Broadly speaking, real estate investors can build a new property from the ground up, or they can buy an existing property. But, what option makes the most sense? Is it better to build or buy an investment property?
Whether to buy or build an investment property depends on your individual situation. If you hire a general contractor (GC), the fees will cut into your profits. If you act as your own GC, you’ll need to manage the subs yourself. As such, buying an existing property typically makes the most sense.
In this article, I’ll dive into some more considerations about building versus buying investment properties. Specifically, I’ll cover the following topics:
- Commercial Development vs Residential Properties
- Buy or Build Option 1: Hire a GC
- Buy or Build Option 2: Act as Your Own GC
- Buy or Build Option 3: Buy and Rehab an Existing Property
- Buy or Build Option 4: Neither – Wholesale
- Final Thoughts on Investment Properties
Is It Better to Build or Buy a Property: Commercial vs Residential Properties
Prior to diving into a buy-or-build discussion, I need to provide some context. In this article, I’ll analyze these options within the context of single-family homes. In other words, does it make more sense to purchase and rehab an existing home, or build one from the ground up?
As such, I am not looking at this question via the lens of commercial real estate development. With that strategy, developers purchase a parcel of land with a vision for improving the property. They then execute that vision, constructing some form of commercial property (e.g. apartment buildings, offices, warehouses, etc.) on the land. For these commercial developers, the question of renovating existing properties (e.g. converting warehouses into apartment buildings) versus ground-up construction also exists. However, commercial development poses some major obstacles:
- Experience: Commercial development requires a vast amount of experience and knowledge about the intricacies of project management, commercial zoning, commercial financing, construction, and local laws (among other subjects). This reality prevents most new investors from pursuing this investment strategy.
- Capital: Successful commercial development generally requires far more initial capital than residential investing. While every project differs, developers typically need to commit at least hundreds of thousands to a few million dollars to launch a project. These funds can be raised with creative financing strategies, but that implies a commercial structure.
- Risk: Prior to even breaking ground, commercial developers need to spend tens of thousands of dollars (or more) on project soft costs. These expenses include architectural plans, engineering studies, zoning petitions, legal fees, building permit applications and more pre-build requirements. If a deal falls apart, developers lose all this money.
Bottom line, commercial development represents a completely different investing strategy, separate from the scope of this article.
Buy or Build Property Option 1: Hire a General Contractor
In deciding whether to buy or build, investors also need to think about how they would build. Of note, two broad options exist. You could either 1) hire a general contractor (GC), or 2) serve as the GC yourself. I’ll use this section to outline the considerations behind hiring one to build an investment property for you.
Pros of working with a contractor
Professional GCs have existing relationships with subcontractors (e.g. plumbers, electricians, carpenters, etc.). This means that, when you hire a GC, you don’t need to research and vet subcontractors yourself. Instead, you can rely on the GC to bring in a crew of reliable subcontractors for the project.
Related to these relationships, professional GCs also have significant real-world experience supervising construction projects. They’ve done this before, so they know the best ways to plan and execute any construction project. If you serve as your own GC, you’ll likely spend a large amount of time correcting your own mistakes. On the other hand, professional GCs have spent years learning the trade, so they know how to avoid these common mistakes.
Basically, when you hire a GC, you pay for convenience (not needing to do the work yourself) and competence (a well-executed project).
Cons of working with a contractor
Hiring a GC costs money. While you get the convenience of having a professional build your home for you, that convenience does not come cheap. The fees a GC charges generally remove the profits from a deal for investors (or at least take a major chunk out of them).
In general, a GC will apply a 10 percent upcharge on whatever deals they sign with subcontractors. This upcharge serves as the GC’s fee for planning and supervising your home build. Additionally, GCs often do some of the work themselves (i.e. they don’t contract part of the construction out to subcontractors). When this happens, the GC will charge you both a market rate for those services plus the 10 percent upcharge.
