Building on Spec

By: Joe Hauman

This blog will cover the basics of building on spec and the current spec market forecast in my home market of Cleveland, Ohio.

 What is the Definition of Building on Spec?

Spec means speculative; in its most basic form, spec is when a developer constructs a structure without a tenant in mind to use the space. When a developer builds on spec, they have no specific tenant in mind and rely on their broker to find one to occupy the property while it is under construction.

Why Would a Developer Build on Spec instead of Build-to-Suit?

Almost all developers will “build to suit,” meaning they will be approached by a company that needs a building suited to its specific needs. The developer will agree to build the building in accordance with the business’s specifications, and a lease will be signed so that the developer may secure bank financing to construct the space.

Due to a scarcity of industrial-spec buildings, numerous spec buildings have been constructed in Cleveland. Developers will rarely build on spec if there is insufficient market demand for the space. Since 2020, the industrial market has grown at unprecedented rates. A gap in the market emerged as demand for distribution space increased faster than supply could keep up. As a result of high demand and little supply, an industrial developer and lending institution were willing to take the risk of developing without a tenant in place since they knew that a tenant would most likely come along and sign a lease while the facility was under development.

What are the Risks of Building on Spec?

The most significant risk for a developer building on spec is not finding a tenant to inhabit the space they just completed. Banks lend to developers on a draw basis, which means the developer must achieve certain requirements while building the project before the bank will continue to lend them money. The bank does this to limit their risk and ensure that the property is developed in a timely manner. After the project is completed, the developer must convert the construction financing to permanent financing. This could be a major issue if the developer has no tenants in the building and no income to demonstrate to the bank that the property is profitable. If the property is not performing well, the bank may decide to foreclose on it. One significant project gone wrong could be disastrous for a whole development firm.

 What am I Seeing in Spec Construction?

Newly built spec buildings are some of the most interesting and high-quality buildings currently on the market. As building practices continue to accelerate, almost every new construction has a feature that the last new construction in that market lacked. Cleveland is no different. With over 2 million sqft of industrial space under construction, there is a large amount of spec industrial buildings coming to market in the next 12-18 months. As I stated before, the supply of distribution space in Cleveland was well below demand, and the events of 2020 only amplified that need. Many industrial developers are still building on spec. Many of these buildings are 32-foot-high, tilt-up construction warehouses that can be occupied by a small amount of buildout. Building spec office buildings can be extremely difficult, especially because many banks believe that building spec office towers is not worth the risk. It can be difficult to find solid tenants that are willing to pay above-market rates for brand new office space.

 What is Next for Spec?

I think supply and demand are beginning to reach equilibrium, and increased interest rates have quelled the fire of developers. I think speed to market of the under-construction buildings will be key for many current developers. Many developers are already beginning to dial back their once-ambitious plans of 6-7 building industrial complexes to a more reasonable 3-4 building complex with land for future expansion. Like most things in the real estate industry, only time will tell when it comes to predicting the growth or downfall of spec buildings.

Have a question about spec buildings or want to give me your opinion? Reach out to me at joe.hauman@naipvc.com. I want to hear what you have to say.