Are you an investor who is frustrated trying to find a profitable fix and flip in today’s real estate market? If so, you might be wondering if you should build a spec home.
A “spec” (short for “speculative”) home is built on the premise that, if you build it, a buyer will come. And they will come soon enough for you to realize a profitable return on your investment.
Spec homes are most often built without a specific buyer in hand. They are constructed to have broad appeal to a homebuyer in a certain area, built with a standardized layout, and designed with market trends in mind. Spec homes are offered for sale as move-in ready.
Spec homes differ from custom-built homes in that the end buyer is not involved in the design or building process. However, if the timing is right, a buyer may customize some aspects of a spec home by working with the builder at the end of the process. A spec home may be a one-off project. It could also resemble a house next door or one down the street.
There are a range of builder types that build spec homes, including larger companies and smaller startups. However, according to a 2021 Home Building Census reportby the National Association of Home Builders, 80% of all home builders and specialty trade contractor firms are independent, self-employed entrepreneurs.
The #1 PRO of doing a spec home is that it can provide a quick turnaround and high profit. Building new also helps the investor avoid the pitfalls that can come with fix-and-flip projects.
The #1 CON of doing a spec home is a big one. If the market changes (or the laws change, or a natural disaster hits your build area) between the time you break ground and the time you put your home on the market, you can lose your shirt. There is no shortage of stories about investor-builders who have done just that, by building spec homes.
So, let’s look at how you can decide whether building one or more spec homes is right for you.
Why Investor-Builders Build Spec Homes
Investors often start their real estate careers with fix and flips and light rehabbing of rental properties due to (relatively) low barriers of entry.
However, building a home from the ground up, especially without a committed buyer, takes both expertise and capital. Due to the risks involved, spec houses are often built by more experienced investors.
Some builders make the leap from rehabs to new construction when real estate markets tighten. When finding fix and flips becomes more competitive and time-consuming, profit margins can become too thin to pencil out. This could make the move to new construction make sense.
Another reason investors build spec homes is that they are tired of working with older buildings and technology. Some builders grow weary of dealing with the surprises that can show up in fix and flips.
Custom home builders, tired of demanding clients, may also move to building spec homes. Although there are still challenges (primarily funding), it can be a welcome change for the builder. (This article by the Association of Professional Builders compares custom home vs. spec home building.)
Expertise Needed: Fix and Flips vs. Spec Homes
Although building a spec home is a more involved process, the leap from completing major rehabs to building spec homes may be closer than you think.
A spec home project requires a solid understanding of the overall economy and your local real estate and labor market. How are interest rates influencing buyers’ home purchasing choices? Are homebuyers able to get financing for new homes? What is the average time on the market for a new home? Which amenities are new home buyers looking for in a new house? Is there a consistent availability of experienced contractors in your area?
Building a spec home will involve a more involved permitting, design, and budgeting process than doing a fix and flip or rehab. Builders already doing major rehabs, however, should be more comfortable with the building process itself. The marketing and sale of your spec home will be similar to selling a fix and flip.
A solid and knowledgeable team (i.e. experienced general contractor, architect, lender, and realtor) will help you avoid the many challenges that can arise along the way.
Hot Tip! For a great play-by-play of what it takes to move from rehabbing to new construction, read investor J Scott’s “Diary of a New Construction Project.” This free BiggerPockets e-book is dated—it was published in 2014—but it is 157 pages of invaluable information as J documents every detail of his first new construction project.
How Much Money Can You Make Building a Spec Home?
A 2022 NYU Stern report analyzing 29 home building companies reports the average builder’s profit margin was 24.87% in 2022. Their net was 12.73%. The 2022 NAHB Builders’ Cost of Doing Business Study reports builders earned 18.2% gross profit in 2020 (Covid effect possible) with a 7.2% net profit.
The profitability of your spec home will depend on many factors. National and local real estate market conditions, location, price of your lot, construction costs, buying and selling pricing strategy, and your overall experience in executing the project will all come into play.
Experienced investors advise that your spec home profit often comes down to what you pay for your lot. When you go to sell, you may be competing with larger builders who have lower costs than you do. Nailing your lot price could provide room to move in your sales price, while still making your needed profit margin. Be creative in looking for a great land deal. What are the zoning options—are you able to build at a higher density than the lot’s listed usage? Can you scrape an old home to build two homes on the lot? Can you add value by changing the zoning on the lot?
The more spec homes you build, the more expert you will become at managing the budget and timelines. Building multiple spec homes at once will allow economies of scale. You should be able to use your labor more efficiently and purchase your materials in greater bulk.
