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When Will the Builders Stop?

Ron Wynne on

You might be one of those neighbors who is not very happy about the big homes being built in your once-simple and once-charming neighborhood of homes built in the late '40s and early '50s. It's easy to understand why you are not happy. Realtors encourage good taste and neighborhood conformity no matter what, but unfortunately, developers don't always follow suit. Although some developers are more neighborhood-sensitive than others, it's a business, and it's about how they can turn a profit. There are some really good and collaborative developers who care about goodwill and keeping neighborhood conformity, so don't throw them all into the category of only caring about money.

I'll share a quote I just heard from a builder in response to the question "How much longer are you going to build those big white houses?" He said, "As long as buyers keep buying them." This seems odd, but it's just that simple. It would be nice to see a bit more creativity, attention to detail, architecture and diversity, in my opinion. Anyhow, I'll share with you the builder's secret formula for property development.

Say a builder wants to build a property on a teardown lot. The process starts with going to the city to determine how many square feet can be built on the site and then deciding if building the maximum size allowed will produce the best return, which it usually does. For the purpose of this imaginary lot, I'm going to say that the zoning would allow 3,600 square feet and building to maximum size is desired.

Next, we need to consider the cost of construction per foot, which varies from "simple basic" to "extravagant quality." The quality is determined by others in the neighborhood. Let's say it's $300 per foot. We must then consider the cost of the borrowed capital and the length of time the money is being borrowed. Let's say 8% and 18 months.

Next, we need to know the ballpark value of the teardown lot to determine the "cash-on-cash return" needed, which varies from developer to developer but averages at 18%. Then, we need to factor in real estate commissions and closing costs, and a buffer for unforeseen cost increases and delays. Here is your example pro forma.

1. Let's say the landowner wants $1,600,000 for his land.

2. For 3,600 square feet at $300 per foot, your construction cost is $1,080,000.

3. Using 18 months at 8%, your money cost will be $321,600.

 

4. If the desired profit is 18% (which is only 12% annualized), add in $482,400.

5. Add $220,000 for closing costs, commissions and other costs (number based on recent sale comps).

The most important part is to determine whether the deal pencils out. Are we good, or are we short? If we are short, the only way to make the deal work is with a lower profit, which may or may not be acceptable, or with a lower cost for your borrowed money.

Add all these costs together ($3,704,000) and subtract from the realistic sale price of the newly constructed home, which we could estimate at $3,900,000. This works out to a thin margin, and if the house sells at only $3,800,000 due to, say, a shift in the market, there will be a major void in the anticipated profit.

The length of a build is not an emotional decision for builders and developers. They utilize a mathematical formula that backs into the purchase of the lot and anticipates a desired future profit and unexpected hiccups.

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For more information, please call Ron Wynn at 310-963-9944, or email him at Ron@RonWynn.com. To find out more about Ron and read his past columns, please visit the Creators Syndicate webpage at www.creators.com.

Copyright 2021 Creators Syndicate, Inc.
 

 

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