Spec Homes / Custom Homes

I was asked for information on the differences between building spec vs. custom homes. For additional input, we asked for help from contractors we know that have been successful in new home construction. We heard from two of them, Paul and Lou.

If you are going to build spec homes, you will need a lender. Make sure you can you live with their terms for a loan. How long will they finance you for? Will they put a time limit on when they want the loan paid off or will they give you adequate time to build and sell the home?

Decide what price range you want to work in. Do you want to be in the starter home arena, or mid to high end homes? Is there a niche that you think you can focus on and do well at?

You need to select a plan with maximum customer appeal. How? The best research you can do is through a successful realtor in your area. Ask about floor plans, finishes, colors, appliances, lighting, everything the potential customer will want in their home. A good realtor knows what is selling and what potential customers want.

Of course, you have to pay for the realtors time, or list the home with them. That is fair. You are asking for their professional advice and opinions and you should be willing to pay for it, just as you expect to be paid for your work.

Another source of help is an interior designer or architect. They keep up on the latest trends and what is “hot”. If you hire either, you will have to pay them by the hour or a lump sum figure, but again, it is worth the investment if it gets the home sold.

Paul added, “We are working with a realtor that has contacts at the major employers in town; he has brought in a couple of nice custom home sales and has sold our spec home. It has made a positive change in our business. It took a long time to find the right one, but was worth the effort.”

Finding the right realtor for your company takes work. When looking for a realtor, you need to weed out the order takers and find the salespeople that can sell homes.

One of the positive aspects of spec homes is that you get to make all the decisions on how and when you build. When you know what you are going to build before you start, the building process is faster and easier. Spec homes should also have fewer changes, which keeps your original budget and your loan intact.

By doing spec homes, you will be able to participate in a local Parade of Homes, Street of Dreams, or other joint ventures with other builders in a specific neighborhood. Spec homes work 2 ways, you have a home ready to sell and you can capture leads for another home to build.

The biggest downside to spec homes is that they can eat all your potential profits in interest, insurance and utilities. It is amazing how fast profit can disappear on a home when it sits, and sits and sits some more.

Lou told a story that illustrates how to make a spec home go bad. I’ll include it here in it’s entirety:

“Advantage to spec building . . . Set the price after completion! Anything that wasn’t properly budgeted for can now be included, right?”

“Well, not really. I have not seen many contractors have the discipline to wait until final completion to list their home for sale. This is probably the biggest mistake if you want to make money selling spec homes.”

“Typical scenario –

Budget for 3,000 sq.ft. spec home – $375,000
Set selling price at the start of construction – $472,500
Anticipated profit – $97,500″

“You start construction – after roof is on you put a for sale sign in the front yard. (You are going to save the real estate commission by selling it yourself).”

“Every time someone wants to see the house you will be called to meet them (of course you are so anxious that pre-qualifying is not even thought of.) So you spend an hour or so giving a tour explaining what the house will look like when it is done in 3 months. Of course you consent to making changes if they buy at this early stage but you will have to see if you can cancel the cabinets, flooring and appliances you have on order. All of this promising to someone that you don’t even have a deposit with but your bank interest is piling up and your starting to get nervous so you jump at every prospect.”

“So after a month or so of giving free tours you agree to list with a local realtor who promises to sell it in no time!”

“3 months pass, no offers, rooms painted, cabinets are installed, ceramic tile is installed – Wait a minute! We have an offer – out of town buyer loves the house wants to know how quick you can finish. BUT they want a FEW changes . . . Kitchen Cabinets are ok but hate the vanities . . . 2 of the light fixtures are ugly . . . Dining room has hardwood but they want ceramic, can you add a laundry sink to the laundry room? They offer you $450,000 (they know you need to sell.)”

“You accept if they pay for the changes. They agree to pay for the materials if you provide the labor on the changes . . . you’re desperate . . . bank interest is piling up . . . you agree.”

“How did you do?

