There’s a significant housing supply shortage in many parts of the United States, and this is especially true when it comes to newly-built homes. A spec house might seem like a smart way to invest in real estate, especially if the supply of new homes is low in your area or the general real estate market is doing well. While there is certainly money to be made by building a house on spec from the ground up, it's not a great investment strategy for everyone. Here's what you need to know to help determine if building a spec house is the right move for you.
What is a spec house?
The term spec house refers to a house that is built for the sole purpose of selling for a profit.
As far as investment dynamics go, building a spec house is a close cousin of fixing-and-flipping houses. Unlike most other types of real estate investments, spec house construction and flipping houses aren’t intended as long-term investments. The objective is to build or renovate a house and sell it as quickly as possible.
Reasons you might want to consider building a spec house
There are a few good reasons why you might want to consider a spec house as opposed to buying an existing home to renovate and flip.
- Predictable costs -- You’re far less likely to be surprised with costs when building a spec house than you are during a fix and flip. There are no repairs to estimate and little possibility of hidden problems that you’ll have to pay up for. When building a spec house, you get bids for the construction costs, and these tend to be close to the actual cost of the project.
- Higher margins -- When things go well, profit margins tend to be rather high when building a spec house.
- Lower upfront cost -- To get started with a spec house, you’ll just need to pay for the land. You typically pay your contractors as you go. On the other hand, with a fix-and-flip, you’ll need to put up the capital to buy the house before you can proceed with any renovations.
- Desirable -- In real estate markets with a low supply of newly-built homes, a spec home can be very attractive to potential buyers. Buyers tend to like spec homes because they are typically custom designs, as opposed to so-called “cookie cutter” homes. In other words, they can be very appealing to people who want new homes but don't want to live in a new neighborhood where there are only a few different floor plans, but also don't want to take on the project of designing and building a home themselves.
- Less competition -- Thanks to popular TV shows about flipping houses, there are a ton of investors looking for great fix-and-flip opportunities. There’s much less competition when it comes to building spec houses, and it might be easier to find profitable investment opportunities.
Potential drawbacks to building a spec house
There’s no such thing as a perfect way to invest in real estate and building a spec house is no exception. Before you decide that new home construction is a good fit for you, be sure to consider these potential downsides.
- Financing difficulties -- It can be much easier to finance a fix-and-flip than a spec home. Over the past few years, many lenders have entered the fix-and-flip market, and it can be rather easy to finance most of the cost of a project. Building a home from scratch can be difficult to finance, especially if you don’t have much experience.
- Timetable -- The average fix-and-flip takes about 3-4 months before the house is ready to sell. With a spec house, the average timeframe is about a year. In fact, the length of time it takes to build a spec house is one of the biggest risk factors to consider. For starters, the profit you make needs to be more than you could make in several flips in order to make it worthwhile. And there’s always the risk that your local real estate market could cool off in a year.
- Sales risk -- It’s entirely possible that your spec house could take a while to sell. And don’t forget that you’ll be paying property taxes, insurance, and loan payments (if applicable) while you’re still the owner. A few months of extra carrying costs can significantly hurt your profit margins.
Three smart moves to make if you decide to build a spec house
If you decide that building a spec house is the right move for you, here are a few tips to keep in mind to help the process go as smoothly as possible:
- Be realistic: Don’t assume that the house will sell immediately. If you are looking at a piece of land listed for $100,000, don’t assume you can get it for $50,000. If your real estate agent tells you what you can realistically expect to get for the house, believe them. There’s no one-size-fits-all guideline to determine how much profit you need to make on a spec house, but by using a realistic budget and sales estimate, you’ll be in a better position to decide if a project is likely to produce enough profit for you.
- Don’t forget carrying costs: One classic rookie mistake is to forget to include the carrying costs of owning a property before it sells when formulating your budget. Taxes, insurance, and mortgage payments aren’t cheap, and continuing on the last point, it’s not only important to account for these expenses while you expect to own the home, but to also give yourself a bit of wiggle room in case it takes longer to sell than you expect. For example, if your total construction timetable is 10 months, it might be a good idea to budget for 12 months of carrying expenses, or even more.
- Time is money: Don’t wait until after you close on a lot to start planning construction. Don’t wait until the house is completely finished before you hire a real estate professional and list it for sale. In short, making these decisions and plans as soon as possible can save you thousands of dollars of unnecessary carrying expenses. Have your team in place and ready to go as soon as you can.
The bottom line and the next steps
If you decide that building a spec house is the right move for you, the next step is to decide where you want to build and what price range you want to build in.
If you’re not sure about the best location and type of home to build, a local real estate agent could be a great resource. They can tell you what types of spec homes are most likely to sell quickly in your local real estate market and the features prospective home buyers are looking for. For example, where I live, there isn’t much of a market for luxury homes in the $750,000 and above range, but in some areas of the U.S., this could be the sweet spot. On the topic of features, buyers in South Florida may expect a pool when buying a new home, but this could be a turn-off to potential buyers in many Northern parts of the country.
You’ll then want to hire an architect to draw up house plans and start looking for general contractors to start the home building process and make your spec home a reality. And unless you have the cash needed for construction on hand, you’ll need to find a lender who makes construction loans to investors. Your real estate agent can be a great source for all of these things, so it’s very important to look for someone with experience selling homes at your desired price point and ideally one who has experience selling spec homes.
The process of building a spec house isn’t an easy one, so expect a bit of a learning curve on your first attempt. Just remember, be realistic, move quickly throughout the process, and listen to the advice you get from your real estate professionals.