Is it better to build new investment properties or to buy and renovate existing homes?
This year, we’ve seen a number of real estate investors posing the question of whether it is now better to simply build their own rental homes versus buying and rehabbing those already out there. What factors should investors really be paying attention to in this equation? Which is the best move for you?
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The Buy or Build Dilemma
Many are asking if it is now just more profitable to build because properties in their areas are so expensive. They may have a point.
While it may be perfectly acceptable and normal to buy negative cash flow properties in other countries, there is no need for it in the United States — at least, not yet. However, many investors are finding that the numbers on available rental homes just don’t work. In some cases, this is because the investor hasn’t changed their demands as the market has changed. For others, it is because prices and demand have risen so much that properties can’t cash flow when using financing. Just wait until interest rates go up!
It is true that in some markets, some real estate agents and home sellers are pricing their properties to a point where it does appear cheaper to build. You can literally construct a brand new home for less than one that may be 10 or 20 years old. In the very long run, that may result in better cash flow. However, that isn’t the end of the math. So what else do investors need to consider?
The Problem With New Construction as an Investment
There are three challenges to the new construction strategy.
1. Build Time
In many markets, it can easily take 12 months to build a home. That’s if everything goes right and if the construction is well-timed around seasonal weather. When it comes to new condo buildings or more complicated structures, that construction time can be two years or more. There is no cash flow coming in during this period. None. That means no positive returns. That means all of the holding costs need to be covered by the investor, too.
Building can be highly risky. There are many additional risks and potential issues that can arise when building from the ground up compared to renovating an existing property. That liability can be extended out a year or two after completion if you end up selling that property to someone else. Let’s not forget that you’re speculating on what the rent could be. Anything can happen in a market during the time you’re building.
3. Lack of Leverage
New construction typically requires larger down payments. That means coming up with a lot of upfront cash. Cash for the land. Cash for the building materials and labor. Cash for the plans, permits, and holding costs. Now compare that with spreading your capital amongst three or four existing rentals with cash flow. There will be a substantial difference in wealth building potential and yields.
Rehabbing Existing Rental Properties
I love new properties. There are a lot of beautiful ones. I like historic homes, too — but I understand why some buyers like shiny new homes and condos. However, in the time it takes an investor to build a new home or duplex, another investor could have acquired a portfolio of 10 properties — properties that are already cash flowing and are delivering returns every month. The leveraged path means earning appreciation and building up equity in multiple properties at once, all while providing the safety of diversification. Think about it. If you plan to hold for 10 years but spend two building and finding a tenant, you’ve already lost 20 percent of your returns and cash flow compared to an existing property.
At some point, building new housing may be necessary, but there are still so many vacant homes. Last summer, the data showed that the ratio of empty homes to homeless people was 6 to 1. Some vast mansions that lie empty could house multiple families. But we’re still building new. That’s something to think about.
The bottom line is that new homes are nice. In some cases, they are needed. Property prices are high in some places. But investors don’t have to build when they can find deals that make sense in other areas. The less speculation you engage in, the better. For me, that means buying based on actual current rents and cash flow, not a roll of the dice — though perhaps I am just fortunate to be focused on the Midwest, where there are more great deals on existing homes.
What will you do? Have you had to face this challenge?
Let me know your thoughts with a comment!