Buying in bulk is a strategy many shoppers use to save money. That same strategy can also help real estate investors expand their profits.
Real estate developers typically have to pre-sell a certain percentage of condo or home developments to get a construction loan from banks. In addition to allowing for bank financing, getting the first few units sold tends to help start sales momentum and helps the developers get started on the project more quickly. As a result, developers are often willing to offer huge discounts in order to move large blocks of units. Most investors, though, will likely find it difficult to come up with the funds necessary to purchase a block of condos.
Investors interested in this type of investment should be glad to know that there are now several institutions that work to bring together investors to buy these bulk offerings. These institutions get deep discounts from the developers and pass them along to buyers, who can then buy individual properties at prices much lower than what they could have bought them for if they had purchased directly though the developer.
Most investors, after buying a property as part of a bulk rate discount preconstruction offering, sell it after construction is completed at retail price, often making thousands in profit. This investment strategy is called wholesale preconstruction, bulk preconstruction or preconstruction syndication.
A wholesale preconstruction sale typically involves three players: the developer, the business offering the bulk deal and the investor.
In order to get a construction loan to get a project off the ground, developers must pre-sell a certain percentage of units to a number of different individuals, rather than a corporation or other singular entity. Some developers do this on their own, but it can take three to six months or even longer, according to Eric Jafari, CEO of Bridgepoint Ventures, a preconstruction syndication company.
Marketing condos for pre-selling can be difficult for a developer, who must pay the fees for marketing, sales centers and other expenses out of pocket until approved for a loan. Into this void step bulk preconstruction businesses, which can offer a solution to a developer facing six months of out of pocket expenses.
“We tell the developers that we’ll purchase whatever amount of inventory is needed for them to unlock financing, and we’ll have the entire transaction consummated within 30 to 60 days,” Jafari said. “They can immediately access their construction loan for building the project, and now instead of paying out of pocket…they can use the construction loan to fund those initiatives. It significantly mitigates their risk.”
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Investors looking to get into wholesale preconstruction usually get into it because of the leverage and the rate of return the strategy offers.
“I heard that a lot of money could be made with wholesale construction,” Evan St. Germain, a wholesale preconstruction investor, said in an e-mail interview. “I was surfing the web, trying to find investments that were different from the typical stocks and bonds investments. I found there were a lot of different types of preconstruction investments. A lot of them sounded too good and too easy.”
Many of them are indeed too good to be true, but St. Germain persisted in researching until he found some companies that looked legitimate.
“Eventually, I came across several companies that were offering a similar package, but with condos, and they sounded more professional,” St. Germain said. “The profits could be large. If you bought a $500,000 condo, it would be discounted to $425,000 with $42,500 down….It would then be re-sold for $500,000 and you would have a profit of $75,000, which would be split with the company that arranged the deal. That is an 88 percent return.”
When a project goes well for these companies, the returns can be phenomenal. Axiom, another preconstruction company, claims 40 to 90 percent returns on investment on any given project. Exit strategy timelines with Axiom range from 18 to 36 months, according to their website.
Bridgepoint, meanwhile, has done several projects with a developer in Tennessee, including a land project where their clients put up deposits and the units were flipped within two months for a 40 percent return. The worst return clients got on that project was 17 percent, for a six month return.
For the developer, the benefits of selling preconstruction units lie primarily in being able to unlock financing and get a construction loan.
For the businesses involved in connecting investors and developers for financing a construction project, the benefits are primarily financial. Each bulk preconstruction company takes a cut of the profits made from the eventual re-selling of the project’s units.
To be able to do business with a preconstruction company, investors must do several things. First, the investor must be accredited to mitigate the risk that comes along with an investing strategy that can be speculative.
Each company then has its own process for what comes next. With some companies, after an investor decides to pursue a partnership with the company, they put their funds in escrow. With Bridgepoint, investors put up a letter of credit against their stocks or against a bank-issued CD.
“The way we’ve engineered our program is that we tell the developer that we put up a 10 percent deposit, but we put it up in the form of a letter of credit,” Jafari said. “We’re not going to put up cash, and under no circumstances can you ever access that letter of credit.”
While the developer can use that information to get bank financing, the individual’s money is safe and earning at least a small amount of interest while everyone waits for the project to be completed and the developer to re-sell the units. However, every investor should be aware that these projects can take years to come to fruition.
“Do your homework…find out everything you can about the company before investing any funds,” St. Germain said. “I would talk to others who are already investing with the company and see if they are satisfied….Also, the investor has to remember these can take years before you’re finished.”
There is also risk if a developer does not complete a project, which can happen, particularly in today’s real estate market.
“The biggest issue in this industry is because of the market softening, there have been a number of projects that have gone bust or haven’t proceeded,” Jafari said. “As a result of that, [investors] get their money back, but they only make the 5 percent return from sitting in the CD, and they don’t get the 40 percent return.”
In one scenario, Bridgepoint had to go into litigation against a developer who claimed bankruptcy, Jafari said. Bridgepoint also has several preventative measures in place to encourage developers to follow through on their projects.
For instance, Bridgepoint requires monthly updates from its developers in its contracts and requires the developers to copy all correspondence to the lenders to Bridgepoint as well. If a developer fails to make a monthly update, penalties may be assessed to the developer.
Because banks are looking at these situations as actual contracts, the worst case scenario is that a developer is unable to re-sell and the investor has to close on the unit and get a mortgage.
Investors who choose to invest in preconstruction syndication, or in any investment, need to be sure to do due diligence and have one or more exit strategies.
“I think investors should really do their due diligence,” Jon Thielen, director of acquisitions for NewCondosOnline.com, said. “Truly know the objective—you’re in there to satisfy a pre-sale requirement. Understand why the developer is using you, which is a good thing, because if the principal of the project is working with you on the inside, that’s an advantage to you. Just know the objectives. Know that you may have to close and rent it out. Know your exit strategies.”