Recently, while speaking to an investor real estate summit, I was asked why I invest in new real estate developments. For those of you who know me, some reasons are obvious. I own a real estate development, construction and investment company so we make more money when we develop new projects, but the real reasons why I invest in new development projects are these:
Written By Ken Holman, NAREA Group
First, new development projects have the potential to earn a significantly higher return for the investors. New development projects appreciate in value faster than older properties. When you build a new project, you build it at cost. When you sell it after the project is stabilized, buyers are willing to pay a better cap rate for the property. Capitalization rates are somewhat counter-intuitive. The higher the cap rate, the lower the price. The lower the cap rate, the higher the price.
To give an example. We are developing a new 116-unit apartment project. The appraiser valued the property for the lender using a 6.5% cap rate. Lenders always take an ultraconservative approach. We valued the property using a 5.5% cap rate which is also conservative compared to the market.
For this property, the Net Operating Income in the fifth year will be $1,870,000. At a 5.5% cap rate, the value is $33,900,000. At that price, the return is over 23%. In reality, the cap rate for new apartments is 4.5%. That would reflect a value of $41,475,000, which pushes the return to over 30% per year over the holding period.
Second, new development projects attract buyers because they like purchasing projects that are state-of-the art. New development projects usually avoid the functional and economic obsolescence of older projects. The ceiling height reflects today’s demand. The amenities and project features reflect today’s latest innovations. Buyers like new projects.
Third, new development projects have a one-year warranty from the builder which means repair and maintenance costs are lower. Most states mandate that the construction company provide a one-year warranty on the entire build job. That means if any construction or maintenance problems arise, the construction company is liable to repair the problem free of charge.
Fourth, new development projects command higher rental rates. Whether it’s an apartment, an office building, a retail center or an industrial building, new buildings generally get higher rental rates than older properties.
Fifth, new development projects require less renovation to accommodate the tenant/s. If you have an older property, undoubtedly you will need to set aside money to cover tenant improvements and renovation of the property. New development projects require no renovation.
Most risk-averse investors view the development, construction and rent-up process too risky. They worry about municipal approvals or rising construction costs or how long it will take to stabilize the property. We view these as obstacles to overcome and focus our attention on how to develop the most attractive project for the least cost. We know that when complete, the project will command the highest rents and the best cap rates in the market. That’s why I like to invest in new development projects.