Just recently I have come in contact with builders looking for private investors to finance spec homes. Since the housing market around Austin is very good at the moment, they are offering 10-12% interest. Seems very enticing but I don't have experience on how the legal process would be to set it up so the investor is strongly protected. I know that the best way would be is to set up a 'draw' schedule, etc. However, I am looking for some advice on the details. How is the investor protected if the builder leaves town? What liability coverage does the investor need to see from the builder so the investment is protected as it is getting built? Your advice is greatly appreciated.
I would only do it if I have the first trust deed and the loan in your name. All draws need to be paid and lien releases from the vendor and or supplier before the next draw is taken. An honest ethical builder should have no problem with this. A separate account for the property so there is no co-mingling of funds. I know of 3 builders that took money up front, pulled draws, received investor money, and didn't put the money in the appropriate areas. All the investors can do is sue the builder who spent everything.
Make sure there is a market for the spec home and that it will sell for the right price, after lot, build and holding costs. The builder has nothing to loose if it doesn't sell, but you can be stuck with the house and holding costs. They factor in their margin and make money on the construction draws.
Another way to do it is a profit sharing agreement, where you get 30% and they get 70% of the true costs, be aware it is easy to pad building costs on a project
It does work and can be very profitable.
DO YOUR HOMEWORK AND DUE DILIGENCE!!
Myself and other investors got burned from a builder pretty bad on spec homes. The builder really had nothing in it but was reaping the rewards. At the end there were numerous houses that were getting liens, and all the draws were exhausted. The investors have to get more loans to pay off the vendors and finish the houses.
I received an expensive education from this and hopefully it will help others
Lots of issues as pointed out above. Is there a bank involved? Are the lots current owned? Improved?
What is total investment size? These questions will determine if 10-12% return is worth your legal cost/risk. I wouldn't touch any "equity" investment for only 10% return, these should be 2x or 2.5x equity of $500-1,000,000m investment.
This particular builder owns the lots. No bank involvement. He is looking for private investors (hard money) and is good with doing draws. From different investors in the past I have heard that they involve a real estate attorney to be the go between (release the draws) and receive subcontractor invoices/confirmation of payments. Are any of you familiar with Attorneys in Austin doing this?
Did you ask why they aren't using a bank for the spec build loans? I am doing a spec build and my construction loan is 6%. If they have their ducks in a row then they shouldn't have an issue getting that construction loan. If they have prior legal issues or bad credit then they may need to go the hard money route which should make you question the deal. I am not saying don't do it, just protect yourself as best you can. I also agree that I would not be a private equity investor for just 10%.
Good builders have banks lining up for their business , ask yourself , why this builder is looking for money
It always makes me wonder why builders would not use banks. However, I met with a banker friend (VP of loans) and he let me know that very few banks loan on specs these days. Their primary target is the home owner for the new construction and not the builder for a spec waiting to be sold after finished. He also let me know if a bank does spec financing, they will only do 2-3 per builder.
We'd love to work with investor business because it tends to be a little more flexible, but we've got a bank that provides spec home financing currently. It CAN be difficult to find banks to work with, so many times a builder is relying on their history, relationships, etc.
The biggest thing before you begin to work with a builder is that you need to review and call up their vendors. Do a thorough check on this because you'll know if the builder is paying vendors on time. If the builder isn't paying vendors on time, RUN, far away. This is a huge indicator of trouble and could mean they are not good at managing their money.
A good builder will also get all or most bids PRIOR to breaking ground. This is the only way to know if the numbers are solid or not.
As @David Ferrette said, 6%, and even a little better, is not that hard to come by. But there could be good reasons to go with private lending: speed and simplicity. Banks require a lot of documentation and time. If the builder already owns the lots and is ready to go (particularly if it has plans and permits), private money could make more sense.
Also note that it's possible the builder isn't making a perfectly rational economic decision. I think a few of these guys think of themselves as builders making their money on building, not on the other factors like lot price and holding costs. Even though that makes no sense.
You should ask the builders their rationale. If you do it and you find a good lawyer to help with the contract, I'd like to know who it is.
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