Sunday, September 12, 2010

Should You Build a House? Probably Not.

Building a home is one of those interesting life events that everyone dreams of doing.  But from a financial standpoint, is it worthwhile?  In most cases, no.

NOTE:  When I say "build your own house?" in this context, I mean actually of hiring someone to build it, which can be a nightmare of expenses, and oftentimes, the resulting house is worth LESS than the market value of the home.   If you are thinking of hiring a contractor to custom-build a home, think carefully about it.
Remodeling is also a path fraught with peril, if you hire people to do the work.    It is often far cheaper to just buy the house you want than to tear apart an existing home and make it into something else.
Actually constructing a home with your own hands could be cost-effective.  This is not as impossible as it sounds, for a reasonably-sized structure.  And in fact, in days gone by, if you wanted a house, well, you had to build your own.
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Building your dream home!  That, along with the "dream of home ownership" is often touted as the end-all of humanity, at least in the United States.  We are sold this as some sort of ultimate experience - to build a home "just the way you want it".  But in most cases, building a home is a stressful, financial nightmare that you should walk away from.

Why is this?  Well there are a number of factors.  I have witnessed many friends and family members build homes, and in most cases, they were not ecstatic about the outcome.

Note that when I say "build a home" I mean buying a piece of land, hiring a contractor, designing a house, and having it built.  I am not talking about building your own home by hand from scratch (an even more daunting task) or going to a development under construction and picking out one of the three models under construction (which is more akin to buying an existing home, really).

Here are some factors you should take into consideration before building your "dream home":

1.  The myth of the Unique Home:  One thing touted about building your own home is that you can design it "just the way you want it".  But in reality, most people design homes just like everyone else.  In fact, most new home builders get their plans out of a plan-book.  So much for originality.

And in fact, you don't want to be "too original" in building a home.  Quirky and odd houses are very hard to sell later on, and odds are, you will sell later on.  And banks aren't going to lend money for you to build your underground energy-dome, or yurt, or whatever.  Chances are, they are only going to loan money for a conventional, traditional home like everyone else has.

So forget the idea that you are going to build a unique home - because chances are, if you are a middle-class schmuck like the rest of us, you are going to build a very conventional home.  And if you build a weird house, it will hurt you in the long run, as we shall see.

And since we all end up buying pretty conventional homes, the idea that an existing home is ill-suited to your needs is somewhat folly.  We all end up wanting and buying the same kind of shelter, it turns out (which is good, because, as noted, a "unique" home could be a financial nightmare).  And there is a wide variety of existing home styles and types on the market as well.  If you want "unique", chances are, it is already for sale somewhere, probably for cheap.

Granted, the very, very wealthy (100-millionaires) can afford to hire an architect and build state-of-the-art cutting edge houses.  But they don't care about resale value.  And you and I are not hundred-millionaires.

2.  The Amateur Home Builder:  Like in remodeling, as a amateur home builder, you are at a disadvantage over the home building companies, who build developments of 100 houses at a time.  They have access to resources and materials far cheaper than you do - and pay less per acre for lots than you do.  So if you "stick build" your "dream home" on a vacant piece of land, chances are, it will cost you more than it does Pulte homes (or whatever) to build a similar home in Meadow Cove Mews.

More than likely, you, as the amateur home builder, will pay top dollar for labor, supplies, materials, land, permitting, and you-name-it, because you don't have the access the "big boys" have, who do all this for a living.

The contractor you hire to build your home probably also builds homes "on spec" and sells them.  He can build them cheaply and sell them retail for more money.  He isn't going to charge YOU what it costs HIM to build a home - he is going to charge the retail price of a finished home.  He makes money.  You don't.

So there is no "savings" in building a new home, and in fact, it will cost more than existing construction, in most cases, as we shall see.

3.  Construction Costs exceed Market Value:  In many markets, the cost of construction today can easily exceed market value of the finished home.  For example, here in Central New York, you can spend $400,000 building a nice home, and the finished product may be worth $350,000 on a good day.  Right off the bat, you are underwater, and may have to wait years, just to break even.

In other markets, such as Florida, the number of unsold units, foreclosed units, and distressed-sale units continues to suppress prices.  Building new units made sense during the go-go years of 30% annual appreciation.  With so much inventory on the market right now - at distressed prices - it makes more sense to buy a foreclosure than to build anew.

With homes appreciating only a few percentage points a year these days, you may be "upside down" on a new home for quite some time - or end up losing money when you sell.  For this reason, financing on home construction is harder to come by and you may need to have a hefty down payment to get permanent financing on the home.

The other problem, as we shall see below, is that cost over-runs are typical in new home construction, as unexpected events cause delays and additional costs.  And most consumers building a home fail to take into consideration all the extra added expenses beyond the home itself.  As a result, it is very easy to end up "upside down" on a home.

