Is developing real estate a profitable approach to real estate investing? Have you ever considered constructing a building, from the ground up, on commercial land? Far too many people have been seduced into developing property and nearly all of them later regret it. You’re about discover 3 reasons why real estate development is such a bad idea for real estate investors and what you should do instead.
What is Real Estate Development?
Imagine you have a piece of bare land, and you want to construction an income producing property, such as a fourplex, a warehouse, flex space, or an office building. That is what real estate development is: taking a piece of land and constructing new buildings on it, from the ground up.
Challenges for Beginners
I often receive questions like, “Peter, I own or inherited a piece of property and want to build something on it. What should I do?” My immediate response is to inquire about their experience. If they are beginners, my recommendation is straightforward: don’t do it! If you’re a beginner with a piece of land, sell it or maybe get it approved and then sell it to a developer because developing real estate from the ground up is complex and laden with challenges. However, there are exceptions. If you can meet these three requirements, then you are the exception to the rule:
- 10+ Years Experience: You need extensive experience in renovating real estate or in real estate construction.
- Well Capitalized: In addition to being highly experienced you need to be well-capitalized because real estate development requires a lot of money upfront.
- Time: Thirdly, you need plenty of time to see the project through to the end, as real estate development projects take years to complete.
Why Real Estate Development is a Bad Idea
Reason #1: Financial Risks
One of the most significant drawbacks of real estate development is the substantial financial risk involved. To get a project off the ground, you need considerable upfront capital. Costs include purchasing land, obtaining permits, hiring architects, engineers, and contractors, as well as conducting necessary environmental studies. For even a small project, these expenses can easily run into thousands, if not tens of thousands, of dollars—money that is out of pocket and you may never recoup.
Additionally, unforeseen costs and delays are almost guaranteed and can seriously impact your finances. Unexpected issues like contaminated soil, utility line obstructions, or changes in building codes can arise, causing delays and additional expenses. For instance, on one of my development projects, the city demanded I redirect the water supply even though it wasn’t my responsibility, delaying the project for several months. Litigation with neighbors or other parties can also add to the unpredictability and financial burden. Then there’s the substantial debt you will need to take on and construction loans are both expensive and extensive.
Candlestick Park Development
There is a project in my own backyard, Candlestick Park, that is a prime example of the financial risks involved with real estate development. In 2015, they tore down the stadium with great plans to build homes, a shopping center, theater, and commercial spaces. The developer has already spent $136 million on community improvements, investing in hospitals and parks around the development site, just to show favor and good grace to the neighbors. They’re still working on construction because they’ve hit all these roadblocks that cause delays and additional expenses. This is why initial capital, and contingency funds are crucial. And this brings us to the crux of the issue: the considerable financial risks in real estate development are huge, making it too risky for beginners.
Reason #2: Regulatory and Legal Hurdles
Another significant challenge in real estate development is navigating regulatory and legal hurdles. Developers must comply with zoning laws, building codes, and environmental regulations, all of which can delay the permitting process by months, if not years. Each of these regulations brings its own set of challenges: environmental impacts, traffic studies, utility provisions for the city, all contributing to extended timelines and increased costs.
Downtown Development Example
Let me share an example that illustrates this point. Sal owned a prime piece of land downtown. He had a vision of developing a mixed-use property with apartments and retail spaces. So, he hired architects and planners, however despite conditional approvals from city boards, he faced numerous hurdles. First, he had to apply for a small zoning change, revise his plans and pay for impact reports costing thousands of dollars. He had to contend with the public hearings scheduled by the planning commission, where neighbors raised complaints and other business requested changes. So, Sal had the architects revise the plans again and make the changes that everyone wanted.
Then, just when he was expecting approval, a neighbor filed a lawsuit saying that Sal’s building would impact the parking and the traffic in the area and take away some of his peace and enjoyment. Litigation took months and cost thousands, and in the end, Sal had to revise his plans again by adding parking and reducing the size of his building. Three years and three months later, Sal finally broke ground. So, even a small zoning change led to significant delays and legal battles. This experience, though frustrating, is typical in real estate development, which is why it’s not ideal for beginners.
Reason #3: Market Volatility and Uncertainty
The third reason why real estate development is a bad idea is market volatility and uncertainty. As a developer, you are at the mercy of economic conditions, interest rates, and consumer demand. Predicting these factors years in advance, from initial design through to project completion, is nearly impossible. Will the demand still be there when your project is finally completed? Will there be a market shift? Developers must have substantial holding power and financial reserves to weather unexpected economic downturns or shifts in demand.
Real Estate Cycle
The cyclical nature of the real estate market adds another layer of risk. Real estate markets are cyclical, with peaks and downturns. If you start a project during a market peak, you may face a downturn by the time the development is complete, leading to significant financial losses. This market volatility and uncertainty is yet another reason why real estate development is not advisable for beginners.
What Should You Do Instead?
While real estate development can be lucrative, it comes with substantial financial risks, regulatory hurdles, and market volatility. Given the significant challenges, a safer and more predictable alternative for beginners is to invest in existing properties. This approach provides two main benefits:
- Predictability: With an existing property, you can more accurately predict performance.
- Cash Flow: Unlike real estate development, which requires significant upfront investment with no immediate returns, existing properties generate cash flow from day one, providing a steady income stream.
For example, Chris, a student of ours, asked us if he should build new or by existing. Of course, we chose to buy an existing 23-unit apartment building rather than develop something new. The purchase price was $875,000, and he put $200,000 as a down payment. Chris hired a good property manager, and over three years we renovated each unit, increased rents, and maintained steady cash flow. Today, the property is worth $1.7 million, and Chris is able to do a cash-out refinance and pull out $500,000 tax-free to reinvest in another property. During those three years, the property generated consistent income and increased in value, making it a safer and more stable investment.
Questions or Comments? Text PETER to 833-942-4516.
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