An Analysis of Rehab vs. New Build in Rural Development
To rehabilitate an existing building or to build from the ground up, that is the question. It’s a dilemma that plays out with rural investments in particular because rural towns usually have many vacant lots and dilapidated buildings from which to choose. Hi, welcome to Bring Back the Bustle, a podcast about revitalizing rural America. I’m Shavon Jones, your host.
This week we’re discussing the impact of the rehab versus new build decision on rural investment returns. So that’s where we’re going to end up—with a formula or process for deciding. But it will take us a while to get there because investment returns depend on cash outflows and cash inflows. How much did you have to invest to earn a certain amount of profit? Notice, I did not say revenue. I said profit. Let’s keep that in mind throughout the episode. Whether you rehab a space or build a new one can determine profitability for medium-term investments, like the ones we do at the Rural Fund.
There are 3 interrelated factors that weigh most on the rehab versus new build decision. Those are building use, funding sources, and time considerations. Even though these are interrelated factors, let’s take them one at a time. Later, we will merge the considerations to arrive at a process or formula for deciding.
BUILDING USE
Most rural towns have large inventories of both vacant land and abandoned buildings. Typical available buildings include manufacturing plants, retail shops, industrial plants such as cotton gins or rice plants, strip malls, diners and cafes, theaters, school houses, and bus and railroad stations. The buildings are generally in varying degrees of disrepair.
Building use is changing with the shift in the rural economy. The new economy’s primary real estate needs are warehouses (for storage of consumer products sold online), data centers, power plants, and housing.
Also important are what I like to term “quality of life” buildings. They house resident services such as groceries, resort amenities, and recreation and amusement offerings. This real estate is becoming as important as courtyards and green spaces in ensuring the livability of a community.
Conversions
With the exception of warehouse use, the inventory of old buildings tends not to be suited for today’s needs. Older single family homes are often better suited as inns or hotels. Residential real estate has gotten smaller and smaller over the years. Families are unlikely to have private ballrooms or dining rooms large enough to accommodate 40 or 50 guests as was the custom of yore.
It is architecturally possible to remodel some older buildings to house quality of life projects. But the rehab process for such conversions may be extensive and time consuming, and may drag down profitability. While older buildings tend to be sturdier and more soundproof than new construction, the plumbing and wiring are outdated.
Also, while houses were larger before the 20th Century, commercial buildings were considerably smaller. So, it’s necessary to retrofit the building and enlarge its footprint. Depending on the funding sources, a gut renovation may not be possible, and an add-on may not be simple.
If you can’t find a building that can be converted, in rural areas, space generally isn’t a problem. There usually is ample vacant land available for development. The downsides to new construction are:
- the location of the vacant land may not be ideal, and
- the project won’t qualify for historic preservation incentives or certain incentives set aside for new investors.
Which leads us to a discussion of funding sources.
FUNDING SOURCES
Do you have more time than money? Because incentive money is not free. You pay for it in time, concessions, and money. It takes time to apply. There are generally requirements to get the incentives such as creating local jobs or holding the investment for a specified period of time. There are also out-of-pocket expenses such as application fees, consultant’s fees and/or finance charges.
Do you already own the land or property to be used for the project? Assuming the site is suitable and that you’re not forcing the project into a site simply because you don’t want to buy an appropriate site, then your owning the site may open up additional funding sources. It may also eliminate some costs as such fees (and time) to secure zoning or variance approval.
Is it a ground lease or fee simple ownership? A ground lease means not only paying rent, but also losing the value of your equity at the end of the lease term. It means having a lower price when you exit the investment since your buyer will take into account potential rent increases at the end of the lease term and the limitations that the ground lease places on their future exit options.
Is the property part of the incentive package? If the government is giving you the land, building or a ground lease as an incentive, then using the land grant results in a savings of whatever it would have cost to acquire the property. But can you afford to accept the land grant?
TIME CONSIDERATIONS
The answer to that question may depend upon whether you already have a customer waiting for the project. How quickly an investor needs the asset in service often is the decisive factor in rehab versus new build analyses.
For Rural Fund projects, we take into account the most likely customer for each project. If the projected early adopter is the construction team building the data center, then the project needs to be brought to market quickly to maximize revenues to be earned during the years the facility is being built. By contrast, if the end user is likely to be a permanent resident, we can pursue incentives that have a longer application process.
For power plants, the demand for energy is immediate. There’s usually a power purchase agreement in place. Meaning the revenues will flow as soon as the project is operational. Such a project could lose money chasing small incentives. Thus, investors in power plants should choose only the funding sources that can be accessed without delaying the project or that are so large that the value of the incentive outweighs any delay necessary to secure it.
We’re talking about investments here; we’re talking about money. So, you have to run the numbers.
Impact on Profitability
For a medium term investment, such as opportunity zone investments, which have a ten-year horizon, how much money investors earn during the holding period may depend on how they financed construction and how quickly they deliver the project.
If the project was self-financed, then that is part of the investment which must be recouped before you earn a return. If, on the other hand, the project was financed with incentives, then the amount of incentive received is profit to the investors.
However, securing incentives takes time. Any delay in bringing the project to market means loss revenue. Thus, to the extent that the incentive application process caused a delay in the delivery of the project, the profit attributable to incentives must be reduced by the profit the project would have earned during the weeks and months spent securing the incentives.
This calculation should be done as part of the planning process when the investor is deciding how to finance construction and whether to rehab or do a new build.
Which is Better?
So, which is better? Should you rehab or build from the ground up? It depends. There are fewer incentives available for new build. However, unless a building is highly convertible and gut renovation is permissible, new build is generally faster. To repeat myself, do you have more time than money? If you forgo the incentive money, do you have adequate alternative sources? Is the incentive money a lot? For example, opportunity zone money is potentially more than 20% extra money in your pocket. If you forgo the incentive money can you make it up in other profits such as operating profits or gain on exit? Run the numbers and find out before you close on the site.
At the Rural Fund, sometimes we build from the ground; sometimes we rehab. If you invest with us, you can trust us to make a data-driven decision for each project. We are in the midst of a capital campaign. The minimum investment for this round of funding is $50,000. Visit our website ruralqrof.com for more information.
I’m Shavon Jones. I hope you’ve been enriched by this analysis of the rehab versus new build question. I’ll be here again next week, and I hope you will be too.
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