Selling Price – $450,000
Real estate commission – $21,150
Bank Interest – $11,750
Additional Labor – $4,500

Net proceeds – $412,600

Budgeted Profit – $97,500 (26 percent markup)
Actual Profit – $37,600 (10 percent markup), great! Let’s build another one?”

“The thought of spec building lures many contractors. Imagine, build it the way you want, no customers breathing down your neck looking over every move . . . no change orders . . . this is great!”

“OK, if you have the courage to complete 100% of your spec before marketing . . . and don’t forget to include real estate commission & bank interest!”

“And when you sell the home and the buyer wants a change . . . Charge for it! It’s now called a remodeling project.”

“Over the last 4 years I have built 2 spec homes and 16 custom homes. (All homes $350 – $700,000) The last spec home I built I sold for $455,000 at a profit of $29,000. (Just about like the scenario I described above). The last custom home I sold for $590,163 at a profit of $130,469. Of course that last house was after I read your book!”

“If I estimate & markup properly, I choose custom.”

Lou’s comments show how to make a reasonable gross profit to pay your overhead and keep your business going through good and bad times.

Building a custom home stops the worry about what the customer might want or require. But you would be well advised to have an interior designer or architect on call, who is good with customers and can help with selections, colors, etc. to keep the project on schedule. Drafting should be sub-contracted out and your contract should have a maximum number of drafting hours included with provisions for additional time and changes. You don’t want to spend endless hours drawing or redrawing floor plans.

This next comment is for the designers or architects only. Please listen carefully to what the contractor wants and the budget they have set for the home. I hear this complaint frequently from contractors across the country. Don’t go off on tangents that run the cost of a home up. Don’t add creative things that you’ve always wanted to add without talking to the contractor first and learning how it will impact the budget. For example, nothing round (well, maybe light bulbs). Keep it simple. When you deviate without clearing it with the contractor, you are driving up the cost of construction, often beyond the budget, and put the homeowner and the contractor in a contentious situation from the start. Be a hero, and talk to the contractor before you deviate from the basic plan they have provided.

When you build a custom home, the buyer is “on the hook” for payments on the building loan and that makes the whole process a lot more appealing. Additionally, with a custom home, when you are done, you are done. You are paid in full and ready to move on to the next project.

Let’s look at a couple of the downsides of building custom homes. When you are tied up building a custom home, it takes conscious effort to continue marketing, to maintain your advertising and keep your name in front of the buying public. You need to focus on running your business, not working with the tools.

Paul said, “I have finally put myself in the office to run the business, finding new clients, maintaining contact with existing clients, and doing project management. I also am allowing time to work on the business instead of just working in the business. I think this will allow us to have a more profitable company and find greater reward in what we are doing!”

Estimating a custom vs. spec home should be almost identical in approach. The one thing you must watch closely is the changes the customer may request on a custom home. Be sure that you have the additional or change work order procedure clearly defined in your contracts, and follow that procedure to the letter. Remember, you should be paid upfront for changes of $2,500 or less and only make changes when the customer has signed your additional or change work order. No verbal changes.

Allowances can save a lot of estimating time and reduce your risk on underestimating the cost of getting the job done. On the flip side, you must set your allowances within a 5 percent range of a reasonable expense for the type of home you are building. Setting an allowance of $4,000 for appliances in an $800,000 home is just asking for a fight. Keep the unwritten law of “Good Faith and Fair Dealing” in mind when you set your allowance amounts. If you set it too low, you stand a good chance of having to make up the difference out of your own pocket.

When you give an allowance for an item in the new home and the customer picks something that goes over that budget, they often want or expect you to pay the difference because it’s “what they wanted all along.” Be sure to write an additional or change work order when any selection exceeds an allowance amount.

Another downside to custom homes is keeping the customer focused and making decisions on selections in a timely manner to keep the job on schedule.

If I might add here, we address the issue of selections at length in our new book Profitable Sales, A Contractor’s Guide, and if you handle this correctly, you can drastically reduce the amount of time almost anyone takes to make selections on either new homes or a remodel project.

I hope those of you involved in building new homes will find some pearls of wisdom here. Thank you to both Paul and Lou for sharing their expertise and their advice.