Real Estate: It’s Almost Always Better To Build Than To Buy

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Real estate is one of my favorite asset classes to build wealth because it’s relatively easy to understand, has tax benefits, is tangible, and provides utility. Let me share another reason why real estate might be a great part of your retirement strategy in this post.

Back in 2001, I spoke to a friend in the construction business who told me, “It’s always better to build than to buy.” I couldn’t afford a single-family home in San Francisco then, but I kept his advice in the back of my mind.

At the end of 2004, I finally saved up a large enough down payment to buy the cheapest house I could find in the north end of San Francisco. It traded at a discount to comparables because it was on a busy street, in between busy streets. But, it was a single family home with three bedrooms, one full bathroom, and two half bathrooms. And gosh darn it, I was determined not to live a lower quality life than my parents!

With three bedrooms on the top floor and only one full bathroom, I decided to blow out a closet and create a Jack and Jill bathroom for the other two bedrooms. The price tag? $24,000 after materials, labor, and permits. Value created? Surely someone would find having another full bathroom rather than a closet to be worth at least another $24,000, no? Run comparables in the neighborhood to see how much more a house of similar size with two full bathrooms are worth compared to only one full bathroom. Renovations rarely recoup 100% of the cost, but adding a feature does.

Despite my remodeling efforts, I realized I could do something more, but I didn’t have enough money until a decade later. That something more was to expand.

PROPERTY VALUATION ARBITRAGE

The north end of San Francisco – Pacific Heights, Cow Hollow, Marina, Presidio Heights – sells for $800 – $2,000 a square foot, depending on location, view, and condition. Location is clearly the most important mantra to buying a property with long-term appreciation potential. Today I’ll argue that expanding a property might be an even better way to make money in real estate.

Although my house isn’t on the best block, it’s in a good area that could sell for up to $1,100 a square foot based on my neighbor who sold their place in mid-2014 for $1,185 a square foot, with a nice remodel.

When I bought my property in 2004, I noticed that my left neighbor went back 13 feet, while my right neighbor went back the full length of my house because he hugged a perpendicular street. In other words, I knew I could expand by at least 13 feet back since the city allows for one to expand up to your neighbor’s depth. If I leave five feet of space between my right neighbor and myself to comply with fire safety regulations, I can expand by 13 ft. X 20 ft. = 260 sqft per level. Given I have three levels, that’s 780 square feet of legitimate expansion potential.

780 sqft X $1,100 = $858,000. Let’s be more conservative and peg a $900/sqft selling price = $702,000. $702,000 – $858,000 is the theoretical value created by adding an additional 780 sqft to the back of my home. Now let’s take a look at the costs.

Cost To Build

According to my contractor — who is currently building a master bathroom in a fixer-upper property I purchased in 2014 (a project I may write about at a later time) — it costs ~$200/sqft to build a basic completed room with hardwood floors, moldings, and electrical. It will cost him closer to $250/sqft since plumbing is involved.

A build cost of $200 – $250/sqft is in the ballpark because I’m paying $310/sqft to build the bathroom in my fixer. My costs are higher than his estimate because I’ve decided to go all out: high-end tile, double vanity, double showerhead, hot tub, electrical toilet seat and other fixtures.

FS-hot-tub

You only live once right? I’ll happily spend $55,000 on a master bathroom and drive a $20,000 Honda Fit than the other way around. My plan is to live in the home after the project is done for at least five years and either rent out the home or sell.

Value Creation

After my contractor is finished building the bathroom in my fixer upper, I’m going to ask him to draw up some plans to submit to the Department of Building Inspection to expand my north end house by 760 square feet at a cost of no more than $300/sqft. Given he would just be expanding the ground floor room, creating a family room off the kitchen on the second floor, and enlarging the top floor bedroom, $300/sqft is generous.

The total construction cost is roughly $228,000 (760 sqft X $300). What goes into this cost?

