When considering real estate development, there are two main paths a developer can take – either ground-up construction projects or renovation projects. Both have advantages and drawbacks, and it’s worth assessing the local real estate market and analyzing which approach best meets the needs of that market.
What’s the Difference?
A ground-up construction project entails constructing a building completely from raw materials – which means producing new walls and foundations, footings, etc., in a brand-new location. A renovation project doesn’t start from scratch, though. Instead, some of a building’s components are demolished and rebuilt, while structural elements are left intact. Renovations typically involve a fair bit of construction work, just like a ground-up project, but if a large part of an older building is being utilized, it’s still referred to as a renovation. Local building codes can differ on this definition, though, so it’s always worth investigating local laws.
Renovation projects often prove to be a more cost-effective option, since much of the structural work is probably already completed before the project. Building permits tend to be easier to access for renovation projects when compared to ground-up construction projects. In addition, by renovating an existing building, a project can frequently get access to desirable locations that would be unavailable to new ground-up construction projects. The big disadvantage regarding renovation projects is that they necessarily come with reduced flexibility in the construction of the building.
General contractors need to work within the existing renovation framework, and that can sometimes result in a building that is less than perfect for the desired purpose. Still, renovation is the clear winner in terms of budget, since a renovation usually costs less money than a ground-up construction. Usually is an important qualifier, though, as it can sometimes wind up costing more to do a renovation since one never knows what unanticipated problems might be found in the walls of old buildings.
Updated building codes could require an overhaul of many of a building’s existing components in order to bring them up to the current code, which can easily add unforeseen costs to a renovation project’s bottom line. Renovating an existing building can also put limits on further expansions to the buildings, as well, whether due to location or incompatibility of elements.
Ground-Up Construction Projects
Ground-up construction offers unlimited flexibility. A ground-up construction project allows for building customization so that a building can better meet the needs of its purpose. For instance, if the building is intended for a company, it can offer opportunities in the area of workflow, capacity, machinery, etc., but that flexibility doesn’t come cheap. Commercial building construction usually has a higher price tag than renovation. However, depending on the nature and volatility of the local real estate market and the stock of existing buildings that are available for renovation, ground-up construction can sometimes be cheaper than a renovation simply on account of avoiding costly problems or the need to modernize outdated components so that they match current codes.
Another important benefit is the option to grow out a building in stages. As a building needs expansion, due to a growing business or a need for more tenants, so can the building. However, it can be difficult and require a longer waiting period in order to obtain the necessary permits to construct a new building from the ground up. Ground up construction projects tends to eat up more time than renovation projects, as well.
It’s important when approaching any sort of development project but especially for a ground-up project, to have an idea of what a development project will look like in full. Development can be divided into three distinct stages.
- Pre-development: The earliest stage of a development project requires the development team to show due diligence, perform research and get the proper permits. It can be the most variable in terms of duration. Investing at the pre-development stage carries the greatest and most varied risks because of the slew of unanswered questions, but can also be where some of the best opportunities can be found. Some of the common tasks that need to be accomplished in this phase include:
- Environmental assessments
- Studying the market and feasibility
- Acquiring the land or an option to purchase the land
- Site plans and development plans
- Acquiring necessary permits
- Arranging the finance of construction
- Making some infrastructure improvements
- Construction: The middle stage involves constructing the improvements or the entire structure. Since the volatile pre-development tasks have been completed, the project risks during the middle phase have a much lower chance of backfiring on investors, but the risk hasn’t been eliminated yet. Some of the most common steps in the middle stage include:
- Vertical construction
- Project marketing
- Tapping into construction financing
- Arranging for the property manager (if this task hasn’t been done during pre-development)
- Operation: The final stage of the development process is operating. This phase is also the first stage of the building’s life. While the pre-development and construction risks have been removed by this point, obtaining tenants or the dependability of found tenants still creates some risk at this stage of development. The most common elements of the final stage include:
- Finding a buyer, if this hasn’t already been done
- Ongoing marketing and leasing
- Determining a hold strategy, if not selling the property
- Ramping up property management activity
- Achieving stabilization
Considering a Potential Development
There are a few major ways to discern whether a development project is a safe investment. First, checking the loan-to-value ratio is a valuable first step. If the numbers don’t come out in a way that you’re comfortable with, then the project is an easy pass. Second, and in a ground-up development especially, it’s important to angle for a good lien position. The first lien position is obviously the best, as it greatly reduces the risk of losing the investment. Third, investors will want to investigate the people constructing the development. If their track record and experience aren’t extensive, then the project carries a considerably higher level of risk.
Last, investors should evaluate the location of the development, and the health and volatility of the surrounding real estate market. Big urban centers carry less risk because they’re guaranteed to have interested tenants or buyers, while rural locations tend to offer a wider array of real estate options and thus such locations present a higher risk of a development going to waste.