Pros & Cons: Investing in New Construction vs ExistingFeb 17, 2021
Today we're going to cover various pros and cons of investing in new construction properties and existing properties "post-construction". The reality is, this actually boils down into three categories...
First, we'll dive into already built properties. Second, pre-construction properties where you close on a construction loan before it even starts. Third, properties that are new construction, but you don't close until they're done.
These all have a variety of advantages and disadvantages.
Pros & Cons of Existing Properties
This is definitely the easier of the three for investors to wrap their heads around. You've probably spent the most time looking into the already built properties, right?
You know what you're getting from day one and they're very 1031 exchange friendly. For example, you can analyze a fourplex, a home, an apartment building... You can see that it's been in existence for 30 years, you can back into maintenance and repair projections, you can analyze the leases, utilities, and everything that's already in place. You can pretty much get to a known quantity here and know exactly what you're going to be buying.
That's a big advantage.
Another big advantage to buying existing multifamily is that you know what your interest rate is going to be. You could lock in that rate today. You don't have to wait and take your chances on what interest rates might be in the future.
When we have all of these things, we can drill down a pretty specific pro forma, and have a very good idea as to how a property is going to perform.
So an existing property is 1031 friendly, right? Let's say you've got $100,000 coming out of a 1031 exchange. The already built property is for sale at $120,000. That's a relatively clean exchange that most accommodators or intermediaries can handle.
- 1031-exchange friendly
- Easy to analyze (ie. easy repair projections)
- You know your interest rate and can lock it in today
- Pretty good idea on how it will perform on day one
New Construction Properties You Reserve and Then Close On
Let's move on to properties that you reserve, and then close on. A builder might come to you and say, "I've got this plat, you can reserve a property for a deposit of X amount of dollars, and you don't have to close until it's done." One thing you want to be careful of in that instance is whether you have a fixed reservation. If all you're really doing is reserving it, that builder can (and oftentimes does) come back and say, "Well... now the price is different".
There's a difference between a reservation form and an actual purchase contract. They don't necessarily have to follow through with a reservation form. So you could see pricing shift around and interest rates will be different. You're reserving it today, but it's not going to be done for seven or eight months. There's uncertainty and risk when you don't know exactly what that will look like when it's all the way done.
A benefit to making a reservation on new construction multifamily and closing later is that most of your capital is still in your hands. You might have a small reservation deposit down, but you don't have to give up your full downpayment or the rest of your capital until the property is done.
- Do you have a fixed reservation?
- Most of your capital is still in hand until close
Pros & Cons of New Construction with a Construction Loan
Finally, we can look at a pre-construction build-to-rent where you close on a construction loan and go through the build. In this case, you're going to put your money down at the outset and become the owner of the dirt. You have a construction loan and go all the way through the construction process.
Most investors in this case will have some kind of a refinance done at the end, where you can roll from your construction loan into a permanent loan. In the FIG world, that's typically a conventional 30-year fixed-rate loan. This has some advantages and some disadvantages as well.
One thing to be careful of before getting into a new construction investment: Make sure you know whether the contract that you signed/closed on before construction is a fixed bid contract or not. We're not necessarily saying that one is better than the other. But you'll want to know if your costs are going to change during the build process.
You'll need to accept the fact that your interest rate may be a little bit higher by the time the property is done. When we build a proforma here at the Fourplex Investment Group, we always bake that interest rate a little bit higher than what we know it to be at the current time because we want to allow for a little bit of variation there. This is important to avoid a giant unpleasant surprise in your interest rate when you refinance out of the construction loan into the full 30-year fixed loan.
Another aspect of new construction multifamily that can be tricky is the property taxes. If you want to go on an adventure, try calling a county tax assessor and getting them to tell you anything productive about what property taxes might be like on a fourplex or a single-family home in a year from now. They're really reluctant to give any meaningful info on that because they don't want to be liable. They don't want to be the one that you go back to and say, "well, Susie said it was gonna be X and now it's Y!"
You have to put in the work and review the comps. You have to go off of past experience to be able to proforma and dial in what the property tax amount may be.
A huge benefit to locking in a construction loan on new construction projects (especially in the 2021 market right now) is the growing material costs. At the time of this post, more often than not, material costs are higher when you go to refinance than when you originally went under contract. Meaning, if you sign a purchase agreement this month, and don't close on the loan for another 10 months, you won't be able to buy that same lumber package, those shingles, or those appliances for the same price as if you bought them at this moment.
Traditionally, this has held true in the history of real estate. Very rarely are refrigerators or lumber less money than in a year from now. Typically the up and down fluctuation is in the land.
Looking through each of the options above, ultimately one can conclude that pre-construction is a little tougher for a 1031 exchange. You're usually only getting the land value, and there are some ways to wiggle around that a little bit, but it's complicated.
- Owner of the dirt on day one
- Leverage construction loan into a permanent long-term loan
- Do you have a fixed-bid contract?
- Mapping out property taxes and interest can be difficult
- Potential savings on material/appliance costs
- Difficult to 1031-exchange
Whether you're looking to buy existing or pre-construction real estate investments, know that each has its distinct advantages and disadvantages.
If you're thinking about investing and want to dial in the pros and cons as they apply to you... or maybe you're thinking about one of our deals... Either way, we'd love to help you analyze things and talk through it all with you. Feel free to reach out or schedule a free consultation with anyone on our team at fig.us/consult