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Construction Programs & Results Inc

We Like to See The Good Guys Win!

Spec Homes / Custom Homes

by Michael Stone

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.

Comments

I give each client an allowance sheet for floor goods, appliances, bath tiles, etc.
Each line item states, for example," Up to $3800 for appliances." Each home has it's own allowance sheet, in keeping with the allowances and price point of each project. My intention is to not get deeply mired in the bookkeeping of credits. As each allowance is budgeted to create a certain gross profit at the end of each project, how should I protect my overall gross?
Further, should I set the allowance at my cost or at cost plus mark-up?

Dear Sir;

I have just read your article on Spec Homes/Custom Homes. We have 4 lots that we purchased in different locations and thought we would try a spec house on one. We understand about the budget for a 3,000 ft. home, plus selling price and anticipated profit, but we also had closing cost, architect fees, drive permit, cost of land, clearing, rough drive, utilities, well, septic, etc before we even started to build. So if we include these cost, then the cost to build the actual 3,000 ft.house, plus selling fees, the effort does not seem to be profitable. We are not a developer with muliple land parcels all together. So we fall in between spec house but custom built.

Could you give me an accurate example of what we should have paid for land cost plus other cost before the actual start of building the home?
We are building a straight custom ranch 3 bedrooms 2 baths, open livingroom-diningroom with vaulted ceilings, 1, 800 sq ft plus 2 rooms in basement framed up for additional living space. The drive cost more than we expected because it is quite long.

Do we also pay ourselves just like if a customer would hire us for a contract price, in orser for our company to make sales, overhead and profit?

Thank you for any help to these questions.
Kevin Halton

Derrel:

On your cost estimate sheet, you include the amount for the allowances. Total all your costs, mark it up, and that gives you your sales price. Your markup is buried on your cost estimate sheet, which no one else sees, including any lenders.

If an allowance comes in at less than what you have listed on your allowance sheet, you refund that amount off the final payment, you keep the marked up difference. Your overhead keeps right on truckin here, so get paid for it.

If an allowance comes in over the allowed amount, you should write a change work order on the spot, have them sign it and pay you the difference on the spot. An overage on an allowance amount should be treated exactly like a change work order, the only difference being that the customer knows exactly what the cost difference is, and that makes it difficult to use your markup without giving away proprietary information about your company. So if you are going to charge a markup on any purchase that exceeds the allowance amount, you must have the amount of the markup clearly spelled out in your contract so there is no argument about what is fair when it comes time for the customer to pay for the change.

You might not want to use your usual markup. I would keep the markup on an allowance amount in the 20-30% maximum range to limit any arguments about what the industry standard is. Remember, most of our customers still believe that there is some mythical industry standard of 5 - 10% overhead and 5% - 10% profit that contractors are supposed to charge on their jobs. It shouldn't affect your overall profitability that much, because you want to establish allowances that are reasonably close to the actual cost anyway.

Kevin:

We always assume that when folks write in either to post a comment or ask questions, they want honest answers. You will always get our best effort and answers. Our answers are not always the most popular, and sometimes we step on toes. We never deliberately hurt anyones feelings or try to embarrass them. In short, you will get the truth, regardless of how it may come down. Now, that said, let me give you the best answer I can, based on your note.

First, if you havent done so, get a copy of our book, Markup and Profit; A Contractors Guide and read it. It is apparent from your note that you are caught up trying to sell your homes (and services) on price. You wont stay in business long with that approach. You can see from the article above that Lou does very well selling basically the same type home as you outline. He and Paul have made a commitment to make a profit on every job they build and sell.

If you dont see a profit in the home you are talking about, then you are setting your sales price too low. No yah, butts here, it is too low. If it isn't possible to sell the home you are planning to build for the price you need to ask to be profitable, you shouldn't have purchased the land. This has nothing to do with being a developer, or the difference between new homes and spec homes. If you dont charge enough for your homes, you are going to go away. There is only one reason to be in business, and that is to provide a service and make a profit.

Your markup on any home, custom or spec, has to be NO LESS THAN 1.26 times your job costs. You would be smart in using a 1.30 markup. Many of our coaching clients use markups of 1.35 to 1.40 times their costs and easily sell any home they choose to build. Price is seventh or eighth on the list of priorities that customers list when they buy a new home or remodeling work.

If your driveway cost more than you expected, it wasnt because it was too long. It cost more because you did not take the time to get a written quote for the driveway before you finalized your estimate for the job. My 6th Cardinal Rule is to get written quotes on everything on your estimate sheet that exceeds $300. Had you done so, you would have known the cost of the driveway expense before you started.

You need to do your own research in your immediate area as to what can or should be paid for dirt. I can't attempt it from here, because I don't know your area and have no idea what a fair price would be. Where I live, building lots can range from $80,000 to well over $350,000 and more all depending on location.