Ultimately, you will maximize profitability with consistent build times, reliable material costs, a continual labor supply, and a constant stream of buyers for your homes.
Spec Home Funding: What Your Lender Wants
A major consideration for building your spec home will be funding. This could be a bank loan, a line of credit, partnering with another investor, using private money, or talking with an alternative lender like i Fund Cities. (See this article for a list of 50 reasons why people like you have chosen to use lenders like us.)
The primary thing a lender wants to know is that they will get their money back. That’s why, when funding spec homes, lenders prioritize investor-builders with some building experience, preferably in their local area. Lenders fund projects they believe will come in on budget and on time and will sell on schedule. Your accurate market research, building plans, project numbers, and development of a solid team will assure your lender that you are a good risk for funding.
Spec Home Funding: What You Want From Your Lender
Remember … you also want some important things from your lender. Your criteria should include:
- Reliability of Funds: Don’t put the work into your project only to find your lender has stopped funding new construction lending a week before you close (trust us, this happens). To avoid this, understand where your lender’s funds are coming from. (For more information, read this article: Where Do Lenders Get All That Dough, and Why Do I Care?)
- Consistent Funds: You want a clearly defined draw schedule so you can properly plan your budget timeline.
- Lender Experienced in Spec Homes: You want a lender who understands the spec home process, and who can help you go through your numbers and dial in your process upfront.
- Personalized Relationship: You want to be able to call your lender directly, have them answer, and have an open conversation with them.
- Fast: You want a lender who can act quickly to help you capitalize on opportunities.
- Creative: An alternative lender (like i Fund Cities) can often help fund your project when traditional banks cannot. For example, we may give you credit for the imputed equity in your project (e.g. if you added value to your land by taking it through zoning changes) while also funding 100% of your new construction project.
Best Market Conditions for Building Spec Homes
Builders aim to minimize the risk of the market changing by doing their spec homes quickly—with a build time of approximately 4 to 7 months (or approximately 1 year from lot purchase to sale).
On a national scale, you want a real estate environment of high demand for homes and low supply. Just remember that the real estate market can change quickly, leaving you with a lower sale price (and even an unsold house). Be sure to have a backup plan (like switching over to a long-term rental) in case this happens. On a local scale, you need solid demand for the type of home you choose to build and a consistent regulatory and labor environment to build in.
(See “Resources” at the end of this article for websites helping in researching your area’s market conditions.)
Today’s Market Conditions
A recent Reuters article based on the October 2023 New Residential Construction report noted, “U.S. single-family homebuilding increased marginally in October and activity could remain moderate in the near term amid higher mortgage rates … Nevertheless, new construction remains supported by an acute shortage of houses on the market.”
Redfin’s October 2023 Housing Market Update states: “This year is likely to end with roughly 4.1 million existing home sales nationwide, the fewest since the housing bubble burst in 2008 after the subprime mortgage crisis. … The last time home sales were this low was during the Great Recession. At that time, tough economic conditions and slow demand pushed home prices down30% year over yearin some parts of the country, creating an opportunity for first-timers to snatch up starter homes–but this time, there’s no deal to be had.”
“Redfin agents recommend that buyers who are frustrated by low inventory and high housing costs consider new construction. Sales of newly built homes are holding up better than existing home sales, largely because builders–unlike regular homeowners–aren’t locked in by low rates, and they’re often more motivated than homeowners to close a deal. Sales of U.S. new-construction homes increased 1.5% year over year in September as prices dropped about 4%, according to Redfin’s data.”
What Kind of Spec Home Will You Build?
Choosing what type of spec home you want to build will depend on your lot size, budget, experience, the market demand in your area, consumer housing preferences, and your available financing.
According to Builderonline.com, the trend is building spec homes on smaller lot sizes which, they say, “reflects unprecedented lot shortages confronted by home builders during the pandemic housing boom, as well as their attempts to make new homes more affordable.” They note that the share of spec homes built on lots more than half an acre shrunk from 12% in 2011 to 8% in 2022.
Your house needs to be a modern enough design to appeal to many buyers, while still being profitable to build. It will also need to be in a neighborhood where you can attain your desired profit margin when you sell it. If you add in modern amenities, which most spec home builders do, your spec home will likely need to be in a high-end area. This may also require you to build the maximum square footage and the highest density allowed for your lot.
Experts suggest you hire an architect and structural engineer to do your plans rather than purchasing a set of pre-drawn plans. Your architect will prove valuable in researching your site, zoning, etc., and will provide you with your building schedules.
