It’s sort of a natural progression for real estate investors to move into home flipping, then into small development. Many real estate investors dream of one day being a big developer. Unfortunately, many investors chase that dream right over a cliff. It’s starting to feel a little like a cliff is ahead, and so I’m leaving the herd and changing directions.
I’ve changed with the market over the years, going from landlord, to builder, to flipper, then back to builder. Right now I don’t like what I see in the new construction market, and it seems like it’s a good time for a change.
Here are the major factors in my decision:
Long in the cycle and due for change:
Sure, the market is good right now, but we are long into this current cycle and statistically due for a change. I am really reluctant to agree to any projects that might take more than 24 months to complete.
Usually, a home can be built from the ground up in a year but it can easily take two or more years to complete. There are a lot of potential surprises in a new construction project. And new construction requires much more contact with the government bureaucracy, which is cumbersome, confusing and often aggravating.
Land costs are way up:
I constantly get calls for lots priced at, say, $675,000. The agent will tell me a new house on that lot will sell for $1.2 million to $1.3 million. I look and find the houses selling at that price are 4,000 square feet plus a finished basement and a two-car garage. Well, that house is going to cost at least $450,000 to build and that’s if the site doesn’t require infrastructure development. So that puts my acquisition and development costs at about $1.125 million.
Looking that those numbers, you might think I’m going to make at least $75,000, but you’d be wrong. I still have a lot of expenses to account for, such as closing costs on the purchase and the sale, which could easily be $15,000. I have to pay for marketing and sales, which are typically 3 to 4 percent of the sales price or $36,000 at the low end in this scenario.
Then I have to pay interest, which, if I borrow the entire development cost, is $60,000, and that’s if the project takes only a year. Now my total costs are $1,236,000. In this case, I’m looking at a best-case scenario profit of $64,000, which is about a 5.2 percent profit margin. Sixty-four thousand dollars might sound like a good profit, but a 5.4 percent profit margin is flirting with bankruptcy. Especially if that’s your best-case scenario.
Interest expense can kill you if the county delays your project or if you run into trouble with a contractor. Even if you borrow only 80 percent of the project costs, that interest will be more than $100,000 if the project takes two years to complete. If you’re not getting a return on the money you use as a down payment, then you’re risking your money for nothing and losing income. What’s even worse is that many of these investors are raising that down payment from private investors and paying high rates or sharing the profit on the deal, or both.
Also, there’s a very good chance you won’t get the absolute top dollar for your home. Increased project costs and a disappointing sales price can quickly start to squeeze an investor. At the end of a market cycle, sales prices typically start going down long before the cost side realizes it and adjusts. So contractors and material prices will still be high even though the investor knows the asset value is declining. That’s a sickening feeling.
Construction costs are way up and quality is way down:
Contractors are in high demand, and it shows in their pricing. I’m also finding a lot more problems with quality as the tradespeople bounce from project to project trying to juggle all the work they’ve taken on. Just this year, I’ve received two calls from people who bought my houses that ended up having pretty significant problems because of mistakes made by the state-licensed professional contractors I hired. I did my best to help resolve these problems and pressured the contractors to repair their work, but the damage is done. I don’t want to continue to base my business or reputation on the hope that the contractors I hire will do quality work, because it’s not happening.
I was talking to a home builder who has been licensed for only a couple of years and is feeling very confident these days. He started building speculative houses for a real estate investor I know, but he told me that there’s no sense in building houses for investors or even building spec houses himself. He’s focused on working with custom-build clients and says he’s making an average profit of $200,000 per house.
Now, with just a year or two of experience under his belt, he’s buying lots at around the price I mentioned above and he’s selling them to his custom home clients. This way, the client is responsible for all of the interest costs, for almost all the cost overruns, and for the risk of declining prices. If they end up building a house that costs $1.4 million but is worth only $1.2 million after it’s complete, then it’s the client’s problem, not the builder’s. It happens all the time.
