and attentiveness to me but since I am following an A&D path on this project this only added more experience to what I would be gaining. Well worth the added time I must spend on this project. I do take on the added responsibility of getting subs paid on time but I’m ok with that…some might not want that.
The second, is that he charges a flat fee instead of a percentage. This means that he does not charge an additional percentage if there are any change orders. So I can make changes in the middle of the project and I don’t have to worry about an extra up charge from the GC. I still have to pay any additional charges for material and labor but that also means I get to save more if I chose to remove something or do the labor myself.
Other than those two things he acts just like a normal GC. He hires all the subs. He does the coordination and scheduling. He orders materials. He has all the proper bonding, licensure and insurance.
Finances
If you have followed along you will have known that in order to build my Townhouse I had to do a short plat (subdivision). There is no issue here, relating to the mortgage, if you don’t plan to sell or get a construction loan but as soon as you want to do either there becomes an issue. This is because even though I now have two lots, the second lot is still under the mortgage for the first lot. This will mean one of two things. You either have to get a construction loan with the same lender that has the original mortgage, or you have to get that second lot of the first mortgage. In order to do this, you have to get a release of lien for the second lot which can be done by a Release of Lien waiver or can be done through a Refinance. Both will require a new appraisal be done. If you happen to go with the same lender some will still want a refi done and other wont. It just depends the lenders rules. An appraisal, at least for the new lot, will have to be done regardless though.
One blessing that came with the covid crisis was the drastic drop in interest rates. I was originally going to do just a Release of Lien Waver from my lender but with the me being able to shave an entire point off my mortgage, I just went ahead and did a full refi. Covid, of course, slowed this process down too but it was finalized which allowed me to get my second lot off the mortgage and be free and clear….sort of….a little more on that in a bit. The goal of this refi was not only the get the second lot free and clear but also to try an ensure that the house did not loose any value. This was a critical line item in my pro-forma. This ensured that I did not have any extra cash payments. With it being almost a year now since I bought the house this allowed be to have enough equity in the house to cover all the closing costs. So, at the end the appraisal came back with a value of $420,000, which is what I paid for it a year earlier but minus 6,000 sf of land, and I did not have to pay any closing costs. Well…I did pay for the appraisal. So small amount. This let me do two. One, get the short plat approved (not recorded but approved) which would allow my GC to start the utility hook ups. The second would be finish up the construction loan.
I did forget to mention that in order to get the short plat recorded I had to have utility connections stubbed into the property. I can’t get the construction loan sent to underwriting until the lot is recorded. And I couldn’t start the utility connection until the short plat was approved. So ya, even more moving parts.
Now that the second lot is “free and clear”, and the short plat is recorded, I was able to push forward with the construction loan. Mind you I had been working on the construction loan at the same time as the refi. So, there are a lot of different things going on at the same time here. A lot of juggling pieces that needed to land at certain times in order for others to fall into place at the correct time too. Of course, that all got blown to pieces with covid. The construction loan process was just as big a convoluted mess as everything else and did not go smoothly at all. I was originally told a 20% DP was all that was needed (and the reason I chose them) but then they back tracked on that and said a 25% DP was needed. Luckily, I had proof showing they said 20% and they approved me for a portfolio loan. Extra review time and extra points but I got my 20% DP.
Then the appraisal was a nightmare too. Numbers where under valued and comps where horrible choices. I wrote up a 5 page contest of the appraisal but long story short I decided not to contest as it would cost me at minimum 2 more weeks of time, which I did not have. So in order for the appraisal numbers to meet the bid numbers my GC took the difference out of his fee. I signed a separate contract with him for the difference. I will have to find some savings or come up with the difference at the end of the project but I will cross that bridge later. A couple things on the appraisal I learned where that when dealing with a residential loan, banks only look at the Build Cost Approach for valuing you build. They also give you the Income Approach and the Sales Comparison Approach. Both of these are used to validate the Build Cost Approach but the bank only uses the Build Coast Approach since it’s a residential loan.