Hiring a general contractor (a good idea for first-time new construction builders) will help you navigate the legal, cost, quality, and time factors that need to come together to make your project profitable.
Spec Home Design
Your house design and amenities will be a major factor in whether your house will sell, and how quickly. Spec home builders add design features that are currently on trend, and that will appeal to a range of buyers. This could include things like an open layout, granite countertops, outdoor living areas, smart home technology, etc.
Housing Design Matters says: “It’s easy to go over the top with the fixtures and finishes. Perhaps the biggest mistake I’ve observed is builders fill the house with their personal preferences, forgetting they are not the buyer.”
They suggest staying in a lower price range for things that can be easily replaced like carpet and appliances, and spending more on things like windows, doors, and exterior finishes. For colors, they suggest a neutral palette, with a wall of color in a few rooms, that a buyer can repaint. And, they add, “The front door is a great place to make a statement with a splash of color.”
According to expert Massachusetts realtor Bill Gassett’s MaxRealEstateExposure, buyers seek the following amenities in spec homes: energy-efficient features; emphasis on outdoor living spaces; integration of home offices and flexible spaces; focus on health and wellness (home gyms, natural light); smart home technology; sustainable and low-maintenance materials.
Spec Home Sales
Because everything is new, of good quality, and under warranty, a new spec home should sell more easily than an older home. However, do not overestimate your sales price. If your home sits on the market too long, the carrying costs (electricity, insurance, etc.) will cut into your profit margin.
The best-case scenario is to have a contract for your home before you put it on the market. If you don’t have offers right away, consider lowering your price. Some builders stage their homes, but if you have the right house at the right price point, that may not be necessary.
If the market changes, you may not sell the house for your intended price. Here, you have a few options:
- Try staging the home with furniture, artwork, etc.
- Lower the price.
- Offer owner-financing for buyers.
- Refinance your new construction loan into a long-term rental loan.
Mitigating the Risks of Building a Spec Home
Here are 10 tips for mitigating your risk in building a spec home:
- Buy the land low.
- Hire a licensed/experienced general contractor that builds homes in your price range. Or, work with other investors who have done spec homes before. (Learn from them and avoid making all of those mistakes yourself!)
- Move as quickly as possible from planning to execution. (Start your planning before you close on your land.)
- Build a buffer into your budget.
- Add all the project’s carrying costs into your budget. This includes taxes, insurance, and mortgage/loan payments. Should your sales timeline not go as planned, these could add up quickly. (Download this helpful Deal Analysis Spreadsheet.)
- Set a realistic sales price to sell quickly. The longer your home sits on the market, the more risk of the market changing. The home could also become less desirable over time or get damaged. Also, your quick sale can provide you with funding for your next project.
- Work to pre-sell your home before it is built.
Can You … Should You?
Even if you can build a spec home … should you? Speculative homebuilding offers the allure of quick profits, while avoiding the uncertainties of fix and flips. However, the market and process can pose significant risks, which are rarely predictable. Changing markets can sometimes even be career-enders for some real estate investors, and is nothing to take lightly. (This ConstructConnect.com article detailing how many construction companies fail each year and why, serves as a good reality check.)
However, for experienced rehab investors who can purchase land wisely, budget meticulously, and aim for a fast sale through strategic pricing and pre-selling efforts, spec home building could offer a successful new real estate investment strategy.
The key lies in market timing, with a focus on quick and efficient construction timelines. Your choice of professional team members is critical. Find a reputable general contractor, architect, and real estate agent. In addition, find a lender that is reliable and tuned into spec home dynamics, who can be a solid, have-your-back, member of your team.
And, of course, if you decide building your first spec home is on the horizon, we are here to help fund your project!
Resources
The following resources will help you research your area’s market conditions:
- The Census Bureau Index of Economic Activity follows major economic indicators. The New Residential Construction page has national and regional data on new housing units authorized by building permits.
- Redfin, a national real estate brokerage, provides tons of free, detailed, housing market data. They provide the number of home sales, pending sales, new listings, inventory, months’ supply, and homes sold above list price, among other criteria. Data is searchable by state, region type, property type, and more.
- Realtor.com also has a major database of reports detailing everything from the real estate market outlook and national market trends to local market trends, a market “hotness” index, and more.
- A highly experienced realtor is one of your best local resources. New business moving to town (or one leaving), changing local regulations and/or building codes changing, or rising insurance rates can all impact your home sale. A great realtor will know about all of these things.
- Follow nearby spec homes online to see what their amenities are, and how quickly they sell.
- Your local home builders association can also help you find information on all aspects of home building in your area. They also know reputable local spec home builders.