If it costs $200,000 to build an investment property, you’ll need to pay an additional $20,000 ($200,000 cost times 10% GC upcharge rate) for $220,000 total. In most cases, this cost-plus fee structure removes the profit from a deal. Instead, investors who go this route end up basically paying retail price for the finished property. If you’re looking for a long-term rental situation, where you profit on home appreciation and loan amortization, the numbers may still work for you. However, you’ll have a difficult time making a profit on an immediate resale when you factor in these additional GC fees.
Buy or Build Property Option 2: Act as Your Own General Contractor
The next option investors have also entails building an investment property. However, with this path, the investors themselves serve as the GCs for their respective projects. In other words, you’ll be the one to A) find, vet, and hire subcontractors, and B) supervise their work through the entire construction process.
But if you’re not a licensed contractor, the only way you’ll be able to make this happen is if you plan on occupying the property. More precisely, if you serve as your own GC, pulling a building permit requires that you serve as the owner/builder planning on occupying the home as a primary residence.
How does that work for investment properties? Well, you can’t take this path to build a pure investment property, that is, one you plan on selling or renting immediately. But this doesn’t mean that you can’t pursue an investing strategy. I’ve seen plenty of people over the years build a primary residence, live there for a couple years, and then either A) sell it for a profit, or B) convert it to a long-term rental. Advantages and disadvantages exist to this strategy.
Pros of acting as your own general contractor
Serving as your own GC can be an extremely profitable option, especially in a hot property market. These owner/occupiers have the potential to profit in two primary ways:
- Appreciation: In a hot housing market, a recently built home can appreciate significantly over the course of two years. As a result, by living in a property and paying the mortgage for that period, when you sell the home, you can potentially make a large profit and recoup your mortgage principal payments, even considering the transaction costs of the sale (e.g. real estate agent commissions, title transfer fees, etc.).
- Capital gains exclusion: Typically, when you sell an investment property, you need to pay capital gains tax on your profit. For example, if you built a property for $250,000 and then sold it for $350,000, you’d need to pay tax on the $100,000 gain. But, due to the IRS’s Section 121 exclusion, if you’ve lived in a home for two of the last five years, you can exclude up to $250,000 in capital gains taxes on the sale ($500,000 for married couples).
For investors who serve as their own GCs, the above means that they can boost their home sale profits by A) not having to pay a GC upcharge, and B) not having to pay capital gains taxes. By not having to pay these items, investors can add tens of thousands (or more) to their total profit.
Cons of acting as your own general contractor
Before diving headfirst into acting as your own GC, you should consider the following drawbacks to this strategy, too.
First, as a novice GC, you won’t have any established relationships with subcontractors. This means you’ll need to spend a significant amount of time researching crews and comparing bids before actually signing contracts. And without established relationships, you have a far greater likelihood of hiring an unreliable subcontractor, which can pose a major headache.
Next, as a GC, you’ll also need to supervise these subcontractors. This means properly sequencing and timing work. Certain construction work depends on other work being finished. As a result, you’ll need to make sure the entire project has a set schedule, and that the subcontractors follow this schedule. Unfortunately, this supervision more closely resembles babysitting, and it can take up a massive amount of your time and energy. If you have a separate, full-time job, you’ll likely struggle to effectively manage a project—it just takes too much time.
Lastly, in addition to the time spent building the property, the entire investment lifecycle with this strategy takes a lot of time. According to the US Census Bureau, it takes an average of seven months to build a single-family home. So, between A) building the property, B) living there for two years, and C) listing and selling the home, you’re looking at close to three years to cash out on the deal.
Buy or Build Option 3: Buy and Rehab an Existing Property
With this option, you don’t build an investment property from the ground up. Instead, you purchase an existing home in need of some repairs, complete those repairs, and either sell the home for a profit or rent it out with a long-term strategy.
