Building A Custom Home: The Financial Benefits
It’s certainly rare to find instances where we get to ‘have our cake and eat it too’ – but this is one of them!
Building a custom home for yourself comes with a unique set of challenges. However, when it's done right, you get to live in a home that's designed to your specific taste, AND you can actually build equity in the process. I’m going to give a quick breakdown as to how that works, some unique challenges and ~of course~ the potential risks.
How It Works:
That starts with answering the question – “where does a home’s value even come from?” That answer is surprisingly simple. A home is worth what someone else will pay for it. For example: If you are building a house to live in… how do you know what someone will pay for it? We use the same method that the banks use – we look at comparable houses. Identifying properties in the same area that are roughly the same size and condition, and have already sold, helps us determine (with a fairly high degree of accuracy) what your potential dream home will be worth once it's complete.
Once we have that number, the math equation becomes relatively simple. We add up all of our costs for our home and compare it to the completed valuation number. In many instances, we can actually create a situation where our ‘all-in’ costs on a home are less than the completed valuation. In that instance, we’ve now created equity by our construction of the home, leaving you with financial value that didn’t come from a down payment of cash out of your pocket.
In order to make this easier to understand, we’ve created an example scenario. . .
Ex: You have a vision of living in a beautiful 3,000 sqft home with all the fixins, so tomorrow you purchase a plot of land for $100,000. We run an analysis on nearby homes, in the same school district, that are 3,000 sqft, on a similar lot size, and built to similar standards that you want. We find 4 homes that which are similar that all sold for $400/sqft – giving us a pretty good indication that your property will be worth $400/sqft when it’s done, or $1,200,000.
Our next step is to pay an architect, a civil engineer, a mechanical engineer, environmental consultants, permit expeditors and a building consultant to help us create a plan for the site to connect all of our utilities to the home, build in a driveway, create a plan to manage the stormwater and build your dream layout for this 3,000 sqft home. All of this costs us $60,000.
Now that we have a footprint that we love, we bring in a designer to help us to create a cohesive design for this dream home of ours. We pick every little detail from the layout of the kitchen, to the materials of the cabinets and counters, to the lighting fixtures and the paint, all the way down to the color and style of the windows. Each and every detail is organized and categorized so we know exactly what it’s going to look like and we have a plan for our construction.
We’re now 9 months into the process and our next (most exciting step) is to build it! We bring in a construction specialist (General Contractor) to manage the execution of this build for us. Step one is going to be to excavate the land according to the plans that we already created and the GC will manage the process all the way to step 4,357 which will be the final inspection and cleaning of our brand new dream home 1 year later! The entire build, including hard construction costs and the fee to our GC is $750,000. At this point, we’re 18 months into the process and have spent $100,000 on land costs, $65,000 on entitlement costs, $750,000 on build costs and we’re starting to move our stuff in! These, however, are not all of the costs we incurred during the process. We also paid $30,000 in taxes, insurance and closing costs AND we’ve paid $75,000 in fees to service the loan that allowed us to build it. Let’s review in totality:
Purchase: $100,000
Entitlement: $65,000
Tax/Insurance/CC: $30,000
Financing Costs: $75,000
Build Costs: $750,000
Total: $1,020,000
Value of the home: $1,200,000
Equity Created: $180,000
In this example, we’ve created $180,000 in equity through the process of building our dream home! Also, worth noting – in this example Axe Philly is handling the entire process. We are helping you run an analysis on the valuation when completed, we are your “building consultant” during the planning process. We are your designer (or working with a 3rd party designer to make sure we remain on budget). And finally, we are your General Contractor. This is a very basic example of how the “Design Build” process works from a bird’s eye view and contains all pretty realistic numbers of how you can have your cake and eat it too by building equity while you build your dream home (without relying on market appreciation). This is exciting, but I also promised you that we would provide the biggest obstacles and risks.
The Challenges:
Challenge #1: Hiring the right people. It’s self explanatory -- If you don’t have the right professionals in your corner then the process can be a mess.
Challenge #2: Financing. Few people have the amount of cash to do the entire deal themselves and obtaining a loan as a home owner rather than an investor can be challenging. However, we’ve worked with financial institutions in the past who have funded deals exactly like this and we’re happy to be involved in the process to lock in the funding. The best product that I’ve seen with an example like above allows you to fund up to 80% of the total costs, so in our example with total costs of $1,020,000 they would fund $816,000. The remaining $204,000 is much more palatable for a $1,200,000 home – I have, however, seen people use private sources for the remaining amount (most often friends and family, who they’ll offer a return in exchange for the money). I do have to give a disclaimer that this is risky, as you are increasing your leverage (that money still has to be paid back at some point) and is particularly riskier in a turbulent market where values may shift **we’ll discuss this more when discussing the risk.
Challenge #3: Changing your mind – the entire point of the planning phase is to execute an efficient construction job. If you’re going to change your mind on finishes or layout decisions throughout the process that can get very costly and cause major delays.
The Risks:
Risk #1: The first risk is the same as the first obstacle – not only can it be very aggravating to work with the wrong professionals (unprofessionals), but it can also be very costly! Beware – changing contractors in the middle of a construction job can be very costly, as the new contractor will likely want to redo a lot of the work since he is now taking on the liability of a job. A job that is 50% done in your eyes, may very well be 25% done in a new contractors eyes.
Risk #2: The second risk is a bit more out of your control. The real estate market is a living and breathing organism and does definitely change! The value of your completed property may be $1,200,000 when you purchase the land, but 18 months later there is a possibility of that value being different! There’s a possibility of the value being higher -- if you started this process in late 2020 and finished in early 2022 then you knocked it out of the park with a much higher value and much cheaper debt. However, if you started this process in mid 2007 and finished in early 2009 then you found yourself with a property that’s very likely actually worth less than your all-in costs. That’s called being “under-water”.
The right question after reading that is, how do I best mitigate these risks?
Our Advice:
Advice for Risk #1 is simple – call us! But in all seriousness, if we’re not the one’s doing it then make sure to tour projects that your professional is building/has built AND always ask for a reference!
Advice for Risk #2 Don’t assume appreciation. Don’t assume that debt will be lower when you finish. DON’T overextend yourself. And finally, lock in construction debt that converts into perm debt – meaning make sure that your construction loan has a caveat that it transitions into a standard mortgage once the project is complete so you don’t have to refinance. The option that I referred to above is a 30 year mortgage with a 12 month construction “interest only” option that automatically starts amortizing principle on a 29 yr amortization schedule once construction is complete. Your worst scenario with this loan is that your cash that you used on construction stays in the deal and you’re left with the loan that you expected. In our example above, your loan would be $816,000 and your $204,000 in cash would stay in the deal which is what you’ve expected from the start anyway (this is exactly what I illuded to earlier with the added risk of higher leverage with a private loan). In this scenario, even if you’re underwater on the property then it doesn’t affect you as long as you don’t sell. If history has taught us anything that value will come back and will even increase over a long enough time horizon.
In summary, your worst case scenario is that you’re left with exactly what you expected when you started and your best case scenario is that you knock it out of the park with a refinance, pulling out all of your cash (potentially even more) and locking in a lower interest rate.
So, yea . . . basically my advice is to just call us.