Tear-Down Economics

From Worst to First,
or, Housing "Leapfrog"

More than one would-be Seller has quietly harbored the hope that they wouldn't have to spend big money getting their home ready for market -- or face Buyers beating them up on their home's condition -- because, after all, "it's probably a tear-down." Unfortunately, more than 95% of the time, they're wrong.

Forget that many people are retrenching now in the face of a tough economy, or that new home construction is down dramatically and many builders are in full retreat. Most homes aren't tear-down's for the simple reason that the block won't support the new home's price.

Saved by the Wrecking Ball?

First, a caveat. Subject to local zoning rules and your neighbors' forbearance, your home is still your castle. If you want to tear it down and build a new one -- and have the money -- you probably can, even if it makes no economic sense whatsoever. There are plenty of examples where, either because of the owner's attachment to a particular piece of land, long-standing social ties on the block, etc., the location is decided first, the home (and building budget) second.

However, most people contemplating doing a tear-down at least pause to calculate whether it's a good investment. And if it's a builder contemplating doing a new "spec" home (as in "speculative," or, "build it and they will come"), that's the ONLY consideration.

Rules of Thumb

So, you start at the end: How expensive can a new home on the block be before it sticks out? If prevailing prices nearby are $600k - $800k, you can probably go as much as 20% higher (to around $1M), especially if the neighborhood trend is clearly up. However, anything more than that is risky. After all, if your budget for a new home is $1.5M, you'd probably want to build it on a block where the other homes also cost that much.

The other relevant consideration is the established ratio of land to home prices. Conventionally, land accounts for 25%-33% of the total land-plus-home cost. So, most $1M homes sit on lots worth $250k to $333k. Again, common sense suggests why: a $1M home on a $500k lot would feel undersized, while the same home on a $100k lot would seem ridiculously out-of-place.

Combine the foregoing and you come up with a fairly accurate rule of thumb: if the cost of the tear-down multiplied by 3.5 doesn't overshoot the top of the block, the home's a legitimate tear-down candidate. If it does, the answer's "no."

Housing "Leapfrog"

Note that the condition of the home isn't necessarily a consideration.

There are plenty of well-built, well-maintained homes scattered through expensive parts of Edina, Minnetonka, and around the City Lakes that have been torn-down that were not in disrepair. Rather, they typically were the "runt" on a choice block where the surrounding homes gradually became larger and more valuable (or abruptly -- I can name at least a couple Twin Cities neighborhoods that have seemed to metamorphose overnight!).

Because the margins on a luxury home are fatter than on a more modest home, builders will typically try to find the least expensive house on a block and replace it with the most expensive -- a process that can look like a game of "Housing Leapfrog."