Are you aware of the potential in this space?
The following article is written by Andy Bates (pictured), junior partnerships coordinator at RCN Capital.
Real estate investing has become a time-honored industry known for its lucrative potential, but many are unaware of just how diverse it can be. Many investors have made their business by holding rental investments, flipping houses or executing the ever-popular BRRRR strategy. However, fewer investors try their hand at yet another real estate investing strategy, and one that has the potential to be just as lucrative: new construction for residential investments.
New construction residential investments have their appeal and path to success but there are several factors a savvy investor must be aware of when considering new construction investments.
Understanding the “why” for new construction
Before committing finances towards residential new construction, investors should understand the “why”. In general, new construction is pursued for the purpose of adding inventory. Newly available housing provides inventory for both the market area in which the property is built, but also for the housing market overall.
Arguably the most important distinction for a newly constructed investment is that it is not something that the investor themselves could live in. While new construction of a primary residence is a valid form of development, investment properties and primary residences are legally distinct in the mortgage world and drastically impact financing.
The structure of loans for investment properties and those for traditional mortgages are mutually exclusive. If an investor were to acquire private financing to build a residential investment, but then turned around and tried to live in or stay at the property it would constitute default on the loan, leaving the investor, and potentially the lender, in hot water.
The horizontal view
Alongside a discussion of whether or not to invest in newly constructed residentials is the question of “where to invest?”.
While large-scale developers may be able to finance the construction of several-hundred-unit apartment buildings, track developments, and entirely new neighborhoods where none stood before; A first-time investor, or one who deals in smaller investments, such as 1-4-unit properties will need to carefully consider the area in which they plan to build.
Some things to look for are what are known as “horizontals”. These are structural amenities local to the site of the planned build such as paved roads, power lines, and water lines. These prospects can look like an undeveloped lot in an existing suburban neighborhood, or what is known as an “In-fill” in more Urban settings. In-fill projects position a new build where there is already set infrastructure. Choosing to build on a parcel of land where horizontals are already in place can make it easier to establish plans and permits for the build. Local horizontals can also make it easier for the investor to acquire funding as well. Lenders are aware of the difficulties and up-front costs of developing horizontals in an area where there are none, and these developments can be seen as a detriment to the deal.
Often times it is easier to find areas with well-maintained horizontals in place in less rural areas. Lenders may favor financing deals in urban or suburban areas for this very reason while dismissing builds for more rural properties.
Plans and permits in place
Without plans and permits, a new construction deal is dead in the water. To investors, the notion of having to keep things, “up to code” is no new concept, especially those with experience renovating and flipping houses. For newly constructed residentials the same is true, but the parameters are much more strict. Plans and permits have to be in place before building can begin and often before funding can be secured. These documents are standard across US housing markets, such as zoning verification letters, zoning compliance reports, or entitlement letters, but the standard of compliance to which they are held will always be relative to the local municipality in which the project will be built.
Bureaucracy takes time, and acquiring these permits and approvals for new construction is no different. In order to keep to a desirable building schedule it will be imperative that investors keep on top of documentation and apply for permits and approved plans in a timely manner. Despite the best laid plans an investor who is working with a lender for financing may find they do not have plans and permits approved prior to closing. In cases like these, the investor may be able to seek verification on proposed plans from a third-party architect who works in the local municipality. Similarly, Investors may seek confirmation of proposed plans from a local council where ordinances allow. Being aware of these and other options available to the investor can be essential in securing funding for the build.
Many lenders will take investor experience into consideration for new-construction projects. An investor seeking capital for a new construction project may find that certain lenders will want to see that the investor has prior experience in construction, or at least rehab, real estate projects. This is where having an experienced builder or general contractor comes into play. General contractors can be reviewed for qualifications including up-to-date licensing, verified references, and project history to ensure that the project can be completed (on time and on par) up to code and compliance.
The only way out is through
It is a common practice in the private investment space that lenders fund construction projects on a reimbursement basis. This means that loan funds are only released to the investor once work has been completed and properly inspected. Under this structure, builds are planned out in phases during which a portion of the work is completed. Completed segments of work are then reported to the lender who sends an inspector to verify that building materials have been used for their intended purpose and that the build is truly at the reported point of progression. Once work is verified funds are released proportionate to the work completed up to that point. With a reimbursement structure in place it becomes clear why having plans, permits, experienced contractors and realistic building timelines are all necessary ingredients for a soup that smells of success with new construction investments.
While any investor would have plenty to consider in undertaking a construction investment project, an exit strategy is the salt that completes the soup to taste. Since an investment property secured through private financing cannot be used as a primary residence, it is important that the investor have a plan for the inventory they’ve created in the housing market. With no shortage of demand for homes on the market, selling the newly completed property can seem like a no-brainer. While direct sale is a straightforward path to success, it can also be beneficial for the investor to consider holding the property for its rental cashflow especially in markets reporting slow purchase activity.
New construction provides opportunities but they are not without risk
When considering residential property investments, to overlook what new construction would be to ignore a lucrative investment strategy, especially considering the unprecedented need for inventory in the space. But to take on a new construction project investors must be aware of the timelines, paperwork, and key players involved to ensure that venture is a success.
