Develop or Buy Your Portfolio?
I recently had a discussion with a fellow real estate investor who is focused on new development in NYC. Given how low yields are in NYC real estate, he beleives that the only real value play right now is to develop your way to a decent yield. He’d rather take the development risk and try to build to a 6% or 7% yield on cost rather than buying at a 4% or 5%. This is a completely valid way to think about real estate, and there are legions of developers who’ve gotten rich doing exactly that.
However, it’s not something that I would want to pursue for a few reasons. Developing ties up your cash flow for multi-year periods in which you don’t earn a return — your project generally isn’t generating enough cash flow to cover operating expenses and debt service until 12–18 months after you’ve opened, in addition to the construction period. You could be looking at 4 or 5 years before you get an initial return on your invested capital. That said if the deal hits you’ve created significant equity value that you can recoup. However, that’s far from a given with all the risks inherent with development.
Let’s put some numbers to this. If you invested $1,000,000 at a year 1 cash-on-cash return of 8% (for the simplicity’s sake let’s say you are not using debt), cash flow grew at 2% per year over a five-year hold period you’d have earned $416k in incremental cash flow that you can use to invest elsewhere. Further, even if you’re only able to sell it for what you bought it for, you make a high-single digit return, nothing to sneeze at. If you developed an asset, you’re stuck with that one until you’re able to refinance at stabilization, at a minimum, and if you can’t refinance or sell due to market conditions or asset performance you’re in real trouble. Developing is sexy, and potentially extremely lucrative — however when times get rough there’s something to be said for buying stable, durable cash flow that can backstop your returns and reduce your risk.
