Building Vs. Rehabbing: Which One Has The Upper Hand?

Is it now more profitable for real estate investors to be building units instead of rehabbing existing ones?

Many real estate investors are turning to the Internet to float their ideas of building houses instead of buying and rehabbing existing ones. So is this one of those genius moments where individuals are catching on, or are they missing out on some big issues and potential pitfalls?

To Build or To Rehab?

What would make some investors choose the prospect of building over rehabbing an existing property? Perhaps even more specifically, what is building new properties being contrasted with? Is it being compared with acquiring existing properties and renovating them to be used as rentals? Building new construction rentals has become popular with big name builders, but hedge funds prefer flipping houses, and financing rehabs. In some cases, it can certainly be cheaper to build on a vacant lot than to completely gut rehab some old homes. But that isn’t a rule that stays true across the board. There are many variables.

Before jumping into the construction game, it is also worth taking a look at all of the options on the table. You can wholesale worn out existing homes, and brand new construction if you really wanted to.

The Cost of Approach

When it appears that existing property prices exceed what it costs to build new ones, real estate investors get interested in construction. This is especially true when it appears that there is little existing inventory to pick from. Note that we do need more housing stock added to account for population growth and migration, but there are still mountains of distressed properties and loans in America to be taken advantage of. However, many real estate investors appear to be way off on their cost to build in terms of square footage. Remember that construction costs will keep on rising with the market and economy.

If you are seriously considering building, make sure that you are factoring in all costs, including: land acquisition, impact fees, inspections, utilities, etc. Note that the direct square foot cost to build is just a portion of the total costs. What about administrative, and sales costs? The NAHB (National Association of Home Builders) notes that the average builder profit in the U.S. in 2008 was in the negative digits.

Why Most Investors Don’t Build

Even where the spreads are great, and investors have an edge, many don’t build because of the cash requirements. While other types of mortgage lending have come bouncing back, construction loans virtually evaporated, and still need to be resurrected. In addition to land costs, there is the material, labor costs, marketing, commissions, and there are always overages. Don’t forget holding costs either. It often requires a substantial amount of cold hard cash to build houses. Others don’t have the patience for the extended timelines or unpredictability compared to existing homes. A good team can remodel a house in 30 days. It likely takes an average of 10 times that to build a home and get it sold, if not longer.

Don’t forget to think long-term. Will you still be able to compete when other builders are throwing up inferior homes and selling them cheap? What about competing for visibility, and on advertising costs? Remember, builders often have a lot of sweet heart deals with lenders, contractors, real estate firms, title companies, and so on. Plus, many have been holding lots for a long time, giving them a cost advantage even before pouring a foundation.

Building real estate can be very profitable. If it wasn’t, no one would do it. But do pay attention to whether the profit margins and timelines are really a match for your goals. Are they the best you can do? What about the match between your strengths and resources? If building, construction, architecture, and design is something you really love, and participating is more valuable to you than higher profit margins from flipping existing houses, do what you love. Just recognize the difference.

Hybrid Options

For those looking to find a way to enjoy the best of both worlds, there are construction REOs to be found at discounted prices. Those that are really trending towards new properties, but don’t want the time and hassle components, may find deals in buying from builders in bulk. There can be deals to be found by being the first in, or helping builders close out a development. What will you do?