Pre-construction real estate investing 101

What is preconstruction real estate investing?

Preconstruction real estate investing is purchasing a property (single family home, condo etc) after it has been planned but before it has been built. Builders will sell you their pre construction properties substantially below appraised value if you commit to buy before the property has been built. Builders give this discount because it helps them to secure financing on their project from the bank. They sell some units in their project to pre construction investors and some at retail price to end buyers.

While realizing huge profits in pre construction real estate is certainly possible, it has its pros and cons.

Can you give me an example of a typical preconstruction investing opportunity?

A developer prepares to buy land in Miami, Florida on which he plans to build a 100 unit condominium building. He goes to a bank to request financing for his project for both the acquisition of land and the cost of building the condos. After reviewing the developer's plan and previous track record, the bank approves the loan on the condition that the developer has to pre-sell 50 units before he will receive any funding.

In order make the bank comfortable to loan the money to him, the developer goes to preconstruction real estate investors like you and says "Mr. and Mrs. Investor, I am building condos in Miami, Florida just a few blocks from the ocean and the beach. After they are built these condos will be worth 300k. I am willing to sell you these condos for 270k if you agree to buy my condos and put up a refundable 10k in escrow as reservation deposit".

You review the plans, appraisal reports and do your due diligence. After completing your research you agree to buy one condo and sign the reservation agreement to buy the condo for 270k when the construction is complete. You put up a refundable 10k in escrow as per the terms of the reservation agreement.

The investor talks to several other preconstruction investors and is able to get 50 reservation contracts. At this point he goes back to the bank and gets his financing approved. Now he asks all the preconstruction investors to increase their deposit to a non-refundable 10% of the purchase price of 27k. Also you have to sign a contract with exact terms and conditions of the sale. You increase your deposit to 27k and sign this contract with the developer.

Developer starts the construction work on the condos. Now you wait for the condos to be completed, the timeline for which is 12 months. In the meantime Miami condo market experiences 10% appreciation during those 12 months during which the construction was taking place. As a result, the value of your condo has increase from 300k to 330k.

After the construction of the condo building is complete you close on your unit. You rent your condo out for two years. During those two years, Miami real estate market experiences appreciation of 5% per year. So the value of your condo has gone up to 364k. At this point you decide to sell your condo and cash out. Your total profit before deducting closing cost and holding cost is a solid 97k in three years.

Below is the financial Summary of this preconstruction investment:

What are the types of incentives that developers offer in preconstruction real estate?

1. Below market value prices: Developers will offer to sell you preconstruction real estate at below market value prices. This is also called instant equity.
    
2. Cash Back after closing: To attract preconstruction real estate investors, developers will often offer some cash back after closing. Of course, the lender has to agree to it.
    
3. Closing cost credit: Closing cost for the pre-construction investor maybe by paid by the builder in part or in full.
    
4. Free Upgrades: Developers may offer to provide free upgrades to move their preconstruction projects fast. e.g. granite countertops, plasma TVs, furniture package.
    
5. Rental Guarantee (also called lease back): Sometimes the developer will agree to manage the property on behalf of the investor for one or two years....and the developer will guarantee a certain amount of rent to the investor whether or not the property is rented. This works out for most pre-construction investors because they plan on selling it after one or two years anyways. So, in the meantime they don't have the hassle of managing the property. Free property management for one or two years.
    
6. No Home Owners Association fees for up to two years: Developers may offer to pay your association fees for a specific time period.
    
7. No property taxes for up to two years: Again, as part of the incentive package, developers may offer to pay your real estate taxes for a specified length of time.
    
8. No management fees for a few years: A lot of times investors do not live in the state. Developers may offer free management services for a few years as an added bonus.
    
9. Free Home Warranty for few years: As an investor renting out a property, you do not want to worry about refrigerators not working or furnaces breaking down. Developers may cover the cost of a home warranty.

Why should I invest in preconstruction real estate?

