The reason for the confusion is that most would-be “custom home buyers” have the basic sequencing wrong. They think that they will be able to find and buy a perfect lot, then hire an architect to design their dream home, then take the architect’s plans to a handful of builders who will eagerly bid out the project, then pick the builder with the lowest bid. The reality is that the order is usually reversed. That is, a home buyer ends up choosing a builder, and then together they identify the lot and build the house. The process is usually faster, smoother and less expensive for the buyer. Here’s why:

First, let’s start with identifying a lot to purchase. To do so, it’s critical to understand the builder/new construction market. In our local real estate market (the DMV), you’ve probably noticed a ton of new construction. While some of the construction is “custom” projects in which a property owner has hired an architect and builder to construct a home on their lot, the vast majority of these projects are “spec” homes. A spec home is one where a builder/developer buys a lot and then designs and builds a new home on “speculation” that they will be able to sell to a consumer.

When real estate markets are strong (like they are now), you’ll see increased spec home activity. Builders and developers invest enormous amounts of energy and resources into trying to identify the best lots on which to build a spec home. When they find a potential lot, they are prepared to pounce and quickly prepare a clean, cash-written offer with limited contingencies and closing terms customized to the seller’s needs (short or long settlement, rent-back period, etc.). They try to make it easy and simple for the seller to agree to their offer. There is a saying among spec home builders that they make their money on the lot purchase (as opposed to the ultimate sale of the finished home). The better the lot, the less risk it is to the builder. In fact, if the lot is good enough (and the builder has a good enough reputation), the builder might be able to presell the new home before it’s even built.

How does a builder identify and price the lots they want to buy? It all starts with the “outsale” price. The outsale price is the eventual price that a builder anticipates they will be able to sell a new home for on that lot. From the outsale price, the builder backs out the hard costs and soft costs of building/selling as well as the profit margin they hope to capture. (Hard costs are the direct costs of the physical construction; soft costs are the “non-build” costs which include carrying costs, architectural fees, permitting fees, engineering fees, real estate commissions, etc.) Whatever is leftover is how much the builder can pay for the lot.

If a neighborhood doesn’t have any new construction there is more risk for the builder because there is no precedent for the outsale price. On the other hand, if a neighborhood has several newly constructed homes that have sold over the last few years, there is less risk for a builder as they will have supporting data with relevant, comparable sales. The more new-home sales in a neighborhood, the more that neighborhood has “turned over” and the less risky that neighborhood is to a builder.

A second disadvantage is that buyers typically do not have the necessary expertise and resources to evaluate a lot’s potential and therefore move too slowly. When an opportunity to purchase a lot arises, builders have a ready team of architects, engineers, real estate agents and staff in place to perform the necessary due diligence. Buyers, on the other hand, often start to assemble their team after the lot opportunity has presented itself. To protect themselves, buyers often ask for relatively long “study periods” in their purchase contract so they can assemble their team and perform the due diligence. Sellers of lots typically don’t want the risk of a long study period.

Buyers are right to be cautious when writing an offer to purchase a lot. Not all lots are the same and there may be hidden problems or challenges. Some examples are setbacks (which determine how far from the property boundary the house can be built), storm easements, topography, soil quality, title issues and lack of public water and/or sewer hookups. Some of these problems and challenges may create additional costs or delays and may prevent construction altogether. For a buyer not familiar with these issues, it can take 30 days (or more) to assemble a team and get to a point where they can safely remove all contingencies and move forward with a purchase. A 30-plus-day contingency period is an eternity in the competitive real estate world. A savvy builder can often complete their due diligence in seven days or less.

Construction financing comes in various forms but basically allows the buyer to pay for the lot and construction costs with one loan. The bank will allow the builder to make “draws” on the loan according to a draw schedule when certain building thresholds are met. In order to give a construction loan, the lender will want to do an appraisal of the finished new house in today’s market. In order to do the appraisal, the appraiser needs to see the design, floor plans, features and specifications. And herein lies the Catch-22. How is the buyer going to get construction financing if they haven’t identified the lot or the builder or the design? They can’t!

Given these advantages and disadvantages, we have seen that the most successful course for a buyer wanting to build a custom home is to first choose the builder they will be working with, and then work with that builder to identify and acquire the lot and build their custom home.

Buyers often fear that by allying with a builder too early in the process, they are losing their negotiation leverage with that builder. While there may be some truth to that, it’s also true that builders value loyalty, and they love having a buyer contractually commit to building with them because it takes the “speculative” risk out of the picture. Taken together, a good builder will reward the end user with some cost savings.

New Home Construction