A recent Harvard study reports that home remodeling is up more than 50 percent since the end of the Great Recession. In 2017, home remodeling topped $417 billion and made up about 2.2 percent of the U.S. economy. I’ve had several conversations with contractors who just giggled at some of the prices they’ve charged their retail clients. We’re talking about 300 to 400 percent profit margins.
Times are fat right now for the construction industry, and that scares me. I walked through a lot of half-built houses in 2009 and 2010 that were started in the last boom and left unfinished during the crash; many were filled with atrocious construction defects.
Dealing with the building departments is never fun. Rarely have I had positive experiences there, but it is even worse when the market gets hot. Just like the contractors, the county building department is busier than ever. That means things take longer and mistakes are more likely. Contractors may take responsibility for their mistakes, but the county never does. If the county tells you the wrong thing and you buy a lot based on that information, then it’s all your problem if that information turns out to be bad.
A couple of years ago, I wrote about a building lot I purchased that a county told me I could build a home on by right. But then after I purchased it and submitted plans, they told me they changed their minds and now I would need a variance. If I didn’t get that variance, then I had just bought a 5,000-square-foot $400,000 garden plot. Then, when I put in for the variance they found the county had mistakenly rezoned the property and I actually didn’t need the variance. That took more than a year and nearly $100,000 in extra costs.
I came out all right on that deal because home values were going up, but I had projected that I would make a $200,000 profit. It ended up taking three years to complete. I got $100,000 more for the house than I had originally projected, but I made only $90,000 in profit. Had the values not been trending upward, I would have been in real trouble. I had to get three extensions on the loan. In a downward-trending market a bank might just say no to an extension request and call that loan due, compounding the problems significantly.
I’ve heard many similar stories. One developer told me he bought a property on which a county told him he could build four houses only to find the he could build only one. That cost nearly a half a million dollars. These were seasoned guys, too.
The problem is that most of the ordinances and rules under which the county building and zoning departments operate are so convoluted and confusing that they don’t mean anything. In my opinion, it doesn’t matter what it says in the ordinance: It matters how the office has decided to implement a given ordinance. This is common in government.
I sat in a county office with a staff member and read a particular ordinance. Now, I’m not the smartest guy, but I’m fairly educated and have fairly good reading comprehension, and I couldn’t tell you what that ordinance meant. The county employee couldn’t either. She was pretty certain it meant one thing, but she brought in someone else who said, “No, we do it this way.” It was clear that the way they did it was just pretty much customary and that as long as they don’t get sued, they’ll keep doing it that way. You and I don’t have the resources to sue the county. But you know who does? The big developers.
The entire system benefits the large developers who pay huge impact fees to the county and strike deals to get a project passed. There’s nothing illegal and maybe not even unethical about it, although it can be abused. The system has become so cumbersome that you need a full-time person or a staff to deal with regulation and bureaucracy. If you have a question about a given issue, you don’t need to know where to look in the county law and ordinances — you need to know whom to call at the county.
The bottom line right now is that the average deal is getting tighter than ever, and with contractors and county zoning and building departments busier than they’ve been in years, there’s an increased likelihood that costly mistakes will be made.
In reality, nothing has really changed for me. I’m not waving off new development because my super-senses tell me the market is going to turn. I have no idea about that. I’m leaving the market because the deals don’t make sense and it requires too much time and costs to find that rare good deal. If a spectacular new development deal fell in my lap right now, I would jump on it. Those deals are increasingly rare and not worth the expense and resources to find them. It just seems like a good time to do some house cleaning and reorganization.
This year, I’m retooling my company to do other types of real estate investing with a focus on cash flow and preservation of capital. I’m lending to other flippers, buying rental properties, cleaning up and selling less productive assets, and dabbling with creating a fund to purchase commercial properties in stable secondary markets with more upside potential. I’ll share my adventures in future articles.
Justin Pierce is a real estate investor and real estate agent who regularly writes about his experiences buying, renovating and selling houses in the Washington area.