4.  Punch List items:  In all new homes, the first year or two of occupancy can be problematic, as issues from construction are realized and many defects have to be fixed.  Homes follow the Weibull curve as well, and new homes can have many new problems.  So expect a leaking appliance, a leak in the roof, a bad sheet-rock crack, and the like.  And you will have to hassle with your contractor to get it fixed.

The idea that a new home will provide "peace of mind" and less maintenance is thus flawed.  Chances are, the first two years of ownership will be characterized by more maintenance, not less, that for an existing home in good condition.

5.  Financing Nightmares:  Financing new home construction is problematic for several reasons.  If you want to buy a vacant lot, you will probably have to pony up most, if not all, of the money.  Banks don't like to lend money on vacant lots, as they can depreciate a lot in value.  As a bonus, most Real Estate Agents charge huge commissions on sales of vacant land.  And if you are planning on buying vacant land on the premise that "someday" you will build on it, bear in mind that in general, vacant land is one of the worst investments out there.  It does not appreciate very much and has a high carrying cost in the form of taxes.

To begin construction, unless you have cash, you will have to get a construction loan. These loans are not easy to get, and you will need a good income or a lot of money in the bank to get one.  Expect the fees and interest rates to be high.  A lot can go wrong during construction, and if it does, the bank ends up the proud owner of a half-finished home, which quickly can deteriorate to nothing in value.  For this reason, banks charge sky-high fees to assume this risk.

Once the home is completed, you may be able to get a standard 30-year mortgage on the finished home.  But expect to have a lot "down" on the property, as the bank knows that it is likely to be worth less on the market than what you paid to build it.  If not, again expect high interest rates and fees, as they are assuming the risk.

In contrast, a Purchase Money Mortgage (PMM) for an existing home is relatively easy to obtain, if the home is properly priced and in good condition, and you qualify for the loan.  Interest rates are very low right now and you can lock in a good rate (4.125% at the time of this writing) for 30 years.

6.  The Little Things that add up:  One aspect of new home construction that most folks don't appreciate is the ancillary things that are part of a "home" and can cost a lot of money, when added up.

When buying an existing home, or a home from a builder in a development, you expect to get a driveway, well and septic (or hookups to city utilities) a lawn, some landscaping, and things like that.  When you build your own home, often these "extras" are not part of the builder's quote, as he builds the house, not the landscaping and driveway.

So factor all of that in to your pricing - as well as electrical service, telephone wiring, and the like.   And then factor in the 20-50 trips to Lowes or Home Depot for all those little things in life that you need in a new (but empty) home that might be present in an existing home.

The cost of construction is only part of the overall cost of a home - to completion.  A home with landscaping, lawn driveway, walkway, etc. is a beautiful thing - and what an existing home comes with.  A finished home on mud-filled construction site is hardly "complete".

Speaking of which, in many cases, for a new home, expect to be living on a lot denuded of trees.  Planting trees costs a lot of money, and it can take decades for trees to mature.  Often the second or third owner will be the beneficiary of your tree planting in a new home, not you.

7.  The Construction Process:  This ends up taking up a LOT of your time, as you have to supervise and monitor each phase of the project, push contractors to finish their part, and struggle to deal with suppliers, contractors, and the inevitable unexpected problems.

And while the process is time-consuming for you, you don't get paid to do this "job".  

Construction can take time off from your real job and cause a lot of stress in your life and to your relationship.  While it may seem like fun at first - watching the foundation go in and the frame go up - after a while, it gets pretty boring and becomes an unpleasant job.  And it always seems that the process "stalls" halfway through construction, which is usually a function of progress payment system.

And expect this process to take 6 months to a year - or more - from start to completion.  It isn't fast or easy.

8.  Contractor Problems: Almost every consumer who has a home built tends up with some contractor issues, from minor to nightmarish.  And of course, one problem with people who build a home is that they become unpleasant to be around - the friend with the perpetual problem.  Whenever you see them, all they do is bitch about the new home construction process and their contractor.

If you are lucky, your problems will be small, perhaps limited to the inevitable cost overruns (plan on these, don't be surprised by them!).

If you are unlucky, your contractor will walk off the job or go bankrupt, after having taken most of your money.  This happens more often than you'd think - which is again why banks charge so much for construction loans.

Most home building contracts are set up so the builder gets payments based on "progress" benchmarks.  He usually gets an amount for starting, so much more once the framing is up, the shell done, and then for final completion.  This is one reason the foundation and framing go up in a hurry and the process seems to "stall" later on.  Most contractors get more than half their progress payments once the shell is completed.  The plumbing, wiring, sheet-rock and finishing work is far more time-consuming compared to the money earned.

So chances are, your contractor puts his men on the next job, to get more money for another shell, and puts two guys on the finish work for your job.

