Real estate markets across the country are up, which has led many investors to look into alternative strategies for acquiring new income-producing properties. If you're in the market for buy-and-hold rental real estate, you may have a hard time finding a single-family rental that works, especially in many large metropolitan areas that are actually experiencing rent decline.
Rather than wait for a market correction, you might consider building a property with the design and intent to rent it out. Depending on the numbers, this may make more sense than buying already-built homes and allow you to continue investing. But several things need to be considered before heading to the permitting office.
Why build new solely to rent?
Rental income is a wonderful vehicle for passive income and building net worth. In down markets, you can easily scoop up homes, both rehabbed and fixer-uppers, that sell for less than you can rent them for. You can buy distressed properties, nonperforming notes, properties for sale by owner (FSBO), foreclosures, or even from the retail market.
But in up markets, it becomes quite a bit trickier to find a good deal. As the value and demand for existing homes increases, it becomes more difficult to acquire properties with reasonable return on investment (ROI). Rather than roll the dice and pay high prices with small margins, the savvy investor will look for an alternative solution: build to rent.
What considerations need to be taken into account?
Residential real estate investment trust (REIT) American Homes 4 Rent (NYSE: AMH) specializes in this model of rental real estate, developing built-to-rent communities, but it benefits from economies of scale. This is something individual investors don’t have the benefit of.
For small to midsize investors, building new single-family homes may not actually save you any money. The average price per square foot nationwide in 2021 is between $100 and $200 per square foot, according to HomeAdvisor (NYSE: ANGI). Compared to the national average of $143 per square foot based on average purchase price and size of home in 2020, there's a real possibility you could end up paying just as much, if not more.
That's why economies of scale are often critical to making the numbers work when building new homes. If you already have a lot you've been holding, contacts within the construction industry, or a source for affordable building material, these factors will all help reduce costs and potentially swing you to the lower side of cost per square foot.
New builds do offer the opportunity to build in cost-saving concepts like installing wider doors and hallways or a no-step entry, which can reduce damage from moving furniture in and out, saving money down the road.
Should you build new to rent?
Even with reduced competition for property, up markets can still raise prices, so it's important to run your numbers thoroughly prior to any purchase. Once you hold the land -- and especially once you start the build -- you're locked into spending without a return for quite some time. Having an adequate financing plan that accounts for delays that may be out of your hands, like permitting, is important.
During your due diligence period, make sure to get accurate estimates for the entire buildout so there are no surprises once construction begins. Although the average costs can run fairly close to buying an existing home, if there are only homes that are overvalued available, this can offer a viable alternative. It's a nontraditional investment model that generates passive income. Ultimately it comes down to the numbers, just like any other investment.