With the recent – albeit modest – pick up in the real estate market, an issue which we’ve heard little of over the recent real estate slowdown has begun to arise again.  Namely, is it a good idea to, rather than purchasing an already existing home, purchase undeveloped land and custom build a home on it.  And, while the “condition” of the real estate market has changed, in some cases, greatly over the last few years, the bottom line basics of real estate have not.  One of those basics – custom building a home is, at best, a very difficult, extremely work intensive, and risky project for anyone to undertake (indeed, much more difficult and much riskier than finding and buying an already existing home. Why?

  

The number one reason is safeguards, or, more to the point, the lack of such safeguards.  When buying an existing home, once you’ve found the home you’d like to buy and had your offer accepted, you sign a contract to purchase (often referred to as a “Purchase and Sale Agreement”), that, when prepared properly, will include the following:

  ·        A mortgage contingency clause.  This clause guarantees that unless you are able to get a commitment for “conventional financing” (i.e. a mortgage loan designed and intended to be sold by local lenders to large national lenders, which generally have relatively affordable interest rates over terms of up to 30 year, you may can cancel the contract and receive your deposit back (a clause that is that much more important given the still existing  “credit crunch” in today’s economy.·        An inspection clause.  This allows you to cancel the contract to purchase and receive your deposit back in full if your inspection of the property uncovers even relatively minimal (costing $1000 or $500 to repair or less) defects.·        A clear title clause and zoning clause, as well a clause relating to local zoning laws. These clauses allow you to cancel the purchase contract and receive your deposit back if the seller is unable to deliver clear title and full possession of the property to you by an agreed upon date, or if the property doesn't conform with certain local zoning provisions.   

FINANCING

  

Unlike finding and purchasing an already existing property, the process for custom building a home, is quite different, and, as noted, is devoid of many of the important safeguards nearly all properly negotiated deals to purchase an existing home will offer you.  For example, let’s start with financing. When custom building a home, the financing available to you will be a land acquisition/construction loan.  This type of financing, available mainly from local banks, generally is split into two parts – a portion to purchase the land, and a portion to fund the construction – the latter part generally set up as a modified line of credit, with the funds paid out in stages as the construction progresses. 

  

Since such land acquisition/construction loans are not considered “conventional” financing – and therefore generally cannot be sold to the secondary mortgage market (at least, not until construction is completed) – banks consider them much more risky, and their terms reflect this (mainly in the form of higher – often much higher – required down payments and interest rates (the latter often only available in the form of a much riskier adjustable rate mortgage.

  

LACK OF SAFEGUARDS

  

Unlike the safeguards we’ve noted that are available to you when buying an existing home there few of these safeguards are available when custom building.  Once the land is bought and the construction begins, not only can’t you get your deposit back, but you’ll also be responsible for continuing payments on the land acquisition/construction loan regardless of whether title or zoning problems arise, construction is delayed or stopped, or you're unable to sell your current home.  Additionally, you'll most likely still be making mortgage, property tax, and other payments on your current home while the new home is being built).

   

ADDITIONAL DRAWBACKS TO CUSTOM BUILDING

 

   

AMOUNT OF MONEY NEEDED

  

The bottom line is, custom building a home will virtually always cost you more – and thus necessitate that you have more liquid funds available – than buying a comparable existing property.  Why?  There are a number of reasons. 

  ·        Land acquisition/construction loans generally require larger down payments and higher rates then conventional loans.·        You'll likely be making mortgage, property tax and other payments on your current home (as well as the home being constructed) during construction.·        "Change orders".  Changes made to the design/construction of the property you’re building during construction are always very expensive. And, no matter how carefully you design and plan your custom built home, changes orders are inevitable.  As a result, you need to count on spending at least 5 %, usually closer to 20%, and in some cases as much as 30-50% more on the home you're building then you first expected at the outset of the project.·        Build able land has, and continues to become even more scarce (even during the recent down real estate market, which, in turn, can add considerably to the cost of custom building a home.

·        Custom building a home requires more, and therefore, greater expenditures on "miscellaneous" expenses – for example, architectural design costs – and more assistance from your attorney on more detailed contracts and/or zoning issues.

  

TIME 

  

The problem of time involved with custom building is threefold:

  ·        The "delay" issue.  Delays resulting from scheduling the construction start with an experienced builder as well as weather delays, delays attributable to the builder (i.e. problems with sub-contractors or suppliers), or delays attributable to you (i.e. numerous change orders) will delay completion of construction, further adding to your costs. ·         The "timing" issue.  As hard as it is to coordinate the sale of your current home with the purchase of an existing home, it’s much harder to coordinate the sale of your current home with the completion of a custom built home. This will often require that you postpone selling your current home till your custom built home is done, which, in turn, may mean you'll need to get a bridge loan or move into temporary quarters (a problem you especially want to avoid in today’s tighter credit/real estate market. This will further increase the cost (and the difficulty) of custom building your home.  Moreover, this “timing issue” is especially difficult if you have children and are trying to time your move to occur before a new school year begins.