And in some cases, a contractor simply takes the progress money and walks away - correctly figuring that the finish work, in terms of dollar of payment for dollar of labor, is far less profitable or even a money-losing proposition for him

More than one new home builder has found themselves proud owner of an empty shell and a contractor nowhere to be found.  At this point, you are totally behind the 8-ball, as you have to try to find a contractor to "finish" the job.  Most contractors will not return your calls at this point, as no one wants a nightmare of finishing someone else's half-finished home and moreover may suspect that you are a "problem client" which is why the last contractor left.  And even if you can find someone, they will want more money than the remaining progress payments, so your cost overruns will be staggering.

And yes, this has happened to friends of mine.  Believe me, they will tell you all about it - for hours at a time!

So the question remains: Why do people build brand new homes?  Well, like with brand-new cars, there are a lot of idiots out there and people will pay extra for status - the bragging rights to say they built their own home.  And I'm not saying it isn't an interesting life experience or that it always goes horribly wrong.  But it is a hassle and a lot of money to risk - particularly if you are a middle-class American and can ill-afford to risk hundreds of thousands of dollar.

Some examples of friends and family members who built their own homes are illustrative:

My parents built a home in Rochester, New York, on Allen's Creek Road.  Dad had just gotten a promotion at ITEK and was making good money.  They designed a house with a local architect that, in retrospect, was pretty conventional.  A center-hall colonial with an eat-in kitchen - pretty standard stuff these days.  So the idea that they were getting a "unique" home was somewhat specious.  About the only "unique" thing about it was the upstairs laundry room, a novel feature for the time.

We lived in the house about a year.  There was hardly a lawn on it and no patio, and no garden, as the home had just been completed.  The lawn was just coming in when my Dad lost his job and we had to move.  My Mother was heartbroken, having to leave behind her "dream" home.  But in retrospect, was it such a good "dream" in the first place?  Their finances were such that in order to afford the home, my Dad had to have a job making X dollars a year, and if he lost that job, well, no more house.

If we had stayed in the more plebeian house at 62 Stoneleigh Court, perhaps we would have been happier as a family, with less stress from the construction costs, and when Dad lost his job, we could have gotten by for a year or more while he found a new one locally, rather than have to move out of State.

My parents didn't build again for decades.  When they retired, they decided to build a retirement home on the Chesapeake Bay.  Zoning limits required them to buy 5 acres of land.  But their personal needs and budget dictated that they build a small, two-bedroom house with an octagon shaped living room.  It was slightly quirky, too small for the neighborhood (and lot) and hard to add on to.  While they made a profit on the sale of it a decade later, if you added up all the time and effort put into landscaping, planting, and "finishing" the home, I suspect the profit wasn't that much.  Since the house was small and cheaply built (for that upscale area) it was harder to sell.  Lesson here?  Quirky doesn't work!

Our present home (which we just sold) was built by our neighbor.  They spent a considerable sum building it, and sold it for more than the construction costs - after living in it for 15 years.  They planted a lot of trees and did a lot of landscaping, which we appreciated and the new owners who we sold it to will as well.  But those first years, it was pretty plain looking.  They did a lot of heavy lifting during that first 15 years, but the results were appreciated by the next buyer, not themselves.

They went on to build another new home, and it is very nice.  But my neighbor confessed to me that if they added up the cost of all the work done on it, it would exceed the resale price - by $50,000 to $100,000 or more.

Another friend of mine decided to build a home, and as mentioned above, had the contractor disappear halfway through construction.  The were able to get someone to finish the house, paying far more than they anticipated and also doing much of the finish work themselves (and cutting many corner in the process to save money).  They ended up "upside down" on their "dream home" for many years, and the dream was really more of a nightmare.

I have another friend who wants to build a home, but I am not sure they have done the math on this.  In Central New York, as noted, many homes are for sale.  And the cost of construction is staggering, as the construction "season" is short and labor costs are high (due to the welfare State we have here).  One reason they give for building on the lot is to avoid capital gains taxes by declaring it as a personal residence.  However 15% capital gains taxes, as bad as they are, could be dwarfed by the construction costs exceeding market value.  And like my parents with their retirement home, they are building a small home on a large, expensive lot, which may backfire in terms of resale value.  And obtaining a mortgage for your retirement years seems, to me, to be a bad idea.  This is the time in your life that everything should be paid for.  I've tried to talk them out of it, but they are hell-bent on doing this, just to avoid paying capital gains taxes.  Go Figure.

So, given all that, do you still want to build your own home?  If you do, bear in mind that you may end up in a worse position that you would be if you just bought an existing home in good condition.  Look around first and see what is already on the market before you re-invent the wheel.  If there are similar homes in your area, that are a close approximation to what you want to build, then why build?

If nothing else exists in your area, or there is a housing shortage, then perhaps building might make sense.  But be prepared to pay a premium in terms of time and money.

And examine carefully your real motives for wanting to build.  Yes, it is a big ego-trip and rush to be able to say "I built this house".  But is status worth paying a $50,000 or $100,000 premium for?

Like so many other things in life we squander money on, new home construction often comes down to a status symbol, and nothing more.