Building an investment property can be one of the most profitable investments in Real Estate.
We’ve seen margins up to 20-30% at times.
The strategy is securing great vacant lots or distressed properties that can be demolished and rebuilt.
As a construction consulting firm, we work directly with investors and architects in estimating the cost for projects so we put together this strategic guide to building an investment property.
Investment Strategy (Sell or Hold)
The primary focus of this article is going to be the actual construction part, but the first thing you have to do when going in the direction of an investment property is going to be deciding if you’re going to sell or rent and hold.
Determining a good area to build your new investment property is going to rely on a few factors including the job market and population growth.
We’re going to give you all the information you’ll need to determine construction cost and other strategic information that is very cost dependent so you can make great investment decisions.
First, you’ll need to find a potential vacant lot or an existing property that you can demolish and build up from scratch.
If you start with a vacant lot, you’ll need to pay impact fees. Many counties and cities will impose an impact fee which is designed to cover the cost for the fire department, police, and other local departments.
If you keep some structure, the impact fee is either lower or removed completely because it is classified as a remodel instead of a new construction project.
Financing Your Project
Once you determine a suitable location to build a new project, the next step is going to be finding financing for it.
Seller financing creates a relationship where the seller finances the cost to you over time. Lease options will allow you to get a renter into your property with the option to buy in the future. And finally, creating a partnership with others who have the cash to invest is a great option where you’ll split the profits.
If you are building a residential investment property, there is a chance you can apply for the FHA New Construction program or if you were doing a major renovation like we had mentioned above where you’re keeping some of the structure, you might be able to get an FHA 203k Rehab loan.
One of the drawbacks of FHA is that you are supposed to be a first time home buyer and actually live in the property. If you are not, you can get traditional financing from your bank.
For new construction loans, you’ll often be asked for 20% down to secure the financing. Lenders will often ask for preliminary construction drawings and estimated costs.
Most of the time you’ll need to hire an architect to produce a schematic design set and you’ll need to have an idea of costs, which we are going to show you in the next section on how to estimate your construction project accurately.
How to Estimate Your Construction Costs
At our firm, the most important things we do are analyze construction costs on a national level and adjust pricing based on specific geographic regions. We’ve tweaked our formulas quite a bit to have accurate data.
The national average to build a new residence is between $120 and $150 per square foot. Commercial real estate is typically in the $175/square foot range. Our construction estimating services division has done a ton of analysis of our own estimates, along with data to corroborate our findings.
The costs are going to vary quite significantly based on two dominating factors: your geographic location and the final finishes you select. Typically if you keep your building structure and finishes with the most common type of design practices, you’ll stay within these ranges.
Here in the Miami real estate market, we are pretty close to the national average which is about $150 per square foot, but if you go to places like New York or Massachusetts, you can expect the cost to be in the $250-$300 range.
Based on over 3,000 estimates we’ve done for our clients, the main factor we’ve determined that affects prices is the labor cost in your area. The average construction worker cost in the nation is in the $30 per hour range. The quickest way to determine if your area is going to be more (or less) expensive is by doing a search online for the cost of a carpenter in your ZIP Code. Here is a link to Salary.com showing the carpenter rate. Just punch in your zip code.
It’s going to give you a yearly salary, so divide the median number by 1,920 (number of hours worked per year). So in this example, $55,481 / 1920 = $28.90/hour.
Estimating Rule of Thumb
Labor and material often times are 50/50. It could be 60/40 or 40/60, but they are usually very close to the 50/50. Since we are performing a rough cost, 50/50 is more than enough.
Take $150 and divide by 2 which leaves you with $75 in labor costs and $75 in material costs.
Calculate the labor cost per hour in your area and divide it by $30. For example, if you look up your labor rate of $50 per hour, divide $50/$30 and you’ll get 1.67. Multiply $75 x 1.67 and that will be your estimated labor costs. So in this example, your estimated labor cost will be about $125 per square foot.
In regards to materials, this will fluctuate slightly, but at this early stage, it is pretty negligible.
The $75 per square foot is based on average finishes. If you are going to go with the higher cost tile or maybe add brick on the outside of your home or building, the cost can go up quite a bit.
The general rule of thumb is to take your estimated labor cost that we’ve just calculated plus your material rate of $75 and that should give you a very close approximation of cost per square foot for your project.
So in the example above, we calculated labor at $125/SF and material at $75 which would be a total of $200/SF. Multiply your cost per SF x average square footage in that block, and that’s what your cost would be.
In our fictional example above, say we are building a 3 bed / 2 bath house, 2000 SF, your estimated construction costs would be in the $400,000 range. If you are going to be managing the subcontractors yourself, you can subtract about 20% of the Overhead and Profit costs for a General Contractor. That’s a cost savings of about $80,000.
Some banks will require a formal proposal from a General Contractor, so you might have to go that route, but at least now you have an estimated cost for you to determine if it’s a good investment, and to make sure that your contractor doesn’t overcharge.
Prepare Construction Drawings
At this point, you have already contacted an Architect and they should have produced a Schematic drawing for you. This typically involves basic structure and layout.