There are many reasons to invest in preconstruction real estate deals. It depends on if you are buying it to live in, rent out, or sell. But the common reason to all types of pre construction investors is getting instant equity. Because most preconstruction deals are offered at below market value, you get equity in the property at closing. This is an extremely advantageous situation not available in other forms of real estate investing.

Other big reasons for investing in preconstruction real estate is appreciation and leverage. Since most pre construction real estate opportunities are in very desirable areas, these properties can appreciate quite a lot. If you would have invested in a good preconstruction deal in Las Vegas or Florida in last few years, for example, you could have seen a return on investment of even more than 100%.

In pre-construction investing, you only put up a few thousand dollars to have the right to buy a property which is worth several hundred thousand or more. Since the property can appreciate even while the construction is going on, you have the potential to benefit from both appreciation and instant equity with very little earnest money. Leverage is controlling more with less and preconstruction investment is a great situation to use leverage.

In some situation developers may provide other kind of incentives to preconstruction investors.

To sum it up below are the major reasons why preconstruction real estate investing is profitable:

1. Instant Equity: because you are buying below market value
    
2. Appreciation potential: you can benefit from appreciation while your project is being built or appreciation after you have bought your property.
    
3. Leverage: You control something worth way more than the money you put up in escrow.
    
4. Other incentives: Rental guarantee, free upgrades, taxes paid for two years, etc.

Why does the developer sell at below market value prices?

Typically, developers plan subdivisions as opposed to just building a home here and there. The financing for such projects is in the multi-million…if not the multi-billion…dollar range. Lenders don’t like to lend that kind of money without some sort of reassurance that the developer is planning a project that will sell. Most lenders require developers to have a certain percentage (usually half) of their units under contract before the lender will loan them money. This means that the developer has to sell their product even before they break ground. It is difficult to sell, and risky to buy, a property that has not been built yet. This is where you, as a pre construction investor, come in and help out the developer by committing to buy one or more of his homes even before construction has began. In return, to make the deal attractive to you and make the risk worth taking, the developer will give you below market value prices. This is what is called pre construction investing.

How much money is required to buy pre-construction real estate?

Usually anywhere from a few thousand dollars to 20% of the purchase price. When it comes to preconstruction real estate investing, the possibility of a no-money-down deal is extremely difficult if not impossible. Developers are not in the market of holding property. They want to know that you are going to close when the time comes. Therefore, developers will require a 5k-10k earnest money deposit and up to 20% down payment. This way the developer ensures that he only deals with serious pre-construction investors.

What are the steps and the timeline for a typical pre-construction real estate project?

1. Developer purchases land or owns option to purchase land.
    
2. Developer plans the project with engineers, architects, excavators, etc.
    
3. Developer gets approval from the local government. Steps 2 and 3 may be repeated a few times.
    
4. Developer applies for financing.
    
5. Financing is approved contingent upon developer pre-selling a set percentage of the units. They could be pre-sold to pre-construction investors or to home buyers. But usually home buyers are not sophisticated enough to buy something which hasn't been built yet. Therefore, the developers only option is to work with pre-construction real estate investors.
    
6. Developer markets (or hires someone to market) the project at a below-market-value price and gathers the necessary number of reservations in order to procure financing. This is where pre construction real estate investors can get substantial discount.
    
7. Developer purchases the land, if not already owned.
    
8. Developer finalizes all plans and gets the necessary legal paperwork done.
    
9. Developer converts the reservations gathered in step 6 to actual purchase contracts and, at this time, may choose to sell more units at a higher price.
    
10. Developer breaks ground and begins construction. At various stages of this step you may be asked to put down more money.
     
11. When completed, developer obtains a Certificate of Occupancy from the local government.
     
12. Final closing takes place.

The timeline of such pre-construction projects can run anywhere from a few months to a few years. It depends on the type of project, how much work needs to be done, and how experienced the developer is. You may have heard of a project being in “phase 1” or “phase 2”. At certain points during the process mentioned above, the developer may raise the price of the remaining units and sell them. This is usually referred to as a phase. The point during the process which this happens is completely up to the developer. For example, let’s say a developer is constructing a new subdivision of 100 homes in Las Vegas, Nevada. When completed, the homes will have a market value somewhere between $350,000 and $375,000. At step 5, the developer needs to pre-sell 50 homes to pre-construction investors to get financing. They are put on the market at a price of $300,000. This is phase one. The developer successfully pre-sells 50 homes and obtains financing.

