Spec construction is speculative – it’s a property built without a buyer already lined up. There is risk and potential reward. A spec property probably isn’t a long-term investment; many projects are under a year from start to finish. When the process goes well, the sale may provide a builder or investor with a substantial profit.
What’s Special About Spec Construction
Spec houses are built based on what the builder or developer feels will result in a successful sale. The eventual buyer, prior to reaching an agreement with the builder, will have no input into decisions, which is different from many other kinds of home construction projects.
Like all real estate investments, there’s uncertainty. For builders, a project could sell at a premium – or it could sit as inventory while carrying costs eat away at the profit margin, or worse. For lenders, repayment is the objective. Lenders, understandably, view spec construction as a riskier investment than for a project that has a buyer lined up.
Understanding how a lender views spec construction success is important, since builders often need outside funding for property purchase and construction.
The Importance of a Lender’s View
A builder or contractor benefits from having the lender’s perspective on success because the lender is probably providing most of the money and therefore taking a lot of risk. Similarly, the contractor is doing most of the work and also taking on risk. Both sides should keep this in mind when dealing with the other. It benefits both lender and contractor to be respectful, honest, and responsive.
When a contractor approaches a lender about a loan, the lender evaluates various factors. In addition to credit quality, the relationship with a borrower is also considered. If the working relationship is good, the lender is potentially more willing to lend and be helpful. This may lead to clear economic benefits for the contractor from the very beginning, while the loan application is being prepared.
Builders have many avenues for funding but the most common options are banks, private lenders, and investments from friends and family.
Defining a Successful Spec Project
Successful project plans are something that the builder can build efficiently and that the market wants.
While we can’t speak for all lenders, at Builder Finance Inc. we view a successful project, whether for a spec or pre-sale home, as one that gets built and sold in a timely fashion and leaves both parties wanting to work together again – not one that requires extension fees and extension documents. This is consistent with what a builder wants, whether it’s a spec or pre-sale home project.
For a builder or contractor, the end goal is to maximize the return on investment and make a profit.
All companies – including builders and banks – make profit on the difference between their revenues and their costs. The primary costs for a lender include staff expenses and cost of capital. The cost of capital per dollar being loaned is relatively fixed, but staff time can vary by loan.
For most lenders, efficiency is directly related to profitability. Staff time is valuable, and the less time staff spend on a project, the more profitable it is. So lenders like working with builders that are efficient and easy to work with.
Benefits of Immediate Planning
By understanding the goals of a lender – to have an efficient, streamlined process and an easy, effective relationship with a builder – we can see the benefits of good planning.
A well-planned project will start with the basics, like appropriate permits. While specific requirements of local authorities may vary, a permit is almost always required. The time it takes to get a permit can also vary – in some places it can take more than a year – so it’s critical to have the right expectations. Many lenders will wait to close a construction loan until the permit is secured.
New construction projects will also need an appraisal. Lenders want to get the results of an appraisal as soon as possible and it can take weeks to receive an appraisal report. From a lender’s perspective this is the longest lead time item. Right away with a loan application, a lender wants the materials necessary to get an appraisal ordered. Having an appraisal as soon as possible also means that if there are any appraisal problems or issues, they can be cleared up in a timely manner and will impact the project timeline less.
When you’re planning, it may help to talk to specialists like interior decorators or landscapers, and establish relationships with real estate agents who will help move the property.
Ultimately, a successful project has a successful plan that leverages research and experience – you’ll have to plan what to build, how to build it, and how to sell it.
Funding for Success
Finding the right funding for your project will impact its success, because while there are many funding sources and options, not all of them are optimized for new construction projects.
The financial needs of new construction projects are somewhat unique. Construction projects need a lot of money but don’t produce any money until the property is sold. Managing cash on hand can be difficult, particularly during times when market conditions are unstable. Supplies, materials, and labor are affected by the market, so a builder’s financial needs may change even when the project is underway.
As a result, managing cash on hand is very difficult. Builders must have enough liquidity to meet their obligations. For example, the builder will have property level carrying costs associated with owning the property, like taxes, utilities, and HOA fees, until the property is sold. Not having enough working capital to meet those obligations can have repercussions. Some lenders also require monthly interest payments and may charge other fees or expenses along the way.
A lender who understands and structures loans accordingly will help set a builder or contractor up for success. Funders who are experienced in construction can help a builder access capital in a way that is helpful to building on spec. Funding is a specialized field, and a good lender will make sure that you understand unfamiliar terms and how different loans for which you qualify may affect your project as a whole.
For example, a contractor working on multiple projects simultaneously might benefit most from a spec line of credit construction loan, because the available line of credit will allow the builder to access capital more efficiently.
A lender who knows the needs and recognizes the realities of new construction will look at the options that are available and suit the project, whether it’s a construction-only or interest-only loan or a revolving line of credit.
Summarizing the Successful Spec Project
Profit is what’s left after expenses.
Spec home construction projects are undertaken to be profitable business investments. Careful planning provides the kind of knowledge and preparation needed for a successful spec build.
A lender with a solid grasp of a builder’s goals contributes meaningfully toward a project’s success. Establishing a solid, strong relationship with a lender improves the overall efficiency of securing the right funding.
Accomplished builders know what, where, when, and how to build as well as how to sell and secure funding. They become experts at managing the costs and timelines and apply a consistent approach to building. Such experience can be leveraged into a scalable building method that increases their return on investment.
