Is building a spec home less risky than flipping a fixer upper?

[Patrick Britton]

I have been looking at spec building since the early summer and cannot seem to find the same level or amount of risk associated as with fix and flips.  It seems that because nearly all of the costs are known well in advance, the biggest risk is whether the home will sell quickly and for the desired amount.  But this is the same risk one takes with a fix and flip...

Considering the risk someone takes with a fixer-upper with respect to unknown repair needs, would it not be a better (less risky) strategy to do spec builds instead?  After all, the construction costs are known well in advance for the most part.  Seems like the most important factor is building a home that will sell for the desired price quickly.

Are there unknown or considerable risks associated with spec building I am not considering?

Please assume that the builder is reputable and can finish the job in a reasonable amount of time.  thanks

[Bryan Hancock]

A lot depends on how you source projects for a risk discussion IMO.  Flips (or rehabs really) have less temporal risk because they're shorter projects.  These projects tend to have smaller margins and can be turned over quicker.  Thus if you execute well and source projects properly you'd make more money in theory.  You need to factor in the time required to source the next project though and that is likely to sap your return.  

Development projects have potentially SIGNIFICANT risk pre-entitlement.  This risk is heightened in liberal counties with hoards of rules to navigate.  If you hold inventory of land all sorts of bad things can happen with zoning laws and such.  Land development codes are not static.

Development projects also suffer from additional execution risk.  The residential building industry is notorious for having contractors under-perform.  A bad builder can draw your projects out for extended periods of time and it is difficult to get rid of them if you have an interim construction loan because the lender will seek releases from everyone.  

Return on equity can be defined by the simple Dupont forumla:

ROE == Profit Margin * Asset Turnover * Equity Multiplier

From my experience the profit margins on spec builds are larger, but the turnover is less frequent.  The financing is generally more expensive for flips and rehabs too whether it is via hard money or equity.  Banks generally don't lend on rehab projects or have requirements that make borrowing sub-optimal.

The MOST important factor is generally TIME.  Here are some general rules of thumb for time in this discussion:

-Flips yield higher inventory turns

-Flips have smaller margins

-Flips have more expensive financing

If you can continuously source new flip projects with sufficient margin and have or can find the capital to execute you'll probably get a higher ROE from those projects.  The work required is higher from what I have seen so this higher ROE is not without an additional labor component.

Make sure you account for your labor apples to apples in both industries for any analysis you do.  

Back to risk....

-Flips have smaller margins and thus more risk that unknown repairs can blow through the profit margin you thought you had

-New development projects have more entitlement risk

-New development projects have more temporal risk

So this is really a margin and inventory turn discussion with a mixture of accounting for your time and financing costs.