Finally, yes, you should be paying yourself a salary to own and run your company. That is an overhead expense. You should also be charging each job and paying yourself for any physical work you do on the job. That is a job cost. If you dont charge your jobs for both, you are working for free on one or the other. Working on jobs also includes delivering tools, equipment or materials to the job site, talking to the owners, your employees or subs and giving advice, cleaning up after those same subs or employees, etc. If something happens and you can't do the work, you need the money available to pay someone else to do that work. Remember, your profit on the home sale is not your salary or your wages for working on the job. Profit is what is left after all bills have been paid, and allows you to grow your company and survive through the tough times.

That is the best help I can give here other than encourage you and all others to read our newsletter and read this blog on a regular basis, both our comments and those posted by others.

What we write in our newsletter and on this blog is called advice based on experience. Experience comes from making good decisions. Good decisions come from having made a whole bunch of bad decisions. We've made bad decisions in the past, and would like to see others not make those decisions! We encourage you to ask questions, but also keep in mind that you may not always like the answers. You will, however, always get our best advice. We care about you and your families, and we like to see the good guys win.

Bruce Hoefling (not verified) /

Hi Michael,

I sell Andersen windows for a large lumber yard in Southwest Florida, I've been reading your newsletter for a few years and I can't get enough.
Your insight and experiance is so helpful to me in my business.
I use your advice all of the time and I want to thank you for taking time out of your business to help other people.

Thank-you

john ryan (not verified) /

Well i find myself just grasping for my visa card to buy this book.
As per normal, mike you have done it again, as per my request may i thank you, it seemed to have caused a stir. I really enjoy this Q/A section, it does give an insite to what is really going on out there.
I have to date been really inpressed with your input, i look forward to reading more
many thanks, john ryan

Althea (not verified) /

Not a bulder myself, I enjoyed the custom/spec home section because I am looking to buy and have found an "almost perfect" spec home on a nice lot. My question is that if I buy the lot adjacent to the home, could I build a home like it but with an extra room here, a larger room there, for the same or less money? Would the markup on a spec outweigh the costs of a new lot and some additions? Since I cant give you specifics, what about if I built the exact same house instead of buying it as a spec?

Now, we are in a time and age where building fantastic looking and strong houses assures us of comfort and satisfaction. Unlike the early men, we have more tools to better our homes. Home remodeling in Riverside is highly in demand because homeowners have a lot of layout designs to choose from for the improvement of their kitchen or bathroom. You will definitely find everything that is in line with customizing your home. Just give your specifications and let the ever-reliable Riverside homebuilders work on it.

I've built both spec and custom homes and I'll take custom homes any day. Unless you are horrible about dealing with clients, why would you want to guess at what they want, always be behind the eight ball with financing, and have all that worry about whether or not you will sell the house? Yes it takes more marketing and sales skills to get a custom home sale but then I always work with the client's money (or agreeable financing draws)and I know ahead of time it's sold. If they make what I consider to be terrible design choices it never bothers me because 99.99% of the time I can't see their house from mine!

I am wanting to advertise a couple floor plans that my company will build for the right customer. Do i need to get an archetect involved to design or can i just buy a plan on line to build and sell?

Michael Stone /

Charles:

That is a question for your attorney. Each state has different laws covering the use of other peoples intellectual property.

Michael

Michael Taylor (not verified) /

Hello how are you, In building a new home from 2700-3300sqf what is the typical cost for a 4side brick or stone upgrade. Thanks

Hi Michael,
A new home can range from 125.00 to 225.00 per square foot if you're going to build a custom home in today's market. This does not take into consideration the land cost. This only takes into consideration the part of the house that is "conditioned space". Also, I might add that costs go up if you're building on a lot that isn't level. That is if you're building on a hillside where you might have retaining walls and a basement which add significant costs to the foundation.

michael hinkle (not verified) /

I have been reading some of the questions that your readers have asked and the response you have giving them back. I am learning a lot from them and will keep them in mind when I venture off to build my first spec home thanks

john (not verified) /

I find your site very informative as a customer. How might I go about making an offer on a spec home in good market, neither buyer or seller, that might be considered a "good buy" without offending the contractor? Any tips or "how to's" would be appreciated. Keep up the good work.

Marjorie (not verified) /

We are going to build a spec home and need to know what the bank will want to see and hear from us. We have a local one in mind, who works with locals and creative financing. We have the credit rating, know-how and target market. Just want him to come away from the meeting feeling confident working with us. Just a few pointers would be great.....

Hi. I read your post and found there are lot of differences between Spec Homes/Custom Homes. Thanks for sharing them so one can aware of these points before buying & can make some profit.

 

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