This made absolutely no sense to me and I argued it to I was blue in the face but what it comes down to is the banks get to make their own lending rules. So it doesn’t matter how much I was right, if they don’t want to lend for a reason that makes no sense it’s a pointless fight and would just waste time. Now if I used a commercial loan then I could’ve used the other two approaches to validate my appraisal numbers. Another thing I learned is that even though Duplexes are commonly built they actually are rarely sold. This is a good and bad thing. The good thing is that it shows it’s a valued asset class that holds its value. The bad thing is that you rarely get to assess the true market value because they are rarely sold. This means that the appraiser has to relay on sales that can be 2 -5 years old, or more, and then use their own judgement to adjust the price for todays market. Their adjustments are based on opinion so they are very subjective at best. And with prices rising so fast across the country this means your value gets undercut. So, doing the short plat the way I did and doing a Duplex, instead of a Townhouse, lead to my value being undercut. Between my building be a Duplex and my market not having a lot of recent Duplex sales really undercut my lending value. Luckily this did not hurt me too much since I found a way around it. But going forward I wont be doing any Duplexes anymore. They will all be Townhouses just so I have less to worry about with the bank lending. The only good thing that came out of the appraisal was that my new lot valued at $110,000, which was $10,000 more than what I had projected.
The last major, but quickly resolved, issue was with the refi and my so called “free and clear” lot. So, what happens when you do a short plat is that the civil engineer will put the parent parcel legal description on the final plat sheet that is submitted to the city for recording. Then the city will assign each new parcel a new legal description. Usually they just add “Lot #” with the parent parcel’s legal description following it. Well when the Title Company, for the Refi, put together the documents and did their checks they missed something that was very, very important. This miss impacted both my construction loan and me refi. What happened was that when the lender put the docs together they did not get the correct legal description for the new lots. They put the original legal description. What this means is that the lender for the refi had lent $420,000 on a parcel that did not exist anymore. The lender had no collateral to back up their loan. How this was discovered was that a week before I was to close on my construction loan, their underwriting caught it. Now you would think that because the new lots had new legal description and that there would be no way to tie the new second lot to the refi. Especially since the refi does not have the new lots new legal description. Well that would be common sense but we go back to the same point I made about the appraisal, I can argue till I’m blue in the face and it be 100% correct but it doesn’t mean anything. Just like banks make their own lending rules, Title Company’s make their own rules on what their will guarantee. So if they don’t want even the very smallest bit of liability…they don’t have to budge. So after I spent a day trying to convince them that it was fine; I finally gave up and called my refi lender. Fast forward 5 days (including a weekend) and everything got corrected and ended up closing 3 day later on Oct 21, 2020. It’s funny how fast banks can decide to work to get something done when they realize they have a non-collateral loan of $420,000 just sitting out there.
Construction Phase
Now normally you don’t start construction until you have the construction loan in place. Since its 2020 and everything just took 10x longer than it should have, I did not have the luxury of having the loan in place when I had to start construction. As you could tell my construction loan didn’t close until Oct 21, 2020. I live on the east side of Washington State and up against the mountains. Winter comes fast here. I actually had to tell my GC to start the foundations at the beginning of September and hoping that the loan would close quickly enough that by the time concrete was poured I could pay for that with the loan. Little did I know that the construction loan would end up in just underwriting for 53 business day! What this forced me to do was push back the pouring of concrete until the first on Oct. At that point I could not wait any longer. With cold weather coming and the fall rainy season already here, I just could not wait. I did a quick look over of the budget numbers and figured out how much I needed to pay for all the concrete. I did not have enough cash on me to cover it all if I could not get the loan closed in time. We did however talk to both our parents and between the both of them we would have enough to cover the concrete pours if the loan did not close in time. Thankfully it did and we don’t have to borrow from our parents. Like I mentioned earlier, we are currently doing the final under slab work and will pour the slab in two days, as long as the weather holds.
I was able to do a pre-construction draw from the bank to help cover some immediate bills and to help partially replenish the up-front cash I have spent on this project so far. Most of which I will be able to recoup when I get to the first construction draw which is up at the first week of Dec. It is important to understand what up-front costs you can and cannot add to the construction loan. This will very by bank of course so you will have to ask specifically. For example, I had to pay for the short plat work, permits, utility connections and labor well in advance of any loan being approved. You will need to decide what items you want to try and put on the loan. Yes, it recoups your cash but at the same time it cuts into your cash flow. So be mindful about what you add. I added the utility connections and labor into the loan since that was an easy tie in for construction costs of the building. The bank wouldn’t argue those items. But if I tried to add the civil’s bills and the permit costs for the short plat, the bank would be less likely to accept those items being added.
Cost Breakdown and Numbers
Finally, I’ve got to the numbers that everyone likes to see. Do note that there are going to be three sets of numbers and costs that I am going to breakdown here. The development cost, the construction cost, and then the investment numbers. Instead of giving just the typical lumber sum of numbers for how the project is projected to run, I decided to break it down a bit further so that you can see where the money is spent and need and at what points in the project.
Development Costs - These are any costs that went towards that short plat process and site improvements.
