Bankrolling any startup business is difficult enough. Capitalizing a new home builder operation is a leap forward in required funds. Typically, small businesses can be capitalized on a shoestring budget, for a new home contractor, just a little bit isn’t going to work. Most lending institutions require that the project is funded to the tune of 20% of fair market value. So if the new home contractor is building three new $200,000 homes, he’ll need 20% of $600,000 to successfully pull this off. In addition, he’ll need capital to run the office operations element too. Altogether, a new home builder business startup needs in excess of $150,000 to start operations. So, how do you finance this type of operation? Where do you go to raise the capital? How is this legally structured to achieve success? This article covers these issues and provides guidance in managing the funds used to capitalize the new home contractor.
There are two elements of capitalizing this startup venture. First is the capital needed to run the day to day office operations until payment is received at the final sale of the first project. For most new home builders (low volume contractor) you are looking at around $30,000 to $40,000 depending on the cost of office operations. Because it takes seven to nine months to design, build and sell a new home, the necessary cash needed has to cover the expenses for this time period. In addition, the licensed contractor will require compensation to live day to day. If you are the licensed contractor and you own this operation, you are going to need upwards of $100,000 to get through the first nine months of operations. To find this money, review the following two articles: How to Find Investment Capital – The Family Connection and How to Find Investment Capital – The Vendor Connection. This does not cover the funds needed to begin site work on the first project. That is where the second element of capitalizing begins.
The key to funding a capital intensive project like a new home is protecting the primary creditor. Banks want two assurances. First they will get their money back and secondly, if things go south, they’ll get their money back. So provide them with this assurance. How? Well first let’s do some math to better understand the bank’s position. Assume that the project can sell for $200,000. Once the closing is completed and the seller (you) have paid the real estate broker, the transfer fees, taxes, and any buyer incentives, you are looking at walking away with a check for around $181,000. Here is how the math worked out:
Realistically, it will be closer to $178,000 because there are always more costs and needed incentives to get the buyers to sign on the dotted line.
From here, that $181,000 has to cover at least three sources of funding for the project. The first source is the 20% fronted by some investor or you to get the project started and moving forward. That number is $40,000. So the next item is the bank that fronted the balance of the project costs. So let’s assume the project costs $158,500 to build. This means that the bank fronted $118,500 ($158,500 – $40,000). The bank will actually require a first deed of trust on the house thereby protecting their position. This satisfies the primary assurance from above, getting their money back. So from your $181,000 check the bank will get a payoff at closing for the $118,500 leaving a balance to be paid to you of $62,500. From this amount you will need to pay back the investor his $40,000. This leaves a balance of $22,500 as the third source of funding for the project; your profit.
Let’s go back to the bank, remember they want two assurances, first their money back. They get that via the first deed of trust. The second assurance is ‘if everything goes south, can we get our money back?’ Remember, banks are not in the business of owning property, they are in the business of lending money. So how do you provide the second assurance? The best tool is a market appraisal done on the house using the plans and the site location for the appraiser to review and do his write-up. The typical charge is $450 to $500 for an appraisal. If your broker thinks it is worth $200,000 then the appraiser should be close. If not, you may want to consider not doing this because, honestly, netting $22,500 on a house and you are assuming all the risk is not worth the return on the time and stress. You’ll make more money flipping hamburgers at the local fast food joint. Once the market appraisal comes back for $200,000 and given the current market conditions as of late 2013, the downward pressure on the new home market is already built into this appraisal. Therefore, worse case is that you’ll have to give up your $22,500 profit, i.e. sell the house for $177,500 (88.75% of the original Fair Market Value) if you have to pay the bank back.
The bank will be mostly concerned with the house sitting for an extended period of time. This is where your broker should provide the necessary data to calm that concern. In addition, you will have to convince the $40,000 investor to give up his rights in case the market warrants a significant decrease in the value of this type of a new home. In effect, you can explain to the bank that if you have to, you’ll sell the house for $137,500 in order for the bank to get their $118,500 back at closing (Sales Price less Closing Costs). Note that the bank has debt to sales coverage of $118,500 divided by the $200,000 sales price which equals 59.25%. This is quality assurance of getting their money back.
In addition to the above, the bank only provides draws after you have already invested your $40,000 which gives them additional collateral right from the start of the project. See Construction Draw Schedule for more information about draw schedules.
Now to the point of all this; how do you find the $40,000 initial investment? Other than the family or vendor sourcing I identified above, there are real estate investors out there that will fund this type of a project. Most are involved in the flipping of homes. They are familiar with the financing of houses. You can find them via real estate agents, real estate brokers and the subcontractors at a job site (a rehab project site or flip site). Actually all you have to do is stand out at the courthouse steps on the day they sell foreclosures and you’ll meet all the investors in the world. These investors will like this type of a deal because buyers prefer new homes over existing ones and the market has no indexing of value for a new home over an existing house for sale. So it is easier to find these types of investors. In addition, the risk is less for them because the house is mostly capitalized by the bank.
So what type of deal will they want? Well, all of them will require a second deed of trust to the primary lender as security. That will be a given. Most will look for some type of interest and a portion of the profit involved. To me, if they are willing to fund 20% of the project’s value, then they should be entitled to 20% of the profit. So in effect they would earn 20% of the $22,500 or $4,500. Remember, as a part of the project costs, interest is paid on a monthly basis to the investor and the banker.
If all flows as identified, your profit from this project should net $18,000. From an accountant’s perspective and historical knowledge of this industry, this isn’t enough profit assuming the risk involved. If you start a project every 2 months exactly like this one, that’s 6 projects per year or around $108,000 gross margin from the projects. This has to cover all your indirect costs and office operations. You will personally net around zero as the bottom line. Again, note who takes the risk in these ventures; it is you.
A reasonable profit should be in the $33,000 to $40,000 range. This means that to cover all costs (construction, interest, profit sharing with the investor, closing, incentives) you will have to build this house for around $139,000. That is 69.5% of the sales price. This will be difficult to achieve. Below is a full accounting assuming a profit of $33,600 to the builder to cover indirect and overhead costs plus a desired net profit for the company.
Note that since the project costs less to build, the bank lends less money (the actual difference between the original estimated cost of $158,500 and the actual of $139,000). So the bank’s two elements of assurance are even better in this situation and as the builder, you need to alert them to this fact. So for you, you need to be able to build a house for $139,000 including the cost of the land, the initial closing costs for the land, site development and construction.
In summation, this article highlighted the best tools to capitalize a new home builder operation. Good luck. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my help as an accountant or consultant, contact me through the ‘My Services’ page in the footer.