The developer decides, at step 9, to sell an additional 10 homes to pre-construction investors. But now the price is $315,000 per home. This is phase two. The developer decides to sell the rest of the homes after the first few homes are completed and closed. This would be phase three and would have a selling price very close to market value.

Or the developer could decide not to have a phase two or three at all and just wait until completion to sell the rest.

What are the steps and the timeline for a typical pre-construction investing project from a preconstruction investor's standpoint?

1. Preconstruction Investor identifies a project in which they would like to invest. This conclusion is reached by evaluating the incentives provided by the developer and the economic factors influencing the area.
    
2. PreConstruction Investor approaches the developer or the real estate agent for the project and expresses interest in buying one or more units.
    
3. Preconstruction investor signs a reservation contract to buy one or more properties from the developer. A refundable deposit of $1,000-$10,000 per property is put up in escrow during this stage. Both the developer and the investor can back out of this agreement without any penalty. The developer is free to change the price and terms of the deal too.
    
4. Developer and pre construction investor sign a hard contract describing the price and terms of the sale. Typically non-refundable 5%-20% down payment is required. This contract is binding and on default will lead to financing penalties as specified in the contract.
    
5. When construction is completed the pre construction investor procures financing and pays closing costs to close on the property. Closing cost can run between 3%-5% of the purchase price.
    
6. Pre construction investor holds the property for a few years and then sells to cash out.

Are there limitations on buying, selling, or assigning preconstruction deals?

That will be decided by the developer. Be sure to read the reservation agreement and the purchase contract carefully. Remember, the developer wants to make as much money as possible. A homeowner will typically pay more for a unit than an investor and will be more serious of a buyer, so the homeowner will be preferred. The developer may want homeowner buyers only or may allow investor buyers but require them to wait a certain length of time before selling their property. The reason for this is if the developer does not want to be compete with pre construction investors to sell his remaining units.

Assignments of pre-construction contracts may or may not be allowed. Do keep in mind, though, that you are on the hook if you assign a contract and the buyer (assignee) does not close.

What are the risks of investing in preconstruction?

Because EVERYTHING about preconstruction is in future (completion date, market value, rental market), all of the information you have gathered or have been provided is speculation. That means the developer can claim a project completion date of  six months, but the project will be delayed if there were a hurricane that destroyed all of the wood in which to build.

Market value of your investment property is the most important figure and, ironically, it is also the most volatile. The good news is you can generally see a trend in market values. While you may not be able to predict market value exactly, you can generally tell if real estate values are going up or down.

What are the potential pitfalls of investing in pre-construction real estate?

• Pitfall #1: The biggest potential pitfall of investing in pre-construction real estate is the case where the developer does not complete the project. If the developer goes bankrupt or skips town, you may lose all of your money. You can avoid this by putting all money in escrow rather than giving it to the developer.
   
• Pitfall #2: During the reservation phase, either party can back out or change the terms. If the property increases in value more than the developer expected, he may decide to increase the purchase price. You have a choice to accept the price change or get your earnest money and walk away. If you walk, he sells to another buyer at a higher price. This is one of those things which you have no control. Therefore, as soon as you are 100% decided that you want to invest in the project,  get into a hard contract with the developer.
   
• Pitfall #3: Time comes for closing and you do a walk through of your property. You notice that the quality of work is not up to the standard you thought it would be. Make sure that you can verify the credibility of the builder to avoid such situation.
   
