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What is preconstruction real estate investing?

Preconstruction real estate investing is purchasing a property (single family home, condo etc) after it has been planned but before it has been built. Builders will sell you their pre construction properties substantially below appraised value if you commit to buy before the property has been built. Builders give this discount because it helps them to secure financing on their project from the bank. They sell some units in their project to pre construction investors and some at retail price to end buyers.

While realizing huge profits in pre construction real estate is certainly possible, it has its pros and cons.
 
Can you give me an example of a typical preconstruction investing opportunity?
A developer prepares to buy land in Miami, Florida on which he plans to build a 100 unit condominium building. He goes to a bank to request financing for his project for both the acquisition of land and the cost of building the condos. After reviewing the developer's plan and previous track record, the bank approves the loan on the condition that the developer has to pre-sell 50 units before he will receive any funding. 

In order make the bank comfortable to loan the money to him, the developer goes to preconstruction real estate investors like you and says "Mr. and Mrs. Investor, I am building condos in Miami, Florida just a few blocks from the ocean and the beach. After they are built these condos will be worth 300k. I am willing to sell you these condos for 270k if you agree to buy my condos and put up a refundable 10k in escrow as reservation deposit".
You review the plans, appraisal reports and do your due diligence. After completing your research you agree to buy one condo and sign the reservation agreement to buy the condo for 270k when the construction is complete. You put up a refundable 10k in escrow as per the terms of the reservation agreement.
The investor talks to several other preconstruction investors and is able to get 50 reservation contracts. At this point he goes back to the bank and gets his financing approved. Now he asks all the preconstruction investors to increase their deposit to a non-refundable 10% of the purchase price of 27k. Also you have to sign a contract with exact terms and conditions of the sale. You increase your deposit to 27k and sign this contract with the developer.
Developer starts the construction work on the condos. Now you wait for the condos to be completed, the timeline for which is 12 months. In the meantime Miami condo market experiences 10% appreciation during those 12 months during which the construction was taking place. As a result, the value of your condo has increase from 300k to 330k.
After the construction of the condo building is complete you close on your unit. You rent your condo out for two years. During those two years, Miami real estate market experiences appreciation of 5% per year. So the value of your condo has gone up to 364k. At this point you decide to sell your condo and cash out. Your total profit before deducting closing cost and holding cost is a solid 97k in three years.

What are the types of incentives that developers offer in preconstruction real estate?

1. Below market value prices: Developers will offer to sell you preconstruction real estate at below market value prices. This is also called instant equity.

2. Cash Back after closing: To attract preconstruction real estate investors, developers will often offer some cash back after closing. Of course, the lender has to agree to it.

3. Closing cost credit: Closing cost for the pre-construction investor maybe by paid by the builder in part or in full.

4. Free Upgrades: Developers may offer to provide free upgrades to move their preconstruction projects fast. e.g. granite countertops, plasma TVs, furniture package.

5. Rental Guarantee (also called lease back): Sometimes the developer will agree to manage the property on behalf of the investor for one or two years....and the developer will guarantee a certain amount of rent to the investor whether or not the property is rented. This works out for most pre-construction investors because they plan on selling it after one or two years anyways. So, in the meantime they don't have the hassle of managing the property. Free property management for one or two years.

6. No Home Owners Association fees for up to two years: Developers may offer to pay your association fees for a specific time period.

7. No property taxes for up to two years: Again, as part of the incentive package, developers may offer to pay your real estate taxes for a specified length of time.

8. No management fees for a few years: A lot of times investors do not live in the state. Developers may offer free management services for a few years as an added bonus.

9. Free Home Warranty for few years: As an investor renting out a property, you do not want to worry about refrigerators not working or furnaces breaking down. Developers may cover the cost of a home warranty.

Why should I invest in preconstruction real estate?

There are many reasons to invest in preconstruction real estate deals. It depends on if you are buying it to live in, rent out, or sell. But the common reason to all types of pre construction investors is getting instant equity. Because most preconstruction deals are offered at below market value, you get equity in the property at closing. This is an extremely advantageous situation not available in other forms of real estate investing. 

