How to get a loan for speculative building
Local factors that influence spec building
- Housing prices
- Home absorption rate
- Job market
- Surrounding infrastructure and amenities
- Architecture and design tastes
Fix-and-flips may be the darlings of the real estate investment world, but they are far from being the only strategy for making solid returns in real estate. Building on speculation is a major part of the new home construction market, with about three quarters of new single-family houses started in 2016 built on speculation. Although a potentially lucrative prospect, financing a speculative construction project can be challenging.
New homes can be custom-built or built on speculation. A custom-built home is a personalized project commissioned by an individual or entity. Building on speculation is the construction of a home with no identified buyer. The investor is speculating that the house will sell, hence the name “spec home.”
Single-family homes, commercial and mixed-use property can all be built on speculation. Spec houses are often affordable, entry-level homes built in a burgeoning market or in-fill housing within an existing development. Investors and developers also use speculative building to construct tract homes, which are several homes of similar size, floor plans and materials located within a single development.
Construction loans for spec houses
Construction loans are typically short term and carry interest-only payments during the construction period, after which a final balloon payment comes due. With a spec house, the buyer’s mortgage can pay off the construction loan, or the investor can roll over into a new, long-term loan to rent the property.
Construction loans are inherently risky as there is no tangible asset to secure the loan. Lenders see financing spec construction to be even riskier, given that there is neither an asset nor a confirmed buyer. Investors need to demonstrate solid financial footing and a meticulous business plan to convince wary lenders of the project’s stability.
Although strong credit and a large down payment are always beneficial to obtaining financing, lender requirements for spec house construction loans vary significantly. Some lenders may offer zero-down financing while others require 50 percent or more equity. Lenders may accept — or even require — some equity in the land as part of the down payment to secure the loan.
Most lenders will, however, require demonstrated experience in building on spec and an assessment of your tax records and financial statements. Strong cash reserves are essential to validating that the borrower has enough funds to complete the project.
Lenders also assess the location and condition of the property and whether the title is clear. Lenders prefer improved land with connectivity to roads and utilities over raw, undeveloped land. Some lenders allow investors to roll the cost of the land into the construction loan as well. Typically, the maximum loan-to-value ratio for a loan for speculative construction is 70 percent, with a few lenders extending as much as 85 percent.
The business plan plays an important role in selling the lender on the story of your project. You must provide a detailed business plan; information on your team or subcontractors; blueprints, budget and materials; as well as your work schedule and loan draw schedule. Providing examples of similar projects in the area and their final selling price can help you make your case.
Investors who cannot meet construction lenders’ rigorous requirements for building on spec may consider hard money lenders as a more flexible — albeit more expensive — alternative.
Pros and cons of speculative construction
Building on spec requires the investor to have a thorough understanding of the local housing market. As every construction cost ultimately gets passed through to the consumer, the key challenge is to balance costs with the features that will make the home sell. Factors to consider include housing prices in the area, the home absorption rate, local job market, surrounding infrastructure and amenities, as well as architecture and design tastes. The home should be generic enough to appeal to as many buyers as possible.
Stability and cost control are two advantages of building on spec. The investor has total control of the project’s vision and therefore its expenses — there are fewer unforeseen problems with new home construction than a rehab. Spec houses are not guaranteed to sell, however. Investors risk building a home that doesn’t meet the needs of local buyers, or overbuilding a home that doesn’t command as high a sale price as expected, resulting in a net loss.