Ground Up Development vs Investing in Existing Assets

 

Investing in real estate offers an outstanding path to building long-term wealth. But, a variety of investment options exist, particularly in commercial real estate. On one side, ground up developers convert vacant land into income-producing properties. On the other side, some investors instead purchase existing properties (e.g. buying a fully-leased apartment building). Both strategies have their pros and cons, so we’ll use this article to discuss ground up development vs investing in existing assets. 

 

Specifically, we’ll cover the following topics: 

 

  • Ground Up Development
  • Investing in Existing Properties
  • Final Thoughts 

 

Ground Up Development

 

Strategy Overview

 

As the name suggests, ground up developers focus on converting a piece of unimproved land into operating real estate. That is, these developers create new property improvements from a previously unproductive (or less productive) piece of land. Depending on the deal, ground up developers may then choose to either A) sell that new building, or B) lease it to tenants. 

 

For example, let’s start with a parcel of unimproved land. A ground up developer could look at that land, design a plan for improving it into a series of townhomes, figure out how to finance the construction of those homes, receive local permitting approval, then supervise the construction of those townhomes. Following the construction process, this developer could continue to lease the homes for rental income, sell them to another real estate investor, or sell them to individual homeowners. 

 

Advantages

 

Customizable. Ground up developers tailor projects to their unique visions. In many respects, a vacant parcel represents a blank canvas, with a developer’s design plans limited only by structural, zoning, and financing considerations. This flexibility appeals to many real estate investors, as it allows them to align their unique vision with the land’s highest and best use. 

 

Potential for higher returns. These development projects pose a significant amount of risk (as we’ll outline below), but the flip side to that is, they also command the highest returns. A well analyzed and executed ground up development generally results in the highest returns of any real estate investing strategy. Depending on the deal, it’s not unusual to see a developer realize annualized returns in the 15-to-25 percent range (or higher). 

 

Flexible exit strategies. Ground up developments also allow for a fairly flexible deal exit strategy, which appeals to many investors. Some developers opt for a fee-only model, where they have limited to no equity in the deal, instead charging a fee for development services. Alternatively, some opt for a develop-to-sell model, assuming all ownership risk until completing construction, at which point they market the property for sale to another investor. Lastly, some developers pursue the develop-to-lease model, with the goal of generating rental income following construction.  

 

Disadvantages

 

Sunk cost risks. Before actually breaking ground on any construction, developers must make significant cash outlays. Developers pay for feasibility studies, legal fees, zoning applications, and architectural designs, among other costs, before receiving municipal approval. A failure to receive that approval – which can certainly happen – means developers forfeit all of these initial costs. 

 

Experience requirements. As stated, ground up development projects entail large amounts of risk. Mitigating this risk and successfully completing a development requires a tremendous amount of experience. Developers need to understand and supervise tasks related to commercial financing, municipal zoning, construction, design, accounting, and law, among others. While developers may not be experts in any one of these topics, they must have the experience to understand how these fields integrate into the broader project.

 

Time requirements. Larger developments can take multiple years to receive zoning approval and complete construction. During this time, the properties don’t generate income. This means that ground up developers (unless charging an ongoing development fee) could end up spending a couple years on a project before generating any income, which can cause significant cash flow issues.  

 

Investing in Existing Properties

 

Strategy Overview

 

This strategy entails purchasing an existing, stabilized property and then continuing to lease it to tenants. When developers build something from the ground up (e.g. an apartment building), they need to “stabilize” it before qualifying for permanent financing. To stabilize a property means to receive a certificate of occupancy and lease it out above a certain threshold, often 95% for multifamily properties. At that point in time, the property is said to have been stabilized. 

 

When you invest in these sorts of existing properties, you avoid the whole development, construction, and lease-up stages. Instead, you purchase a property that is already generating income, with your focus on taking over the day-to-day operations of that property (or paying a management company to do so on your behalf). In this respect, investing in existing properties is roughly analogous to purchasing an established business rather than starting your own from scratch. 

 

Advantages

 

Less risk. When you purchase an existing asset, you inherently assume less business risk, as you know the property already generates income. Furthermore, a thorough analysis of an existing property’s past operating results can allow investors to fairly accurately project future results.

 

Immediate returns. Related to the above, purchasing an existing property allows you to generate income immediately. If soliciting investors, this characteristic often proves appealing. Rather than waiting a couple years, you can start making cash distributions within a few months of closing on a deal (typically after the first quarter). 

 

Less experience necessary. As stated, ground up developments require a ton of experience to successfully execute. While purchasing an existing property still requires solid underwriting skills, this strategy calls for far less experience. Especially if you plan on engaging third party firms to manage the property, purchasing an existing property becomes more of a financial analysis problem than an all-encompassing development challenge. 

 

Disadvantages

 

Paying a premium. While purchasing an existing asset offers convenience and diminished risk, investors will likely need to pay a premium for those advantages. Depending on the geographic area and general market conditions, it’s common for exit (i.e. sale) valuations to significantly exceed the valuations derived by appraiser-assigned cap rates. Simply put, if you want the convenience and reduced risk of an operating property, you need to pay for it. 

 

Limited design flexibility. If vacant parcels are blank canvases, existing assets are finished paintings. When investors purchase a stabilized property, they typically do so to continue operating the property as the developer intended. For instance, if you buy a 100-unit apartment building, you’re likely not going to try to then turn those 100 units into 20 large offices.

 

Assumption of existing leases. This final characteristic could technically be a pro or con to investing in existing assets. On the one hand, when you purchase a stabilized property, lease assumption means the property will continue generating similar revenue as it did in the past. On the other hand, these existing lease agreements may be overly restrictive on the new owners, limiting their ability to raise rents, shorten terms, etc. 

 

Final Thoughts 

 

While we structured this article as a comparison between ground up development and existing assets, the two strategies aren’t mutually exclusive. That is, over time, many investors pursue both options, depending on their levels of experience and the particular deal. We can help you with both. 

 

If you’d like to discuss different real estate investing options for your unique situation, we’d love to chat! Drop us a note, and we’ll set up a meeting to talk about available passive real estate investment opportunities – both ground up development and existing assets.