Real estate deals come in a variety of packages from “ground up” investments to value-added or rehabilitation projects. Each type of investment has its own associated risks and rewards. A ground-up real estate investment typically involves more risk, but they may also provide better rewards. That’s because the developer has much more planning and work ahead of him than with valued-added or rehab projects.
For instance, if a developer is taking an existing commercial building and adding a new wing to it, the project won’t take as long as building the building from scratch. There is already an existing structure to tie the new addition to, which makes the initial groundbreaking simpler and less complicated. By the same token, rehabilitating a building that has already been built involves a different level of thinking and costs much less than building from the ground up, hence there is less risk involved.
Common Risks Associated With a Ground-Up Real Estate Deal
Ground-up construction can often be risky because so many factors are unpredictable. The process can be long, and by the time a project is started and finished, many of the basic facts and assumptions may have changed. The following risks make ground-up real estate deals difficult to manage even for the most experienced managers:
- Price of materials may change – Prices fluctuate. A real estate project expected to take months to complete may cost more than originally estimated due to changes in the price of materials, especially at the later stage of a project.
- Weather conditions – Weather often interrupts ground-up real estate projects and could delay construction or building plans for days or weeks if seasonal weather patterns get harsh. This is one reason planning is extremely important in ground-up construction projects.
- Subcontractor scheduling – Subcontractors could show up to work late or get in each other’s way. If one project is delayed, that could put an important contracting team out of sync with the rest of the construction crew, and in some cases it could lead to halting a project for a few days or weeks until the scheduling is worked out.
- Change orders – Many times, architects or real estate owners change their minds about how they want a project to be developed. Multiple change orders can drive the timeline of a project backward significantly.
These are just some of the risks associated with ground-up real estate projects. In the end, you want someone with experience and a track record working on such projects to ensure that risks are mitigated and investor dollars are protected against unnecessary risks.
The Most Important Considerations for Investing in Ground-Up Construction Projects
Every construction project is different. In general, however, you want to pay particular attention to the following considerations when evaluating a ground-up construction project as an investment.
- Loan-to-Value Ratio – It is very important that you crunch the numbers right on any real estate investment, but if millions of dollars are at stake, you don’t want to miscalculate LTV.
- Lien Position – The best position to be in on a ground-up project is in the first lien position. You want your profits before everyone else or you run the risk of losing your investment.
- Borrower Track Record – It is best if you invest in a borrower who has managed ground-up construction before. The more experienced the borrower, the less risk you are taking as an investor.
- Borrower Experience – Even if a borrower has a good track record with project management, you want to ensure he has the requisite experience to see your ground-up construction investment through. A borrower who has spent 20 years on residential construction but has no experience in commercial could prove to be a high risk if you are looking at a commercial real estate investment.
- Credit Score – The borrower’s credit score is also important. If a borrower is sub-prime and is borrowing millions of dollars for a project, that increases the risk.
- Location – Finally, location is very important. Ground-up investments in rural or emerging markets are higher risk than core urban markets like New York City and Chicago.
Every investment should be evaluated on the merits of the project as well as the experience and track record of the borrower.