By Ridaa Murad, founder of BREAKFORM | RE.
There are several different types of real estate investment projects — from rehabilitation and value-add to ground-up — each with its own potential risks and financial returns. For example, a rehabilitation project has less risk because the structure already exists; therefore, the overall planning and workload are much less than a brand new construction project, but the potential financial payoff may be smaller.
An example of a rehabilitation project could be the addition of a parking structure to a commercial building or the addition of a second floor to a single-family home, requiring no groundbreaking and simply adding to an existing structure.
A ground-up project may have a much larger potential financial reward, but the risk is high — the planning and workload are extensive, since it’s a “from scratch” build on a piece of dirt. Commercial office buildings, retail strip malls and new single-family homes are prime examples of ground-up real estate.
Understanding The Potential Risk Of Ground-Up Real Estate
There are many components of a ground-up real estate project that are unpredictable, which greatly increases the risk factor. While every real estate build is different, there are some commonalities to consider in order to properly evaluate the investment potential of a ground-up project.
1. Project Location
The physical location of a ground-up project plays a significant role in determining the overall risk factor, as building new real estate in Los Angeles, which is a hotbed for real estate in both prices and demand, poses far less of a risk than a build in a less-populated rural area.
My company’s primary focus is on projects around the southern coast of California, which is a thriving market compared to other areas — and considered to be the hottest housing market. When you are in a market that creates buyers before a project is even completed, that risk is further mitigated.
Look at data that naturally leads to real estate demand, such as high employment levels, large-brand expansion in the area and the rate of adult population growth. While there is no perfect or foolproof formula, all of this data can be evaluated and analyzed to help gauge how much risk is involved.
2. Typical Weather Conditions During Time Of Construction
Weather is one of the most important factors to consider when planning and budgeting a ground-up construction project. Severe cold fronts, rain and snow are just some elements that can contribute to delays in work, racking up additional costs and inconveniences.
Every delay, whether a day or a week, impacts the time frame to complete the project, which equates to more costs incurred. Again, I’m going to reference the primary area that my company works in — Los Angeles — as it’s the most ideal location for ground-up construction in relation to weather.
Why? Well, the temperature is fairly pleasant year-round, allowing for comfortable working conditions, and it very rarely rains, if at all. When the Los Angeles area does receive rain, it causes commotion because it’s such a rare occurrence.
If the project is located in an area that experiences extreme seasonal changes, such as Chicago or Atlanta, for example, then you need to take into consideration when the project is scheduled to start and how long it’s anticipated to take to complete. Match this timeline up with the local weather and see if there are any potential concerns that you need to further evaluate.
3. The Possibility Of Increased Material Costs
When initially budgeting for a construction project, it’s important to fully understand that the cost estimates can — and more than likely will — increase. A ground-up build can take several months to more than a year, depending on the size of the project, leaving plenty of opportunity to experience price increases on building materials.
In 2017, the cost to build in Los Angeles jumped 5.07%, topping the national average, ahead of both New York and Chicago.
You would be foolish to not anticipate increased material-related costs over the course of a build, which is why a deal needs to have enough of a margin built in to absorb the increase without eliminating the bottom line entirely. A deal with an initial thin margin estimate can end up in the red at the end due to an increase in the cost of materials.
4. Subcontractor Management, Scheduling And Logistics
Anytime you are dealing with subcontractors — and virtually every single construction project utilizes multiple vendors — you need to account for delays. It’s going to happen, from getting tied up at a previous location and arriving to the site late or simply not showing up at all — I’ve seen it all.
It’s not a matter of if the project will experience subcontractor problems, because it will; it’s more of a question of whether or not they will be a rare occurrence or a major problem that causes a domino effect of delays.
Ground-up real estate projects have several moving pieces that all need to work together in order to stay on schedule. A scheduling mistake or a logistical disaster can not only cause delays but possibly result in a complete shutdown while everything is sorted out.
5. Cost (Time And Money) In The Event Of Change Orders
A ground-up project involves every aspect of the build, from foundation to final finishes, which provides plenty of opportunities to change plans or even directions, which can increase the time it takes to finish, as well as the overall cost.
It happens, and while minor pivots and changes are expected, major changes and multiple occurrences can put the project far behind schedule and over budget — two things an investor fears the most.
You really need to take the project manager into consideration when evaluating risk. Experience and a proven track record help avoid pitfalls that claim many projects. The same deal with two different companies — one highly experienced and the other fairly new — can have very different outcomes from an investment standpoint.