How Do Home Builder Spec Loans Work?

So you’ve decided that your homebuilding company wants to add Spec Homes into your mix of product offerings. That’s a common practice by Home Builders, and it can be a great way to provide homes to those who need a place to live and want to have a newly built home, but they don’t have time to wait for the entire process.

You may have guessed, though, that it takes some money to build these Spec Homes. And, unless you’re independently wealthy or your Company has so much cash that it doesn’t know what to do with it, you’re going to have to talk to a bank (or other financing entity) to get a loan for that Spec.

What Exactly is a Spec Loan?

I gave a brief explanation of the financing of a Spec Home in my blog post explaining Spec Homes, but I thought it might be good to go into a bit more detail.

Now, before I go into the detail, know that there are several different programs offered by banks, so my explanation might vary a little bit from what you are seeing with your business, but the overall premise should remain the same.

The simple explanation of a Spec Loan is that it is TEMPORARY money lent to a Home Builder to build a house on a lot with the intent to sell that house to a Homebuyer for a profit. When the house sells and settles with the Homebuyer, the money received from the Homebuyer pays off that Spec loan (and the Home Builder, hopefully, recognizes a profit on that house).

So How Does a Home Builder Prepare To Obtain a Spec Loan?

When you decide to build a Spec Home on a lot, you will need to choose a floorplan that you think will sell. The decision on which house to build should not be taken lightly – as a wrong decision here can be very costly! You could easily end up with a Spec home that can’t be easily sold. When that happens, you’ll most likely need to cut the Sales Price to a point where the profit is minimized (or goes away altogether).

Or you hold on to the Spec – waiting for the Buyer who will pay your asking price – and end up spending a lot more on interest costs from the Spec loan you took out to finance the build. If you haven’t guessed that more interest costs also eat into your profits, you know now.

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To minimize the chance of being stuck with a Spec home too long, you’ll want to get information on what is selling in the current market. That information can be obtained by asking a trusted Realtor in the area, who can pull recent sales in the area as comparisons (known as “comps”). This information will provide price ranges, size ranges and house styles to consider.

Once the comparative sales are obtained and the “sweet spot” of pricing is determined, you will need to work backwards from that target Sales Number to decide what can be built. The final Spec house and lot price needs to be near that target Sales Price.

So, review current lot inventory. Once you decide on the lot on which you want to build a Spec, you’ll need to choose a floorplan that should be well-received by the Market.

With the lot and house floorplan selected, the Home Builder needs to decide what specifications and finishes can be included to meet the target Sales Number. It’s a delicate balance. Put too much in and you’ll possibly be sitting on a Spec house for a long time. Put in too little and you might not attract Buyers.

When you have the house and lot selection and pricing finalized, you’re ready to talk to a bank about getting a Spec loan. But how does a Spec loan work? Read on!

What Does a Bank Want to See From You?

Now that you have selected the lot and floorplan and established the final Selling Price, it’s time to talk to a bank to get a Spec loan. You’ll need the details of the lot and the floorplans and specifications of the house that you plan to build.

The Bank will want to see a few things from you at this time:

• The details on the lot – including, specifically, the price that you will pay to the Seller for that lot.
  • For this article, let’s assume a flat lot price of $80,000.
• The details on the house that you plan to build:
  • The specifications and included features you will include in that house.
  • The floorplans/blueprints of that house.
  • Your expected costs to build that house. We’ll assume a cost of $300,000 for this house.
• The Sales Price that you intend to market the Spec house/lot combination.
  • For this article, let’s assume you plan to sell the Spec Home and lot at $500,000 ($100,000 for the lot and $400,000 for the house).
• Information on comparable sales in the area (though they will be checking themselves with an Appraisal that they will have done).

Quite honestly, the most important things to the Bank from the list above are the costs and the Sales Price. Bankers are not Home Builders, and they’ll expect that your information is accurate and well-thought-out. After all, they are assuming you are doing everything in your power to make sure you can profitably sell the Spec house you are proposing.