Once your bank has approved it, you can hire your architect to complete your drawings. The second phase of a drawing is called the Design Development drawings, and the last phase is the Construction Document set which is what is sent for permitting.
Architect fees vary, but on average you can expect anywhere between 5-10% of overall construction costs.
Architects also offer Construction Administration where they act as your Owners Representative during the construction phase, although this is not required so you might be able to save money there.
Hire a General Contractor (or Do It Yourself with Subcontractors)
Once you have a final permitted drawing set and the County or City Building Department has approved it, you can move to the next step which is obtaining formal proposals also known as bidding the project.
Ask other investors for referrals of good general contractors, or just do a quick Google search for “General contractors + zip code”, i.e., “general contractors 33196”.
You can find more potential contractors at The Blue Book Network online. These are companies that are actively bidding and building projects if they are on the Blue Book network.
The most important thing is that you obtain a least three bids, and use the lowest bid to negotiate against the higher bids.
Call the higher bidders and tell them their price is high and ask them to lower it. Give them a range of where the lower bidder is but don’t give them the exact number.
Just keep doing this until you can’t get them to go lower in their price.
Once you have a good deal, have a construction contract written up, preferably by an attorney, but, but you can find examples online.
Don’t Pay Too Much Upfront (or Any)
One of the biggest mistakes owners or investors often make is paying too much money upfront to their contractors.
This takes away “power” from the owner and gives it to the contractor because they already have your money.
Often some Contractors or Subcontractors will ask for 50% upfront and 50% at completion, and once you give them that initial deposit, they know they have secured your job because they have the money in-hand, and often times will use the money for your project to finance other projects they have going on.
Contractors are notorious for bad money management. Sometimes they are not trying to be shady, but it’s hard juggling multiple projects at a time.
The way you get around this is not paying any money upfront when you can. This is typically how’s it’s done in commercial real estate. However, in residential real estate, you will find the Contractors are much smaller operations and don’t have the money to finance the job, so you will need to pay something up front to get them started.
One of the strategies I have done successfully is paying them when they arrive on-site with crews and materials. At a minimum, you pay for just the materials when they arrive. But for labor, you ALWAYS pay after. There is no reason to pay labor upfront because construction companies pay their workers typically at the end of every week (not before starting).
Next, I will show you how to use a Schedule of Values to keep control of the job, keep it running fast, and protect your project budget.
Billing by Schedule of Values (SOV)
Now that you see how important it is to have financial control of the job, the next thing you are going to have to do is pay only by a schedule of values.
A Schedule of Values is simply a breakdown of different milestones of the project and how you are going to pay your contractor.
You should never just have one total lump sum and just pay by a percentage because this is very vague and leads to problems in payments in the future.
Here is a simple sample of how you should pay for a new construction house. You want to pay after they get their inspection passed if an inspection is required, or once they finish the milestone.
You can pay small progress payments in-between, but you always need to have more money on your side than theirs.
Exterior shell structure
This keeps accountability because once you pay them, they will have a little motivation to finish certain milestones quickly, or the quality will not be as good.
Years of construction has taught me these principles, so although I know that many contractors may be quality contractors, there are contractors out there that need a little bit of structure for them to perform well.
Lien Waivers and Lien Releases
Whenever you were going to issue any payment, it is important that your contractor signs a Lien Waiver. The specific legalities vary from state to state, but a Lien Waiver will prevent a Contractor from putting a lien on your property for non-payment if you have already paid. If there is Lien Waiver, you may end up paying twice.
You can get a Lien Waiver template online at any of these legal forms websites, but you might want to have an attorney write one up for you.
Quality Control and Punch-Out
One of the most challenging (of frustrating) parts of a construction project is the punch out. This is where you have to call back some contractors to come and do final touchups and repairs before completion.
Often times it will feel like you’re begging them to come back, but if you implement the strategies I’ve highlighted above, you will be holding their money until they finish the job to your satisfaction and you will have a smooth final punch-out.
A good strategy to use is to make a punch-out list and distribute it to all the contractors on the job. This includes touchups to paint drywall, fixing things that may have been slightly damaged or dings, etc.
Simply take pictures of each item, create a Word document with a table and two columns, put your picture on the left and a description of the repair needed on the right along with the company that needs to perform the repair or touch up.
Sometimes they will try to pull a fast one and say “this is not part of my contract because I finished my part so I need to charge you for it”. Luckily if you have followed our guidelines above, you will have their final payment on hold until they complete it to your satisfaction.
If they do not complete the work, you have their funds to hire somebody else to do it. This is called a back charge. Try not to go there if possible because it can ruin a business relationship. Contractors are also notorious for being “hustlers”. Don’t let them bully you into paying more money.
Building a new construction project is one of the most profitable real estate investments you can make because of the high-profit margins.
Our strategies and principles that we’ve listed above will help you get started and build a successful and profitable real estate investment project. I’ve highlighted some common strategies and pitfalls to avoid.
I hope this helps you increase your real estate portfolio and helps you with your next project.
This article has been contributed by Daniel Quindemil.