Trouble finding a duplex... Build one instead?

Question

I am a pretty new investor, I have two properties in Denver currently. My market is very expensive, and I have been struggling to find a duplex that makes sense... I found an off market property that I could buy and it is zoned for a duplex. The property will cost around 300k, I could buy it as a single family rental, and probably break even.

If I were to have a brand new duplex on the lot, it would rent for around $5500/month. I have no experience in new construction, and am not sure what the costs for this would be. My question is would it make sense to tear this property down, and build a brand new duplex? Or how do I go about finding out what it would cost to build one so that I can properly analyze this? I know that there are a lot of different costs to consider with a new build, and I am not sure how to find out what all of these costs are.

Another option would be to keep the current structure and build onto it, it is just very ugly, so I am not sure if it is possible to add on and make it look nice...

Any help would be greatly appreciated.

Scott Choppin · Answer

@Alyssa Healey

Great question.

I have also observed that most duplex/triplex properties in DEN are sold as Bill suggests. But, I also observe that if you are the developer of the deal, you will be able to leave your sweat equity for managing the development process in the deal, and this might make the economics different versus a pure purchase of existing units.

You will no doubt have to raise additional equity to hold it long term in a development scenario, but you need to do that during the build phase anyways. Then the question becomes, how much does your perm loan underwrite at, and how much equity does that require, and what's the net differential between development value/equity vs. new needed equity in perm phase.

So I'll give an example using cap rates (not real numbers):

Example 1 - buy existing (possibly a breakeven buy) at a 4.5% cap rate, with whatever rents, operating expenses and NOI, that generate the value on the deal and the purchase price.

Example 2 - develop the property, and if it's underwritten correctly, you produce a NOI/Cost ratio (the development cap rate) of 6%. If you assume that the sale cap rate in Ex. 1 is true, 4.5%, then you have produced a profit in the development deal, or said another way: 6% minus 4.5% = 1.5% value difference between build cost and sale revenue or profit.

To be clear, this is 1.5% of the entire value of the property (before everybody freaks on me, this is NOT 1.5% profit). Another way to calc this, take your NOI and divide by 1.5% and this would be your dollar profit.

You can now decide as follows:

A. Sell the projects, reap the NOI/1.5% value differential

B. Keep the project, leave the 1.5% value in the deal as equity, underwrite on the "as complete" value with a lender, and plug any equity difference in the deal.

Now, this does not mean the deal makes sense to sell or keep in the first place.

You have to underwrite the whole deal, to make sure you achieve general economic feasibility, i.e. sale revenue less build cost = profit. You also have to analyze cash flow generally, is it enough for all the work of developing the project? And,  you need to calculate the return of equity from the cash flow, your "cash on cash". Is it enough for you/your investor to take the risk to do the deal (remember: someone also has to provide a completion guaranty to the const. lender).

Also, I am giving you rental project numbers in this post, it may be likely that selling the unit as a duplex condo, can produce more on a per unit sale basis than a rental unit of the same size, it depends on how aggressive the condo buyer is, and how much rent you could get for that unit. My analysis above does not take these differences into account. But pull the comps for condo sales in new duplex units, and pull comps from newly build rental duplex, and if the condo prices are higher, generally you might build and sell as a condo. If your orientation is long term hold rental, you may choose to overlook this condo build vs. rental build, in order to keep the unit as a rental.

Developing a deal is a hell of a lot of work, and the returns need to be sufficient to spend the time, energy, and money that you will need to, to do the deal. Sometimes it's enough, sometimes not.

So bottom line, developing a deal should generally produce additional value above a straight purchase (the 1.5% example value diff. above). This is the economic return for doing the extra work of acquire, build, rent, sell/lease. Those are all things above and beyond what you are required to do in a straight purchase. Not everyone can do that, and if you can, that value differential is yours for the taking.

~ Scott

Bill S. · Answer

@Alyssa Healey I realize I'm a bit late on this post but thought I would respond. $300k for a duplex lot is a pretty good price. Generally speaking, the current market doesn't provide good economics to construct new small multifamily units. Look around you don't see any similar projects do you? Without having specific numbers, just knowledge in general, the cost to construct and the cost of land mean that in the end you trade one break even property for another. You do come out with more building but most folks turn around and sell each half of the duplex. Currently they are taking the money in the hand vs brain damage of managing a break even rental. The other thing to consider that the new units will be larger. You stated a $5,500 per month in rent so that is about $2,750 per side. Most folks who can afford $2,750 a month in rent are buying their own place. For those that are not buying, you are competing with all those brand new apartment complexes with saltwater pools and fitness centers who are renting similar square footage at similar prices.

I too would be interested in the property if you don't buy it.

Matt M. · Answer

Location will determine if that price is a deal. $200sqft is a decent starting price for construction costs. Start with the ARV and work backwards to see if it makes sense. I'd be potential buyer if you pass on it.