Sometimes your real estate investments will follow a straightforward trajectory. That’s the case with built-to-suit projects, which means developing to meet the needs and specifications of a specific tenant — like a chain drug store or coffee shop — that is guaranteed to take over when construction ends.
Other times the path isn’t so clear. Maybe you’ll buy a vacant lot hoping to construct an office building without knowing who will lease or buy it after construction is complete. That hypothetical is an example of speculative construction, which comes with more risks than a built-to-suit scenario. But, in the right markets and with the right projects, speculative can have a greater return.
What Is Speculative Construction?
According to Sammy Greenwall, Co-founder and Chief Strategy Officer at Lev, speculative construction means “you’re building something that has not had an agreement signed between the real estate operator, the landlord and a potential tenant. And you’re speculating that because the market has X, Y and Z demand drivers and factors, you will likely be able to get a tenant before the property has completed construction.”
Greenwall added that speculative construction usually involves office, industrial or other single-tenant buildings. It generally does not mean buildings with multiple tenants, like apartment buildings or self-storage.
Traditionally, a client would reach out to a contractor with a development timeline, construction plan and building requirements. With speculative construction, the builder is in the driver’s seat.
Also, while a deal may be speculative in the sense that there is no tenant at the time construction starts, that doesn’t mean the project is simply based on hope and a prayer. Speculative construction deals are generally handled by experienced developers who examine factors such as vacancy rate, market demand, and asset type before deciding to pursue a speculative project.
3 Examples of Speculative Construction
Speculative construction occurs across multiple asset types. Here are three examples, one currently in progress, and two hypothetical but common.
1. Office Building
Greenwall is working with a group of sponsors in the Bay Area to construct an office building. They have $20 million invested, and do not currently have tenants. It’s a very high net worth market, however, with a low vacancy rate for office space and a lot of demand. The investors are betting that it will take three years to develop the property, get all the permits and the approvals, receive a Certificate of Occupancy and sign a lease with paying tenants.
2. Subdividing a Tract
Sometimes speculative construction can involve land, too. In this scenario, a developer may divide up one large tract of land and develop it into multiple lots. They may decide to develop homes on the lots and then lease or sell them, or to sell the lots themselves to another buyer that will then be responsible for sourcing tenants.
3. Last Mile Distribution Center
Because the vacancy rates for these centers are so low, and the demand so high, a developer or investor might decide to build a place where companies like Amazon and Walmart can hold their packages before they’re delivered to customers’ homes.
Advantages of Speculative Construction
Many developers enjoy the control and fast pace of building their own speculative structures. Here are a few reasons why.
More Time to Find Tenants
You can concentrate on the development process without spending time securing a tenant. This is more likely the case if you have good relationships with leasing agents and real estate brokers, which is essential for finding tenants for your speculative project.
According to Greenwall, “your returns can be absolutely unbelievable because you’re building a product that doesn’t actually exist in the market already, and you can create tremendous value from that.”
Great Timing for Industrial Development
With the demand for online shopping at Amazon and other companies at record highs, so is the demand for industrial spaces to store all of those packages, especially for last mile distribution centers, the last place your items go before they get to your door.
“It’s just grown so immensely for these distribution centers,” Greenwall said. “So saying spec in the industrial sense, it’s almost a joke because spec doesn’t really mean spec because there’s no vacancy whatsoever in the industrial space.”
Risks of Speculative Construction
Construction contracting from vetted and established tenants is always a safe bet. Here are some reasons you might steer away from speculative structures.
Speculative Construction is Not for Beginner Developers or Investors
“I would definitely ensure that the individual has a lot of experience or a lot of relationships in the leasing space,” Greenwall said. “Those relationships increase the likelihood of finding tenants once your project is complete.”
You May Not Get Tenants
Hopefully you’ve done your due diligence, researched the market, and chosen a project for which there’s likely a lot of demand. Even if you’ve done everything correctly however, there’s still a chance that it might take you a while to find tenants, which might mean your investment won’t produce income as quickly as you might have planned. That could lead to defaulting on your construction loan, or deciding to take out even more loans just to buy yourself time.
You Might Go Bankrupt
This happened in the 1980s in New York City, where there was a surplus of office buildings, and not enough employers to fill them, which lowered rents across the market. The market experienced a downtown following a glut of building in the late 1970s. Tenants, facing an uncertain economic climate, were hesitant to renegotiate leases or to commit to new spaces for more than a short period of time. According to the New York Times, the market began to stabilize with interest from international companies, and in existing buildings in the Financial District.
You Might Have to Take on Additional Loans
If your initial construction loans are set to expire, and you need additional financing to complete the project before you find tenants, you may consider obtaining a construction takeout loan. These loans replace the short-term construction loans you may have used in earlier phases of the process, from predevelopment to construction completion, when you have additional capital needs. Or, if you can’t get a mortgage because your property isn’t producing income, a commercial bridge loan might be necessary.
Speculative Development FAQs
What Is a ‘Speculative Builder’ in Construction Terms?
The speculative builder or developer is the person who is in charge of overseeing all aspects of the project: finding the land, ensuring the zoning is right for the intended project, obtaining the construction permits, and then ultimately developing the property for the final use.
The builder will often be joined by a limited partner who provides the majority of the capital, but the builder or general partner will be the person who’s responsible for overseeing the product and making it, ensuring it is completed in a timely manner.
Where to Get Speculative Construction Loans?
For speculative construction, you can get capital from either a bank or a private lender. According to Greenwall, local banks that really understand the asset class you’re developing and the area around that development are a good first step, and potentially more so than a national one.
“They can feel it,” he explained. “They can see the property. They have a sense for it. And they’re more competent in that market because that’s where they lend all of their dollars as opposed to a national lender who might not know the specific sub-market.”
Private debt funds have a higher cost of capital, and will be looking for higher returns than a bank, but might be willing to lend more, and do so more quickly and nimbly.
Per Greenwall, “If they feel that there’s a lot of demand drivers within that market and the sponsor makes a lot of sense, they’ll go for that deal so that they can get maybe a 7% or 8% return as opposed to a local bank that might be charging 4% or 5%. If you go with a debt fund, your financing is likely capped at 70-80%. With a bank, it’s closer to 65-70%.
Demand and Timing Are the Most Important Factors to Consider
When it comes to speculative construction, it’s important to consider your appetite for uncertainty. You can do all of the research in the world, and understand your asset type and market conditions thoroughly, but risks and costs can still remain high. Market conditions now may not be market conditions in the future. When engaging in speculative construction, you’ll need to lean on your knowledge and relationships to weather these challenges.