All considered – here’s what the breakdown of our example looks like:

Sales Price of House/Lot $ 500,000.00
Expected Cost of House $ 300,000.00
Cost of Lot $ 80,000.00
Expected Profit $ 120,000.00

What Comes Next?

The Banker takes the information you submitted and – if they decide they want to pursue loaning you money to build a Spec home, they will order an Appraisal. An appraisal is a calculation of final Sales value of the Spec home based on comparable sales in the area. A bank will use a professional Appraiser to get this done (for which you will be charged).

The comparisons used are recent sales in the area of similar-sized homes. Hopefully, those homes have very similar specifications and features to what you are proposing. If you’ve done your homework upfront – as mentioned above by obtaining your own comparable sales information – this will become a formality.

The total sales value of your Spec home/lot combination will be used as the basis for the Spec loan. For this example, let’s assume the appraised value of the house came out as expected, and the Bank is ready to loan you the money to build (Congrats – by the way!).

The Bank doesn’t lend you an amount that equals the full final sales price of the Spec/lot combination. Instead, the Bank lends you money on the COSTS you submitted to purchase the lot and build the house. To be more accurate, they loan you the amount to purchase the lot and a percentage of the costs (typically about 75% of the total amount).

For our example loan, the Bank approves $ 305,000. That’s $80,000 for the lot (full amount) and $ 225,000 ($ 300,000 x .75).

How Does The Spec Loan Work?

Now that you know that the Spec Loan includes an amount to purchase the lot and a percentage of the Spec house cost, you may want to know how the bank pays out the parts of the loan. What follows is a simplified explanation of what is happening.

Since the lot needs to be purchased first, and the full amount is expected by the Seller, the Bank pays the Lot Seller for the lot at the time of the initial loan closing. So, for our example, $ 80,000 is paid out to the Lot Seller.

That means that you now have a loan balance of $ 80,000. At this point, you are starting to incur interest charges on that $ 80,000. You’ll see what that adds up to at the end of the month when your Bank sends you a bill for the interest incurred to date.

Why does the lot need to be purchased first?

Banks need something “real” to attach a loan to, and the lot is that real something. It is something that could be sold in the event that your Company can’t finish building the house. So, the lot is the keystone that “secures” the loan.

Since the Bank loaned the full amount of money to purchase the lot, they have a financial interest in that lot for the same amount. Worst case, you buy the lot and go out of business, the bank has the right to sell that lot and get its money back (or as much as it can – guess where they look for to get any balance due that can’t pay off that loan….).

Now that you own the lot, you are ready to build the Spec home. You secure your permits and get to work!

Depending on how your specific Spec loan is set up, the Bank will release money to you as work is completed. Some banks do pre-set Draw Schedules to receive a percentage of the loan amount based on schedule milestones of the house. For example, your Loan Draw Schedule may look something like this:

• Foundation Complete 20% $ 45,000.00
• Framing Complete 30% $ 67,500.00
• Drywall Complete 30% $ 67,500.00
• Carpet Installed 20% $ 45,000.00
• TOTAL 100% $ 225,000.00

As the work is completed, the money is released. And as the money is released to you to pay your Trades, your loan balance goes up by the same amount.

That $80,000 balance you had at the lot closing grows with each loan draw. At Draw #1, your loan balance is $ 125,000.00. At Draw #2, your loan balance is $192,500.00. This continues until all Draws are released for a total loan balance of $ 305,000.00 (as was originally approved).

As each draw is added and the balance grows, the interest you end up paying also grows. After all, it’s being calculated on a larger balance. And those monthly interest bills don’t stop until the Spec house is sold and that Spec loan is repaid. Better get that Spec home sold!

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Hopefully, this gives you a simplified explanation of how a Spec home loan works. I’d love to hear what you thought – or – what you’d add to this article!