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This is a book which was edited by George Marcus, Bill Millichap, and Harvey Green. I think it is well worth adding to your investment library, and I've included an excerpt below:
Annotation #15: Buying Investment Real Estate Below Construction Costs
a) There are buyers who have built considerable real estate fortunes buying property below construction costs. There are some advantages and some drawbacks in employing this strategy.
b) The primary advantage is that by buying below construction costs, the buyer is able to rent the property for less and still earn a reasonable return on investment. For example, if an investor purchases a 55,00 square foot office building for $150 per square foot, the price would be $8,250,000 (55,000 multiplied by $150). Assuming the investor wants a minimum return of 8 percent on their investment, they could rent the property net of expenses for $660,000 per year ($8,250,000 multiplied by 8 percent). The annual rent per square foot would be $12 ($660,000 divided by 55,000). If the cost of new construction is $200 a square foot, and if a developer was to build a 55,000 square foot building, their cost would be $11,000,000. If they wanted a similar 8 percent return they would have to rent their building for $880,000 net of expenses. Their annual rent per square foot would be $16 which is 33 percent higher than the building that was purchased below construction cost.
c) The obvious rental advantage is not the only benefit. By buying below construction costs and being in the market with very competitive rents, the ability of other developers to bring new product to the market has greater risk. In the short term the added risk could preempt a few new competing projects from being built. Another advantage is that when an improved rental market does justify new construction, the upside in future rent should be much greater for the below-construction cost investor.
d) The final advantage is that lenders are usually more willing to lend on a building with a lower cost-per-square-foot because of the perceived lower risk. This is presuming that the rent from the project adequately covers the debt service.
e) The problem with the below-construction-cost plan is that if this is the investor's only strategy, many favorable opportunities to purchase can be missed. The availability of below reproduction cost deals is usually only prevalent during weak or down markets. Some of the most lucrative buying opportunities are from purchasing at or above construction costs in supply-constrained markets that are at the start of an up cycle. The below-construction-cost investor tends to miss such opportunities.
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