Beyond Value-Add - Why I'm Expanding into Ground-Up Development

Over the past year, I’ve taken a deep dive into ground-up development, analyzing many multifamily development opportunities. You might wonder, "Why now, when value-add investing is one of the few strategies that work well in this market?" This week’s article outlines my reasoning as well as the pros and cons of development.

The Current Landscape: Value-Add Reigns Supreme

It's no secret that the value-add strategy has been the darling of multifamily real estate investing over the past 24 months. Thanks to the interest rate surge during 2022 and 2023, sale prices have slid dramatically, allowing for reduced entry prices. Discounts of up to 25% from peak values are not uncommon. For value-add investors like myself, this moment in time presents a golden opportunity to buy low and sell high.

All the while, ground-up developers are facing significant headwinds. In a value-add deal, 80% of the total cost is real estate, and 20% is construction costs. Development is the opposite. Ground-up projects typically are made up of 90% construction costs and only 10% of the cost is the actual real estate. The discounted real estate doesn’t move the needle much for the overall project cost, especially today when construction costs remain stubbornly high. It’s no surprise that very few ground-up deals pencil out at the moment.

So Why Choose Now to Venture into Ground-Up Development?

The answer lies in positioning myself and my business for growth. While the current market favors value-add, I believe the good times for development will return soon. Here's why ground-up development makes sense for Ridgeview:

1. Expanded Deal Flow: I'm significantly increasing my potential deal pipeline by adding development capabilities. I can now consider both existing properties and development opportunities, giving me more options to grow consistently.

2. Higher Returns: To balance out the added complexity, development deals are underwritten to bring greater returns. A value-add deal might be underwritten to stabilize at 7% cash-on-cash, meanwhile a development deal in the same market might target 10%.

3. Avoiding Rent Control: I avoid investing in cities with rent control laws. However, these cities usually offer 15-20 year exemptions for new developments. This opens up markets that might otherwise be too risky, namely Minneapolis (which is likely to add rent control) and St. Paul.

4. Community Impact: Developers help alleviate the growing housing demand by creating new housing units. Whether a developer builds luxury units or workforce housing, any addition of new housing contributes to lower rents overall.

5. Investing in Newer Buildings: Ground-up development allows me to create thoroughly modern buildings that are easy to lease and maintain. This not only attracts quality tenants but also helps with long-term leasing and maintenance employee retention.

6. Sustainability Focus: Modern apartment buildings are better able to incorporate cutting-edge green building practices and technologies, aligning with my commitment to sustainability.

The Risks and Challenges

Of course, this new venture isn't without its challenges. Ground-up development comes with additional risks and complexities:

• Construction Risk: From supply chain issues to labor shortages, ground-up multifamily projects can face numerous hurdles not found in value-add investments.

• Longer Timeline To Stabilize: Cash flow often starts 2-3 years after a development project has broken ground, whereas value-add usually only takes 1-2 years.

• Tax Considerations: Bonus depreciation benefits are unavailable until construction is completed, typically in Year 2 or 3. With value-add, we benefit from those paper losses immediately.

Looking to the Future

Ridgeview's path forward involves incorporating both the value-add and ground-up development strategies. This move into development is a calculated step that balances added complexity and risk during construction with the potential for better long-term returns.

I'm excited about the opportunities this expansion brings and look forward to sharing my progress. Stay tuned for updates on future projects, and as always, thank you for your continued trust and support.

-Ben Michel

Ben Michel is the founder of Ridgeview Property Group, an investment firm specializing in multifamily real estate. Register Here to be notified of available investment opportunities.