Hi Andy,
I recently looked into this for legal suite development and there are no construction loans / take out loans available at this time for SFH investors available through a bank (to my knowledge). I work in land development and we typically have a capital funding structure of land equity, cash equity, construction loan, mezzanine loan, and take out loan. I believe that the problem for smaller investors / developers is that the margin is so small for large banks that placement of this capital is really not worthwhile. Typically the bank will change 50-60 BPS on a loan (0.5%-0.6%), which is substantial on a loan worth a few million dollars but only about $100 for a $20,000 loan...not really worth the banker's time. Obviously, the risk for the bank far outweighs the likeliness of payback with smaller investors.
Most of the examples I've seen use private money to make the initial purchase and then refinance with a traditional lender, often within months of the initial purchase.
Yes, this is a business system that can be done but probably will not be executed properly without experience in building and a willingness to do a large majority of the work yourself. If you are hiring a GC to complete the renovations you are ultimately going to pay the exact same total price for the home
after renovations as you would for a similar home that did not need the renovations. The developer's margin is earned by having some construction management experience in execution and completing the renovations yourself to some extent.
However, there are ways to use the developer's strategy for smaller investors....(I would avoid using private money if at all possible)
Develop - refinance - hold strategy:
1. First of all, gain an understanding of the property yield = NOI / property cost. (NOI is equal to revenue less vacancy less expenses, before debt). If you are properly developing a legal suite in Edmonton or apartment, this is going to be somewhere between 4 - 6%. Keep in mind any time you promise to pay someone more than that 4 - 6% return you are paying them more than the property is able to make on a monthly basis.
2. Build a pro forma for development: Project cost, development cash flow, equity cash flow, operating cash flow statement (at minimum). This assesses the feasibility of the project. Ensure you include all of the financing costs during development (interest and principal). Until you see that cash back it is a investment. If you use private money, add that financing cost into the project cost as well. Ensure you have a development margin = project market value - project cost. (Real market value is what you receive after liquidation costs - Realtor, legal fees, financing penalties). Use a line of credit as your source for construction loan financing. Add in the interest cost of this to the project cost.
3. Build an operating cash flow based on real market achievable expenses and revenue. Take a look at the return on cash equity...can you live with the returns?
4. Go buy the home if it makes sense. Have a conversation with your broker about refinancing the home early after renovations. Ensure your loan allows for this. Repay the LOC using mortgage funds.
As I’m sure you can imagine, your monthly cash flow is going to get pretty squeezed after you bump up your mortgage to repay your line of credit. If you used a GC, you will not get all of the cash back that you spent with the LOC because the bank is going to be more conservative on the valuation and you will end up having cash invested in the LOC: an extra monthly payment that will put pressure on your monthly cash flow. In the end, you need to look very carefully at whether you are better off to just buy an already upgraded suite rather than to leverage yourself up and develop the unit yourself.
Keep in mind that if you performed any substantial renovations you have “invested” several months of interest and principal costs into the property. That is another $6 – 7k. As you can probably start to see from the numbers above the margin is getting smaller and smaller. There just isn’t a lot of margin in developing a single family home. You need to go bigger so there is more margin in the development - refinance - hold strategy.
When you look at development for rentals, generally the mindset isn’t “flip”. The mindset should be "How can I make this a solid long-term investment is low repairs and maintenance?" It isn’t about the quick fix, it is about the permanent fix that pays off in the long term.
Because of the low yield of real estate, it should be thought of as somewhere to put your money after you have saved up a fair amount of it and want to protect it over the long term. If you want to make a cash play, you are usually better to build houses and sell them retail.