  • Architectural and engineering drawings
  • Electrical, building, plumbing, mechanical permits
  • Material costs such as lumber, paint, doors, windows
  • Labor and overage time

The estimated time for completion is seven months: three months to get approval, four months to build. As good practice, one should always increase the estimate time and cost by 50%. Therefore, the project could take 11 months to build and cost up to $342,000.

Value arbitrage: The estimated low-end return is $702,000 – $342,000 = $360,000 over 11 months for a 105% return. The estimated high-end return is up to $858,000 – $228,000 = $630,000 in seven months for a 276% return.

THE DOWNSIDES TO EXPANSION

When you expand your property you’re creating more value and the city will tax you based on that value you’ve created. In San Francisco, property tax runs about 1.17% of the value of your property indexed to the initial purchase price plus an inflation index. For those who bought 50 years ago, thanks to Proposition 13, they are paying a much lower property tax than those who are purchasing property today as prices have far surpassed inflation.

Despite having to pay more property taxes after an expansion, the upside is that the property tax is based on the cost of construction and not based on the market value of the property, which is subjective. The property might indeed sell for $800 – $1,100 a square foot, but nobody knows for sure until the property is sold. What is for sure is the construction cost of the project because the building department must sign off on the plan and issue a permit based on the cost of construction.

The other downside to expansion is that it takes money that could otherwise be used for other investment purposes. During the downturn, there were people who were overzealous about property expansion and ended up having to fire sale their property due to a liquidity crunch. Before starting an expansion project, carefully run realistic worst case cash flow numbers to see how long you can survive before your money runs out. Having two years of cash flow is a good guideline.

Finally, do not confuse remodeling/renovation with property expansion. Remodeling/renovation is making new an existing living space. Property expansion is creating additional living space that gets inputted into the value of a property when being sold. People often erroneously assume that just because they spend $50,000 remodeling a kitchen that they’ll get more than $50,000 in return when it’s time to sell.

Take a look at the cost / value figures.

Chart 1

Chart 2

Source: remodeling.hw.net

As you can see from the above charts, remodeling seldom recoups 100% of the cost of remodeling.

KEY TAKEAWAYS FOR VALUE CREATION

In order for such property value creation to work, you’ve got to:

  1. Buy property that has expansion potential.
  2. Buy property where the selling price based on all the research you’ve done is at least 50% more than the construction costs.
  3. Find a highly recommended contractor and never let him go.
  4. Do not confuse remodeling with expanding. Focus on building new livable square footage if you want to maximize value.

A Hansgroghe 10” showerhead will cost ~$750 anywhere you live in the country. But the labor cost will be different. What’s also tricky is that contractors may tend to charge you more if you have a more expensive house within your city because they feel they can take advantage of you. Don’t let them.

Expanding is kind of like hell on Earth if you don’t have an honest contractor who sticks to a schedule and a budget. But if you can find one who is honest, meticulous, and within budget, it behooves you to expand by as much as your city or county will allow. It just might take a lot of cash and patience to do so!

Readers, have you gone through any remodeling, fixing, and flipping before? How did it go and how much was construction cost in your area?

Regards,

Sam

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Financial Samurai

Sam is the former Managing Editor of the Daily Capital blog. He worked in finance from 1999-2012 before deciding to focus full-time on his online endeavors - FinancialSamurai.com and the Yakezie Network. Sam is an avid tennis fan who loves to travel. He received his BA from William & Mary and his MBA from UC Berkeley.

19 comments

  1. Julia

    EXCELLENT article Sam! I’m just now late 2013 started back to normalcy: I went through a nightmare of an expansion & remodel that started Spring yr 2000 to Summer 2002! Fall/Winter 2000-2001 trying to heat home bills were $500+exposed areas, frozen pipes/busted, etc. I think the contractor wanted to move in with me! but, I took him to muni court and the judge ordered him to finish or he’ll send the case to the big court because he collected $20,000; so, he 97% completed project and left $25,000+ on the table;I ended up ahead with a solid, well insulated house: whole new roof and siding, upgraded amp/electrical, outdoor outlets & lighting +3 flr levels of hard wired smoke detectors, a Bow window in LR +Picture window and improved adjacent den/office, a lager DR w/quality sliding glass doors+ back steps and 2 small closets, a larger Ktch w/a small bath & Shwr in a large entry w/quality insulated door+ storm door w/backdoor steps~ Plus my huge master BR w/2 full closets dream that started this Project and a larger adjacent BR upstairs! No equity loan was taken; I had borrowed $25,000 from my 401K which I paid myself back within 16 months.