• Pitfall #4: You close and are required to hold your property for at least one year before selling it. During that year, the real estate market tanks and the value of your property drops by a significant amount. If you sell before the year is up, you may face financial penalties as specified in your contract with the developer. To avoid such situations make sure you do your due research about the economic factors affecting the area. Only buy preconstruction projects where there is a strong housing demand. Increasing population trend and job growth are two main drivers of the housing demand in an area

How do I protect myself when investing in pre-construction real estate?

The most important thing you can do as a pre-construction investor is “due diligence”. This means don’t trust what anybody says, especially the people on the other side of the closing table. Research everything from the developer’s license and zoning permissions to his previous projects and finances. Most importantly, research the (speculative) facts and come to your own conclusion based upon your ability to take risk. Check what’s for sale in the market. www.preconstructionfind.com is a good place to start looking for pre-construction investment opportunities which qualify your criteria. Get second and third opinions on the value of the property in the future. If possible, check out the construction site and make sure the quality of work is up to par. While good pre construction investing opportunities are definitely out there, not every deal you come across is a good one.

Another important issue is the money you put down. Make sure ALL money you put down is held by an escrow agent and not by the developer. If the developer can’t finish the project, your money is safely tucked away where he can’t touch it.

Finally, be prepared for all situations. Make sure you are able to buy and hold the property for a few years, if necessary. Never buy a pre-construction investment if you cannot afford to buy and hold it for at least two years.

How do I find preconstruction investment real estate?

Pre-construction deals are in high demand and are not that easy to find. However, with the advent of the internet, it has become much easier to find preconstruction deals. www.preconstructionfind.com has a big list of available projects and is a good source to find preconstruction deals.

What types of real estate make good pre-construction investment?

Traditionally, single family homes and condos have been the most popular types of properties sought by preconstruction investors. Lately, new types of pre-construction projects have become popular like hotel condominiums, land lots in a new subdivision, multi-family apartments, lofts etc. Still, preconstruction condos and preconstruction homes remain the most popular choice among investors.

Historically, oceanfront, beach front and water front condos have offered better return on investment.

What are good areas for pre-construction real estate investing?

Some of the most active markets for pre-construction investment opportunities are:

• South Florida and Central Florida have been active pre-construction markets. Miami, Orlando, and Tampa are some of the major areas where developers offer pre-construction investment opportunities on a pretty regular basis. With population of Florida projected to double in 20 years, this will remain on one of the hottest preconstruction markets.
   
• Myrtle Beach and Pawleys Island in South Carolina: With many baby boomers moving to the this area, there is a lot of new construction going around. With new construction comes pre-construction investment opportunities.
   
• Virginia Beach: Located not very far from major cities in the northeast United States, the rich and wealthy are always buying second homes in Virginia Beach. Pre-Construction investing is popular among investors buying second homes here.
   
• Las Vegas, Nevada: The casinos, the warm weather and major population increase in the area has attracted pre-construction investors in a big way.
   
• Phoenix, Arizona: Baby boomers have been moving to Phoenix area due to warm weather and the rising real estate prices in California. In the last few years, some preconstruction investors in the Phoenix area have made significant profits.
   
• Parts of Louisiana, Alabama and Mississippi:  Due to major damage caused by Hurricane Katrina and Hurricane Rita in 2005, the United States government is providing extremely good tax incentives for real estate investors to come and invest in the redevelopment of these areas. These incentives have created some incredible pre-construction investing opportunities.
   
• Other areas which are beginning to become popular are Texas, Tennessee and New Mexico. But no matter where you are, you can always find a good pre-construction investing opportunity in your local area.

Go to  www.preconstructionfind.com to find currently available preconstruction investment opportunities in these areas.

What's the best way to finance properties which I am buying from a developer in pre-construction phase?

In almost all pre-construction projects, the developer already has a few lenders who have reviewed the projects and are willing to lend to people who will buy the individual properties. These lenders are called preferred lenders. These lenders will lend you as long as you qualify their lending criteria.

Even though you are not obligated to use the developer's preferred lender, its recommended to do so because of the ease of paperwork. These lenders have a lot of paperwork already done and the closing is lot more smooth by working with preferred lenders.