Other big reasons for investing in preconstruction real estate is appreciation and leverage. Since most pre construction real estate opportunities are in very desirable areas, these properties can appreciate quite a lot. If you would have invested in a good preconstruction deal in Las Vegas or Florida in last few years, for example, you could have seen a return on investment of even more than 100%.
In pre-construction investing, you only put up a few thousand dollars to have the right to buy a property which is worth several hundred thousand or more. Since the property can appreciate even while the construction is going on, you have the potential to benefit from both appreciation and instant equity with very little earnest money. Leverage is controlling more with less and preconstruction investment is a great situation to use leverage.
In some situation developers may provide other kind of incentives to preconstruction investors. 

To sum it up below are the major reasons why preconstruction real estate investing is profitable:
 

1. Instant Equity: because you are buying below market value

2. Appreciation potential: you can benefit from appreciation while your project is being built or appreciation after you have bought your property.

3. Leverage: You control something worth way more than the money you put up in escrow.

4. Other incentives: Rental guarantee, free upgrades, taxes paid for two years, etc.

Why does the developer sell at below market value prices?
Typically, developers plan subdivisions as opposed to just building a home here and there. The financing for such projects is in the multi-million…if not the multi-billion…dollar range. Lenders don’t like to lend that kind of money without some sort of reassurance that the developer is planning a project that will sell. Most lenders require developers to have a certain percentage (usually half) of their units under contract before the lender will loan them money. This means that the developer has to sell their product even before they break ground. It is difficult to sell, and risky to buy, a property that has not been built yet. This is where you, as a pre construction investor, come in and help out the developer by committing to buy one or more of his homes even before construction has began. In return, to make the deal attractive to you and make the risk worth taking, the developer will give you below market value prices. This is what is called pre construction investing.

How much money is required to buy pre-construction real estate?
Usually anywhere from a few thousand dollars to 20% of the purchase price. When it comes to preconstruction real estate investing, the possibility of a no-money-down deal is extremely difficult if not impossible. Developers are not in the market of holding property. They want to know that you are going to close when the time comes. Therefore, developers will require a 5k-10k earnest money deposit and up to 20% down payment. This way the developer ensures that he only deals with serious pre-construction investors.

What are the steps and the timeline for a typical pre-construction real estate project?

1. Developer purchases land or owns option to purchase land.

2. Developer plans the project with engineers, architects, excavators, etc.

3. Developer gets approval from the local government. Steps 2 and 3 may be repeated a few times.

4. Developer applies for financing.

5. Financing is approved contingent upon developer pre-selling a set percentage of the units. They could be pre-sold to pre-construction investors or to home buyers. But usually home buyers are not sophisticated enough to buy something which hasn't been built yet. Therefore, the developers only option is to work with pre-construction real estate investors.

6. Developer markets (or hires someone to market) the project at a below-market-value price and gathers the necessary number of reservations in order to procure financing. This is where pre construction real estate investors can get substantial discount.

7. Developer purchases the land, if not already owned.

8. Developer finalizes all plans and gets the necessary legal paperwork done.

9. Developer converts the reservations gathered in step 6 to actual purchase contracts and, at this time, may choose to sell more units at a higher price.

10. Developer breaks ground and begins construction. At various stages of this step you may be asked to put down more money.

11. When completed, developer obtains a Certificate of Occupancy from the local government.

12. Final closing takes place.

The timeline of such pre-construction projects can run anywhere from a few months to a few years. It depends on the type of project, how much work needs to be done, and how experienced the developer is. You may have heard of a project being in “phase 1” or “phase 2”. At certain points during the process mentioned above, the developer may raise the price of the remaining units and sell them. This is usually referred to as a phase. The point during the process which this happens is completely up to the developer. For example, let’s say a developer is constructing a new subdivision of 100 homes in Las Vegas, Nevada. When completed, the homes will have a market value somewhere between $350,000 and $375,000. At step 5, the developer needs to pre-sell 50 homes to pre-construction investors to get financing. They are put on the market at a price of $300,000. This is phase one. The developer successfully pre-sells 50 homes and obtains financing.
The developer decides, at step 9, to sell an additional 10 homes to pre-construction investors. But now the price is $315,000 per home. This is phase two. The developer decides to sell the rest of the homes after the first few homes are completed and closed. This would be phase three and would have a selling price very close to market value.
Or the developer could decide not to have a phase two or three at all and just wait until completion to sell the rest.