Before you build specs, answer these 5 business questions

A builder recently asked for my thoughts on the right mix of specs and pre-sales. My first response, as those who work with me have come to expect, was that there was more than one question buried in that one. Before we could talk about the answer, we needed to pull the pieces apart – because it is hard to find the right answer when you are juggling multiple ideas at once. Once we work through the individual pieces, we can put it back together. In this case, that meant asking five questions before the original one could be addressed.

What type of market environment are you in?

This is the threshold question. There are times when your biggest concern is simply whether you can sell homes at all – can you move more than a certain number per month, regardless of price?

In that environment, you’re naturally more reluctant to start specs. At other times, as in the early pandemic, it was nearly unfathomable that you couldn’t sell them. The harder question then became whether you could control costs and price them for a profit. In a hot market, you’re more likely to wait until near completion, when costs are known and you’ve captured as much market appreciation as possible — and in that situation, you could have spec’d them up and likely captured option profits as well.

How much of your profit comes from options?

Before answering the spec question, it is worth knowing what percentage of your projected profit comes from the base house, versus options, versus lot premiums. Builders sometimes discover their pro forma results are more dependent on options than they assumed – and whether options account for a significant share of the return, that assumption deserves closer scrutiny.

Starting specs and selling later can limit option sales. If you’re a California builder with a fixed product – set floor plans, fixed mix, fixed streetscape – you’re not offering room options beyond minor changes (converting a loft to a bedroom, for instance), so your option revenue comes from finishes. In that case, you might start specs and push to sell before it’s too late for buyers to make finish selections. But if you offer meaningful room options and derive significant profit from them, starting specs may cost you more than you realize.

What is your competition doing – and who are they?

You might feel cautious about specs because of concerns about market depth. If you’re surrounded by other private builders with similar concerns, everyone limiting specs may be the right outcome for the market. But if you’re competing with Lennar or D.R. Horton and they’re pricing to move spec inventory, and your buyer profile isn’t high-end enough to attract buyers who “want what they want,” you may need to build specs simply to stay competitive.

What is your willingness to meet the market versus protect margin?

If you tend to hold for margin, you probably shouldn’t start many specs. If you’re prepared to sell at whatever the market will bear and believe minimum velocity is essential, starting specs makes sense. This is less a financial question than a strategic one – it reflects the kind of builder you are and the business model you’re running.

What does a no-spec posture cost you beyond the obvious?

If you don’t start specs, there are costs that don’t appear directly on a pro forma. Erratic starts are not the way to earn favorable subcontractor pricing or loyalty – subs price in uncertainty into their bids.

Internally, a prolonged stretch without starts weighs on employees. In a homebuilding operation, everyone knows that if you don’t start them, you can’t close them.

Putting it back together

Once you’ve worked through those five questions, the spec question largely answers itself – not because there is a universal right answer, but because the right answer for your company, in your market, at this moment, has come into focus. Market conditions, competitive dynamics, the balance between fear and greed, your product type, and your philosophy on price versus pace all shape what the correct call is. They just need to be examined one at a time.

Most decisions in homebuilding work this way. The instinct is to wrestle with the combined question until an answer emerges. A more reliable discipline is to recognize when a question contains other questions, separate them, and work through each one. The synthesis at the end is usually straightforward. It is the untangling that does the work.

That’s not a hedge. It’s the actual answer.