Pre-Construction Costs – These are any costs that I ended up paying before the loan was approved but are directly associated with going vertical. So they can easily be applied to the construction loan.
Investment Numbers – These will be my projected numbers that will show the profitability of my project. Numbers have been adjusted from my pro-forma number to reflect actual project numbers so far but is still project end of project numbers.
* - Numbers with a single asterisk mean that I did not include these in the construction loan. I ate these costs as part of the up front cash that is needed in development.
** - I included the DP since it was technically an out of pocket cost but its an odd cost to try and calculate in properly since it is my main residence and not a part of the investment property. That and I will be getting it back when I sell the house. Wasn’t sure how best to include this but didn’t want to not include it either.
*** - I put in the Architecture Fee so everyone can see that this item needs to be taken into account. But there are two ways I, as the architect, can handle these fees. One, I can use this fee to pay myself for the work I did designing and drafting up the plans and handling in on-site issues. This is a very common method in A&D. This fee would be applied to the construction loan and would be able to draw this out and pay myself. The other method is to keep this money in the project and use it as equity. Since this is a residential loan, and not a commercial loan, I could not actually use my fee as equity towards the 20% down payment needed. So another way I decided to use it as “equity” was that I did not apply my fee to the loan and thus it kept the overall amount lower and increased my cash flow. Since I am not planning on selling this project at the end and will be keeping it as a rental property, the extra cash flow is something that is worth it and is a worth while return.
Development Costs
House Purchase Price - $420,000 w/ 5% DP = $21,000**
Civil Engineer = $6,000*
Short Plat Permit = $1,000*
Property Taxes = $1,700*
Contractor Down payment = $5,000
Site Clearing (Demo & tree removal) = $9,500
Refinance Cost = $1,000
Const. Loan Cost = $1,200
Architecture Fees = $20,000***
Building Permit = $10,000
Utility Connections = $9,000
Combined Total = $85,400
Actual Total = $44,400
Construction Costs
Pre-Loan Materials and Labor = $15,000
Construction Loan DP = $0 (Thanks to my free and clear lot valued at $110,000)
Investment Numbers
New Construction of a Duplex that is designed and built like a Townhouse. 1480 sf, 3 Bed/2.5 bath. Lot size of 6,000 sf with a future lot split that will bring it to 3,000 sf per side. Numbers below are for long term tenants. I am exploring 90 day leases for traveling professionals but have been too busy to really do a proper pro-forma for this model.
Out of Pock Cash Invested = $32,000 (This number is all the costs that I did not pay myself back in the loan, including the house DP)
Land Value = $110,000 (note is a value add, not an expense, since I got this land for “free”)
Construction Cost = $490,000
Market Value = $620,000 (Once I make this a Townhouse the value will jump to $700,000)
Rental Income (total) = $4,400/m or $52,800/y (I’m being conservative with this number)
Mortgage = $3,300/m or $39,600/y (Taxes and Insurance included)
Expenses = $150/m or $1800/y (Lawn Care/Snow Removal/Trash)
Utilities = $0 (Long term tenants pay all utilities)
Cap Ex = $100/m or $1200/y (this is about 2.25%) This will increase after year 5 to the typ. 5%
Vacancy = $85/m or $1020/y (2%) Yes, this really is a true vacancy rate in my area.
Maint. = $50/m or $600/y This will increase after year 5 to the typ. 5%
NOI = $44,480 or 84.2%
GRM = 11.3
Cap Rate = 7.2% (6.3% when a Townhouse)
CoC = 56.4% (21% if you count all cash spent, regardless if I got paid back by the loan)
ROI = 8.5%
ROI (if I sold as a Duplex) = $98,000 or 18.7%
ROI (if I sold as a Townhouse) = $178,000 or 34.1%
Of course, if you have questions on anything, investment numbers, design, architecture, etc. Feel free to ask. If I made any mistakes in my numbers please let me know to. Here are a couple pictures of the house and construction.
The 1926 farmhouse we bought.
This is the back yard. When its all done this entire yard will stay with the house.
The is the packing shed that had to come down. The building to the left is the detached garage. So the new Duplex lot is pretty much where the she currently sits. Can you see the 50' tall maple behind it...unfortunately that had to come down too. It was a really nice tree.
Demo & Site clearing
Tagging several people here that have PM'd me about this project and a couple fellow architects.
@Steve Vaughan
@Jay Hinrichs
@William Samuel Johnson
@Seth Holmen
@Jared W Smith
@Edgar Martinez
@Jim Adrian
@Colin L.