Are all-out efforts to sell specs such a good idea? Newspapers are littered with ads offering big discounts on spec inventory. It's possible to wonder whether one can even buy a home pre-sale anymore! Even if you can, why would you, given the discounts builders offer on spec houses?
Normally, specs are built to serve a specific and smaller segment of the market, namely people who need to find a home that is nearly complete for a quick move-in. Typically, these buyers may be relocating for employment-related or life-event reasons, and they'll concede choices of a specific lot, certain options and colors, etc., so they can move in faster.
Nevertheless, pre-sales have been most home builders' bread and butter. A backlog of pre-sold homes provides visibility on future revenues and cash flows. Public builders regularly disclose the size of the backlog so investors can gain visibility on future performance. In turn, from a customer's prospective, a pre-sale provides an opportunity to personalize one's home.
Why is 2007 so different, and what does it mean? Spec inventories soared as a result of massive cancellations of pre-sold homes. Faced with too many homes under construction and a lack of buyers, builders discounted aggressively in order to find a market-clearing price. As pre-sales continued to cancel, builders found themselves focusing on selling standing inventory.
Every action has a reaction. The response to the sustained discounting of speculative inventory: Customers buy specs, not pre-sales.
Michael Sivage, CEO of Michael Sivage Homes and Communities, recognized the problem inadvertently being created. "Our backlog shrank while we continued to discount specs in order to move them," he says. "It was difficult to sell pre-sales when we were discounting specs so heavily. Before we knew it, our backlog had shrunk and the margins on our spec sales were far lower than our pre-sales. The significant discounting and special offers to Realtors on spec sales were cannibalizing our pre-sales. We inadvertently conditioned the market to buy spec homes at the expense of the more profitable pre-sales."
This conditioning is not easily undone. Why would any customer buy a home at pre-sale prices when they know they can buy a spec home at a more significant discount? Yet builders are reluctant to offer pre-sale discounts and incentives equal to what they are offering on spec inventory.
Sivage tried a new tack. First, all pre-sales are screened prior to the start of construction to ensure full mortgage approval is in place, which minimizes the likelihood of cancellation. Secondly, starting of spec inventory is restricted, so an adequate number of specs are available for those customers who have such a need, but the supply is such that drastic discounting is not necessary. This levels the playing field between spec and pre-sales. Once the playing field is level, heavy discounting is not necessary and pre-sales are no longer shunned.
With the best of intentions, builders realized they needed to reduce spec inventory. Unfortunately, few realized that heavy discounting of specs erodes one's backlog. Customers are unwilling to pay significantly more for the opportunity to personalize their home given market conditions. As long as builders are willing to offer spec homes at significant discounts, today's buyer is too smart to fall victim to the pitfalls of buying a pre-sale.
One significant way to improve profitability is to focus on the benefits of pre-sales and limit the need to significantly discount spec homes. In today's market, a spec is just a four-letter word.
–Jamie M. Pirrello is the CEO of Vision Homes USA, a Fort Myers, Fla.-based home builder. He may be reached via e-mail at firstname.lastname@example.org.