When a builder constructs a house without a contract, it is known as a spec house or a speculation home. There are several advantages to the builder to build a spec house including timing, financial gains and workforce retention. There are advantages to the buyer to purchase a spec house as well. These include no delay in moving in, an overall lower price, and a simpler contract.
There are two common reasons for contractors to build spec houses. One is the start of a new development. The developer entices the contractor to build a spec house either as a model or to get the project going. In exchange the developer sells the lot for a low price or provides other types of incentives, first choice on lots in the development, waiver of community fees or a reduction in the sales brokerage fees.
The second most common reason for contractors to build a spec house is to maintain regular income for the company. It is important for a contractor to demonstrate regular and consistent revenues. Bankers favor businesses with consistent income and high levels of production. These types of businesses reduce risk for the loan portfolio of the bank. In construction, the ability to borrow money is required. Very few contractors can front the capital it takes to build homes.
Once the decision is made to build a spec house, the contractor will benefit from the following advantages:
It is not uncommon for a contractor to go through lulls of reduced workload. Sometimes it’s seasonal, other times it is due to a shortage or inability to close contracts with potential buyers. For buyers, interest rates, availability of money and local economic reasons have a bearing on getting a signature. In these scenarios, the contractor may elect to build a spec house in order to wait out the timing issues.
Construction of a spec house has several financial advantages. These include:
- Architectural and Engineering Fees – the plans for the spec house may come from the existing pool of homes already constructed in the past. These fees often exceed 3% of the cost of a home.
- Incentives from the developer as identified above
- Maintaining discounts from suppliers for purchases of raw materials
- If the entire new home construction industry is experiencing a slowdown, then many subcontractors are willing to discount their fees to have work.
- The house can be built with fewer amenities thus reducing the overall cost per square foot.
Without work for employees or subcontractors, these skilled individuals will seek work elsewhere and it is difficult or expensive to get them to return. Skilled laborers prefer regular employment and will seek out contractors that can provide this form of security.
For the buyer, they too have advantages when purchasing a spec house.
Typically a new home takes around nine months to build from the day the site is surveyed to the day the Certificate of Occupancy is issued. Most spec homes go on the brokers listing around six to seven months into construction. By the time the buyers find the home and sign a contract, the house is just about ready for move-in. So there is no delay for the buyer in their move.
Overall Lower Price
The financial gains the contractor experiences above are sometimes passed to the buyer. Buyers have greater negotiating latitude in getting the best price for the home. Furthermore, contractors have no interest in continuing to pay interest on the loan for the construction of the home. They are willing to sell the house at a lower than market price to get the house out of the portfolio and move onto the next project.
Because the contractor has already made the decisions on the amenities for the home, there is no need to have the respective clauses in the contract for these items. Examples include:
- Flooring types and materials
- Design of and installation of custom trim to include crown molding, chair rail, and fancier railings
- Custom made kitchen cabinets and countertops
- Windows and doors
The contract goes from the custom design build format to the industry standard real estate contract utilized by most real estate brokers.
The above identifies the reasons and advantages for the contractor to build a spec house. There is risk involved. If the market is in peril as it was from 2008 through 2012, a spec house would most likely have not been sold. For a builder this is tantamount to financial trouble. I have several clients still sitting on newly constructed homes while they wait for the market to rebound. When done correctly, a spec house is a useful tool for the contractor to take advantage of financial opportunities, retain the skilled workforce, and fill the slow periods with work. Act on Knowledge.
If you have any comments or questions, e-mail me at dave (insert the usual ‘at’ symbol) businessecon.org. I would love to hear from you. If interested in my services as an accountant/consultant; click on ‘My Services‘ in the footer of this article.