The Construction Cost Constraint
By Brad Thomason, CPA
June 23, 2015
Several of our firm’s larger clients are real estate investors and we’re involved with project management work for them on a nearly continual basis. As such, we spend an awful lot of time dealing with construction and related activities; far more so than you would expect for a CPA practice (which is part of the reason we don’t have time to do tax work…). So in addition to the standard batch of business periodicals that everyone gets, we also get industry journals for architecture, remodeling, residential construction, and the like. A theme that I have seen in a number of pieces over the past year or so is the “problem” of the starter home, which the home building industry has pretty much realized is a thing of the past.
The issue comes down to some very simple mathematics. But first, a clarification. You can think of two areas of the country when it comes to house pricing. Those counties which touch salt water or those in the proximity of a large inland city (like Dallas or Chicago); and everywhere else. Prices vary widely in the first category from one locality to the next based on a lot of different factors. When you hear people citing the old adage that real estate is about location, location, location, this is the type of place where that applies the most, often because the land itself can carry such a premium. Conversely, in the middle part of the country, there’s a lot more consistency. It is in this area that the following comments most apply.
In general, to build a new house, it costs around $100 per square foot. That number will change a little based on exactly where you are, the grade of the finishes, the caliber of the kitchen appliances and bathroom fixtures, etc. But for the most part, if you want to build a house in Pascagoula, MS, Fort Wayne, IN or Colorado Springs, that’s about what it’s going to run.
So if you need to build a fairly standard 3 bedroom, 2 bath home with around 2500 square feet of living space, you should expect to spend at least $250K to $300K, plus the cost of the land.
Which is all fine and good. Except that a lot of first time home buyers can’t afford to pay that. There’s also the small matter that you can usually buy already-built homes of similar specifications in those areas for $100K to $200K. All day long.
Thus the problem with the starter home as a viable product for the home building industry. But the implications are much farther reaching, and this is an important thing to know for anyone who is investing in any aspect of residential real estate. Because these price differences between new and existing essentially define 2 separate markets.
When we speak of markets, especially in real estate, we tend to think of them as pertaining to a geographical area: one town equals one real estate market. But if you look at the prices, it becomes clear that’s not the case. Even in a given section of a town, you can have more than one market: because you have different groups of buyers looking for different kinds of properties. The value of any particular house needs to be understood within the context of the broader market or markets that exist around it.
For instance, if you buy a new home for your family you may be assuming it will appreciate in value over time. But that appreciation may be constrained if there are large numbers of older homes in the area that are already selling for less than it would cost to replace them if they had to be rebuilt.
Or if you were buying a property to rent, looking in the established areas of town would likely yield a property that had better economic potential for a good cap rate; so looking for prospects in newer neighborhoods could be a waste of time.
Or, if you were thinking about buying a vacant lot on the cheap you might realize after-the-fact that you’d just bought something that was actually worthless: because if you have to try to recover building costs of $100 per foot in a neighborhood where existing stock is selling for $50 per foot, you aren’t going to have a fun time.
There are any number of additional variations on this theme. But you probably get the point.
The present-day cost of construction sets the stage for a disparity between the price of new houses and old houses. The existence of 2 kinds of houses in an area creates any number of forces which act back and forth on each others’ prices. This tendency is the thing which causes traditional home builders to lament the passage of the “starter home.” And it is a factor which real estate investors need to understand from a variety of perspectives if they want to better their odds of doing profitable deals and staying away from the disappointing ones.