·         Your time.  From planning till completion, you will spend a good deal of your time – at minimum, at least five to ten hours per week – overseeing and dealing with minor – and sometimes major – problems and/or decisions concerning your custom built home.  And that's if the project runs smoothly. If a disaster or major complication occurs – for example, your builder goes out of business (not unheard of, especially in today’s slow economy), custom building your new home can take up even more (if not most) of your time and force you to spend considerably greater funds on attorney, architectural and/or building fees.)

  

TWO "TESTS" YOU SHOULD "PASS" BEFORE EVEN CONSIDERING CUSTOM BUILDING A HOME  

  

These are:

  ·        First, and most importantly, funds.  Namely, don't even consider custom building a home unless you have substantial funds to fall back on.  As a very general rule of thumb, have at least 25% of the estimated cost of the custom built home in liquid funds, in addition to 10-20% of the estimated cost of the new home in equity in your current house.   

·        Second, don't consider custom building unless you're certain you'll have the time and can devote the time needed to custom build, even if you have the needed funds.

  

PRECAUTIONS SHOULD YOU TAKE BEFORE CUSTOM BUILDING A HOME

  

Even if you have both the funds and the time needed, if you insist on custom building a home, make certain you take the following steps and precautions.

  

Financing safeguards:

  ·        Apply for and receive a pre-approval  for a land acquisition/construction loan before you begin your search.  Be sure the loan is either a long term (30, 20 or 15 year) fixed rate mortgage (often referred to as a "one time closing construction loan”) or is tied to an "end loan" commitment – a guarantee from your lender that they will refinance your loan to a long term fixed rate mortgage once construction is completed.  (Note – getting such financing, always difficult, is even more difficult in today’s economic/tight credit market.·        Be certain the time you allot for construction (and the length of the construction loan) is at the very least 2-3 months longer than the time you (and the builder) have estimated you’ll need to build the home.  Additionally, try and get financing that does not include a prepayment penalty.·        If you choose the "end loan" financing option noted above negotiate with your lender to have a portion of the original points and closing costs credited to the end loan.

·        Although often not easy to find (and even tougher to find in today’s market) if available, purchase 'construction loan insurance'.  Such insurance protects you from defaulting on your construction loan in the event that construction is halted or indefinitely delayed due to circumstances beyond your control (i.e. if your builder goes out of business).

  

Design safeguards.

  ·        Carefully design the home you want to build before you begin the process, including as much detail as possible.  Doing so will minimize the need for costly change orders during construction.·        Be certain your construction contract is very detailed, and spells out of the builder's duties.·        Be certain you hire a real estate attorney experienced in negotiating and preparing all of the contracts and documents associated with and needed when custom building a home.

·        Although not always possible, try to include a clause in your contract with the builder under which the builder agrees to suffer monetary penalties if construction is not completed on time.  However, recognize that most builders are very reluctant to agree to such a clause, and, when they do, the clause will almost certainly include the condition that change orders you make during construction of the home will automatically extend the time for completion of construction of the home.

  

Additional Safeguards.

  

·        Architects.  Although you may not feel the need – and often won’t want to expend the funds needed to hire an architect to design you home – strongly consider hiring an experienced architect to assist you in many both designing, as well as many of the other duties required when of custom building a home, which will likely include:

       1) Finding a build able lot.      2) Determining the best placement of the home on the site.      3) Acquiring bids from and hiring a builder.      4) General oversight of the project, including on site supervision of

          construction.

  

·        Moreover, if you do hire an architect, be certain that you:

       1)  Sign a contract with the architect that spells out exactly what their                   duties will be and how they will be paid (generally, 5-10% of costs,            or, a flat rate are preferable over an hourly fee).       2)  Check, beforehand, potential architects' references and prior work.   3)     Be certain to hire an architect that you're comfortable working with,            and one who won’t try to substitute their "artistic expression" for your

           housing wants and needs.

  

·        Hire an established, experienced builder. How do you find one?

  1)     Acquire referrals from local real estate brokers, your attorney and            architect.        2) Check at least three to five of each potential builder's references, and                specifically ask these references about the builder's workmanship and              timeliness, as well as the references overall level of satisfaction.      3) Closely view and, where possible, tour homes the builder has             constructed and be certain the builder is experienced in building the             type of home you want. 4)     Check prospective builders' current commitments so that you can better  determine whether the builder will be able to complete your       home in the allotted time.      5) Ask prospective builders for cost estimates and "spec sheets"           describing how and with what materials you home will be           constructed.  (Note that an experienced architect can be          especially helpful in analyzing these). 6)     Be certain the builder you hire has all of the necessary and proper       insurance coverage, and, if required, required state licensing and      registration. 7)     Finally, so as to at least help in ascertaining a prospective builder's           financial health, ask prospective builders for the names of their           suppliers, then check with these suppliers to see how timely the           builder's payments tend to be made.