    Reply
    • Financial Samurai

      Congrats on making it through the nightmare! A trustworthy, dependable contractor is priceless isn’t s/he?

      Enjoy your new finishes!

      Reply
  2. Dave

    I love doing a project every year or so on my home. Over the last few years I built new steps on the sides of my house because the old ones had totally degraded. Now it’s much safer and easier to walk around to the backyard and finally having handrails is a big help. Last year I resurfaced my driveway which looked great until it snowed and covered most of it up. But I’m looking forward to the spring when all the snow will have melted and it’ll be easier to get in and out of the car again.

    Reply
    • Financial Samurai

      I saw my parents struggle up the stairs without handrails when I took mine off to paint the house. They were actually an interesting test subject that helped me buy the right furniture (bench to sit down and put shoes on) and more to help them out.

      Come out to California! You can enjoy the outdoors all year around!

      Reply
  3. Stefanie

    Hi Sam – Interesting article! I’m confused about the chart you posted toward the end. Replacing a garage door shows up on the chart twice, first showing a >100% return, and the second time showing a loss (lines 2 and 8). What’s the difference? I’m also surprised to see that adding a bathroom carries a negative return, which, while it doesn’t “expand” a home, it does add a feature which makes that data point contradictory to your article in some ways. Am i reading it wrong?

    Reply
  4. HKR

    Your article makes many excellent points, and I think your four takeaways should definitely yield a return if followed, however I think that remodeling and expansion are things that your average person should approach with extreme caution. You have obviously done your homework and made very well thought out choices to yield the most value, but I think too many people believe they know enough and have done enough research to take on this type of project and make money on their investment, like this story or so many HGTV type shows demonstrate, when the reality is if it were that easy, everyone would do it and the returns wouldn’t be nearly so good. As a lender, I’ve seen and heard of many cases where returns were less than satisfactory or non-existent. Unfortunately, stories about people who invest $30,000 in adding a new bedroom and expanding kitchen/bath only to have the home’s value increased by $600 do not make for good TV, so the average person is less aware of these outcomes but the fact is, they happen. Again I think you absolutely prove that money can be made, and your guidelines for choosing a property and expansion projects are sound, but I hope that the advice is taken with caution by those who have less experience with real estate and construction.

    Reply
  5. Brad

    As an architect, I heartily agree that real estate is one of the best investments around! That said, the disclaimers on real estate returns are substantial. Supply & demand, along with construction cost are so location specific that few broad conclusions can be made. From my limited knowledge, the supply and demand gap in San Francisco is so large that the return for improvements you describe seem possible. However, analyze a more moderate market, and you might find the net increase in appraised value barely covers the cost of similar improvements. I agree with the warnings against “remodeling”.

    Just like investing in equities, people are equally illogical with real estate. They purchase at highs, diminishing long term returns. All real estate is not equal and managing it using emotion frequently leads to poor returns. My experience is the best returns in real estate are made by those outside of a personal home. Furthermore, those returns are enhanced by purchasing property at relatively low prices using low interest rates and leasing the property for income. Flipping is often tax inefficient (unless a 1041 exchange is utilized) and given the challenges involved, doesn’t reward the risk well compared to leasing an improved property for years on end.

    Final plug, consider hiring architects for projects! Similar to your endorsement for contractors, a good architect is huge asset.