Generally speaking, when you buy a property, it would cost more to build that same property than its market price. As a result, when you buy a property, you buy it at today’s market value, not its cost to construct. This means that, on average, you’ll pay less for an existing home than you would to build a new, nearly identical home.
But, with existing properties, investors also face a tremendous amount of competition when looking for MLS-listed homes. With these properties, you’ll need to compete against primary homebuyers and other investors. This reality means that, even if you do find a deal, you’ll likely need to pay market price (or higher), eliminating most of your potential profit.
As a result, when using this strategy, I highly recommend seeking off-market properties. With these properties, you seek sellers who haven’t actually listed their properties for sale yet. In other words, you want to find people who A) are motivated to sell, and B) have equity in their homes. Essentially, you want to find someone who needs the money from a sale, doesn’t want to address a needed home repair, or both. Our Investor’s Edge software can help you find these potential sellers. With a database of over 160 million properties, you can find an off-market property that fits your investment criteria.
When it comes to these off-market properties, the owners have some sort of problem that needs to be solved. Maybe they need money for a major life event, or maybe they don’t want to repair a leaking roof. At the end of the day, it doesn’t matter what the problem entails. What matters is that, as real estate investors, we act as problem solvers for these homeowners. Simply put, these homeowners want cash, and we want good deals. When you combine these two goals, off-market homeowners find a solution to their problems, and investors find a great deal on an investment property.
After purchasing these properties, investors will still need to play a minor GC role. Typically, off-market sellers have homes that have some sort of problem. To convert these properties into a quality fix & flip or rental, investors will need to do some repairs. However, supervising subcontractors to handle a few repairs poses far less of a challenge than organizing an entire construction project.
This combination of A) better deals, and B) less work makes buying an investment property – even one that needs some work – a far better option than building a new one. In addition to causing far fewer headaches, this approach just has far better potential for solid profits.
Buy or Build Option 4: Wholesale
The final option I want to discuss doesn’t entail buying or building an investment property. Rather, wholesaling presents an opportunity for real estate investors to generate income without dealing with any construction – either ground up or repairs.
With a wholesaling strategy, investors don’t actually buy properties. Instead, they find off-market properties like the ones described above, and they enter contracts to purchase these properties. However, rather than close on the purchases, they assign the contracts to a third party, typically a fix & flip investor, for a finder’s fee. As such, wholesalers find deals, connect the sellers with investors, and collect a fee in the process—all without dealing with the headaches of rehabbing and selling (or renting) a property.
While wholesaling typically entails smaller returns than a conventional fix & flip deal, this approach also requires far less time and risk. As a result, real estate investors who cannot commit to either buying or building an investment property should consider this strategy.
However, I also don’t want to make it seem as if this strategy doesn’t require any work. Successful wholesalers need to spend a significant amount of up-front time developing and implementing a marketing strategy. These sort of off-market deals don’t just fall into your lap. You need to work extremely hard connecting with these potential sellers, providing them offers, and following up with legitimate leads. On the other side of the coin, you also need to develop a network of fix & flip investors willing to purchase the contracts from you once you’ve signed them.
If you’re willing to put in this leg work, the wholesaling strategy can provide solid returns. Some extremely successful investors focus solely on these returns, and some use these returns to build seed capital for subsequent real estate investments. The approach you select depends entirely on your unique investment objectives.
Final Thoughts on Investment Properties
Combining both my personal experience and the experiences of the rest of the The Investor's Edge team, I absolutely recommend buying an investment property over building a new one. While building a property provides you the advantage of tailoring a home to your exact specifications, the costs and associated headaches of a full construction just don’t outweigh the limited benefits of this approach.
Conversely, when you buy an investment property, especially an off-market one in need of some repairs, you typically spend far less than the costs to build a comparable property. And with this approach, you don’t need to A) sacrifice your profit to GC upcharges, or B) play the role of GC yourself and deal with the stress of finding, vetting, and supervising a group of subcontractors. In most situations, it just makes far more sense to buy an existing investment property rather than build a new one.
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