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Builders, Investors Bet On Spec Houses

Spec — short for speculation — builders put up new individual single-family homes and then sell them. In recent months, spec building has been ramping up.

Total construction spending in May reached a seasonally adjusted annual rate of $1.036 trillion, up 8.2% from a year earlier, according to a Census Bureau report. New single-family construction grew 11.2% in the same period.

However, the inventory of new and existing homes on the market is still very low, and rents are high. Spec builders, and their investors, see opportunity.

"Spec building will continue to strengthen through 2015 and into 2016," said David Crowe, chief economist with the National Association of Home Builders in Washington, D.C.

The Census Bureau report, Crowe says, shows that 80% of all single-family construction last quarter was "for-sale," which means that it was spec from large and small builders. That percentage was up from 68.8% in the last quarter of 2014. He notes that the last time this figure was above 80% was the first quarter of 2006, "at the tail end of the boom.

After the real estate bust, construction lending from banks dried up. So spec builders have been increasingly turning to private investment, which has risen from "almost zero" to "22% to 28% for the last several quarters," said Crowe.

Who Lends For Spec?

Banks in construction lending include Timberland Bancorp (TSBK) in Hoquiam, Wash., Bank of the West in San Francisco, HomeStreet (HMST) in Seattle and Associated Banc-Corp (ASB) in Green Bay, Wis.

Timberland is now making construction loans to spec builders. "Historically we've been pretty active in the area," said CEO Michael Sand. "We pulled back after the downturn in 2008 ... but we're in the market to fund spec builders; they just have to be strong projects," he said.

Still, banks often focus their lending on custom homebuilding and larger developments.

"As of March 31, 2015, we only had $2.7 million out in loans to spec builders, out of $77 million in total construction loans," Sand said.

Of that $77 million, $61 million was custom home construction loans.

That leaves plenty of room for private investing. Beau Eckstein of SFR Ventures in Walnut Creek, Calif., is the designated broker for a private money fund backed by high-net-worth accredited investors. The fund is lending to spec builders for "rates that vary from 9% to 12%, usually a 12-month term," he said. The fund then returns the interest to investors, "minus loan servicing and management fees.

Eckstein also works with investors "on a private placement basis" to invest in single projects. Interest rates on those investments are also "between 9% to 12%," he said.

Scott Gunter, CEO of Gunter Construction in Truckee, Calif., says that he's built "upwards of 20 specs in the area over the last 15 years." But during the real estate bust, he laid off from spec building for five years.

Then he started again about two years ago, with a house that sold last year before he finished it. He's building another spec this summer — he says that he'll have it on the market between Thanksgiving and Christmas.

He finances his specs with a combination of his own money and money from private investors whom he's met over the years through his business and his real estate agent. On his spec deals, the investor typically earns interest of "6% to 7% paid monthly and a profit share" when the house is sold.

Lawyers draw up a contract that spells out the details of the build, costs and risks.

Gunter advises investors who might be interested in financing specs to work with a builder who has a good "track record in the spec business." And, he says, investors should make sure they know "how much skin in the game" the builder has. On his spec houses, Gunter typically finances 25% of the cost; the investor funds 75%.

Phoenix-area spec builder and flipper Maria Giordano has been financing projects with private investment money, too. "We use all private investors; we find them via networking and word of mouth," she said. "We do one investor per property.

How One Builder Does It

Giordano says that her lawyers draw up an operating agreement between her and an investor, spelling out all costs and risks, as well as what happens if "the property doesn't perform." She controls the construction and finish decisions.

She used to do profit-sharing deals, but these days she says that she's mostly just paying interest to her investors. "We typically pay 8% if an investor waits until a property sells and 6% if the interest is paid monthly," she said. Some of her investors fund the loans with their self-directed IRAs. When a house sells, "the title company cuts a check right back into the investor's IRA," she said.

Even in Phoenix, where there's a lot of big, new home developments, Giordano says that she can compete by finding and building on open lots or infill lots (vacant, undeveloped parcels of land within developed areas) closer to metro areas.

The best opportunity? Infill lots that can be split for two homes.

"Buyers don't want a long commute, and they want to buy in established areas," she said. "If I can put up a nice house within the city, then I've just beat out most of my competition.

She also offers nicer finishes than big builders, "a little more trendy and a little less vanilla than the tract builders.

She says that she began doing specs in the last couple of years because it's becoming harder to find "distressed houses for flips," and prices for those houses have soared.

Can the building boom continue, especially in hot markets like the San Francisco Bay Area

"The prices in the Bay Area are getting kind of out of control, but there's just no inventory," Eckstein said. "The next two years will be good, and then we'll see a slowdown after that. Everything cycles."