    Reply
  6. Paul

    I’m sorry, I’m still stuck on the notion that some people are actually willing to pay $800-$2000 per square foot for a property!!! $100/sq ft is the going rate in my area for a nice house in a nice neighborhood. We paid $246K for a 2,400 sq ft home a few years ago. Original owner had it built in 1993 for $219K, plus they added a small 2-story addition that added 250 sq ft that’s over and above the 2,400 sq ft listed because it’s an unheated 3-season room. So we got it below cost after you factor in inflation and upgrades. People pay ridiculous sums of money for real estate in some areas of the country. That’s how bubbles are formed (housing prices in these parts never even blipped during the recession.). Some people never learn I guess.

    Reply
  7. Rachel

    I would argue that this might work in a location like San Fransisco, however in my area it is the complete opposite. I am in Atlanta, and have purchased properties for as little as S32/sq ft in 2012 and most recently $60/ sq ft in Jan of 2015. There is no value in a buying a property to expand to increase value. At $200 a square foot, I might as well go buy another whole house and get it rented out for double my money.
    I congratulate you on your great find (i know the pacific heights area is booming) and wish you the best of luck!!

    Rachel

    Reply
  8. Tim

    It seems that the most likely places where this will work are in places where the *land* is very expensive. San Francisco, New York City, and similar locales. In the vast majority of locations across the country, particularly non-urban, home values per square foot are closely associated with construction costs, so there’s not going to be an easy, “instant equity” opportunity.

    In my area, the next best thing is to finish a basement into usable, livable square footage. Assuming a properly-sized home to begin with, the next result can be 250% increased value over cost. Of course, on difference is the actual dollars are much, much lower, so the reward for dealing with the inconvenience of constant construction may not be as enticing.

    Reply
  9. BM

    “Real Estate: It’s Almost Always Better To Build Than To Buy”… Would you say that generally applies throughout the U.S. or just in San Francisco?

    Reply
  10. Michael

    Sam interesting article! It would be worthwhile to find where the ratio works best! Is there a database to search where one can find a list of average sale price/sq foot? And possible a place to find average construction cost/sq ft to compare?

    Thanks

    Michael

    Reply
  11. Focus Property Management

    Buy properties with expansion potential – this seems to be a lot of work but really profitable if done right. Thanks for sharing your experience, Sam. Great article!

    Reply
  12. Fountain Property Group

    Great one, Sam! I’ve never read a piece about valuation and property value creation as detailed as this. Very helpful information for investors.

    Reply
  13. WA Strata Management

    This is really helpful information for those looking at improving the value of their property. This is advantage of a single family home; you can have the freedom to improve/expand it unlike a strata property.

    Reply
  14. Chase Wilson

    Interesting. I have always heard that recycling and using stuff that is old is so much better, but if you can build that much money off of building then it totally makes sense. I have never built a house before, is it a huge headache, or does it generally go pretty smoothly?

    Reply
  15. Smithd196

    Hello there! This post could not be written any better! Reading this post reminds me of my good old room mate! He always kept talking about this. I will forward this page to him. Fairly certain he will have a good read. Thank you for sharing! edbkgeedckdcaadc

    Reply
  16. Yolanda

    Great article. Housing is a consistent and urgent need for everyone. When you build a house you can get to pick out all the colors, type of tiles, cabinet design, etc by yourself besides the house cost would be cheaper than buy. Whereas when you buy an existing home you can move into it right away, usually within 30 days. However, the design and materials used in the home are usually not what you would pick or what you want. So all of this depend on each person needs according to their budget as well. But for you who think build is best choice, you need to meet with your builders to decide the home you want. I recommend http://www.biesterbos.nl as your best option. They do lots of eco friendly house project with cost effective. Maybe you can get solution about housing from the experts.

    Reply
  17. Hannah Schroeder

    I like what you said about buying property with a selling price that’s 50 percent more than what it costs to build a house. My husband and I can’t decide if we want to buy a house or buy property and build to accommodate our growing family. If we get something with a resale value higher than the construction costs, we can make money if we ever decide to move.

    Reply

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