One question that is never far from a residential home builder's mind is…
Is it worth it?
Why don’t I cut out the clients and just build spec homes?
Some builders start out with that model, others turn to it after years of frustration, low margins and difficult clients.
And a lot more spend their time wondering if it’s worth the risk, which is why we’ve created this article.
Because better information leads to better decisions.
Of course, contract building and spec building are not the only options available to residential home builders.
There is the open book/cost-plus model versus fixed price, design and build versus quoting plans, new homes versus renovations, the list goes on.
However, in this article we’ll deal with three big decisions that will really determine how your building company is structured: the process (spec homes or contract building), the pricing model (fixed price or open book/cost-plus), and the strategic positioning (design and build versus quoting plans).
Spec Homes Versus Contract Building
The main appeal for builders building spec homes is cutting out the client until the build is finished!
However, there are no free lunches in business and being a spec builder involves a lot more risk than contract building.
Three factors to consider when moving from contract building to spec building are market conditions, finance and scalability.
Over a significant period of time property values have always risen, however there are periods in the economic cycle where property prices go down.
So while a rising market can be good for margins, a declining market can erode most, if not all, of the net profit on a spec home.
The other factor to consider here is that when the market stalls, the availability of finance tightens up so you may be left with a completed home that cannot be sold quickly, leaving you without the liquidity you need to kick off your next project and effectively stalling your business until the market improves.
It’s easy to get carried away enjoying the growing margins during good times only to over leverage yourself just before a downturn.
So it's important for spec builders to maintain strict financial discipline and carry an emergency reserve fund that can see them through a 12-month period.
In terms of finance, you’ll need to be in a position where you can fund the acquisition of land as well as covering the cost of the build, as well as your salary requirements.
That last point is the reason most builders start off by doing a spec build or two while still operating a traditional contract building company.
The problem with this approach is their financial reporting becomes very muddled as they struggle to combine tax-effective accounting with generating useful financial information from their accounts.
As a consequence, many building companies lose their way at this point and fail to generate any additional net profit from the increased workload they take on.
The third thing to consider when deciding on a business model for your building company is scalability.
What are your goals? If you have a desire to grow your business and build an empire, then how will you finance it?
Growing a new home building company is relatively easy in terms of finance because that model is cash flow positive when the business is operating correctly!
However, scaling a spec building company will require significant investment which means taking on investors.
Which also means you are effectively being held to account again, only this time instead of clients demanding answers to their questions, it’s investors!
This is not a problem for a builder who is happy with their level of income and has no desire to grow, but for those with big goals, this is a serious limitation.
And don’t do what a lot of builders do and fund a spec home from the excess cash flow you’ve generated from building new homes!
If you do that, you will run out of cash during a downturn and your entire business will collapse leaving you with nothing.
Fixed Price Versus Open Book/Cost-Plus
Another hotly debated business strategy among residential home builders is whether it’s best to do fixed price contracts or open book (cost-plus) pricing.
Some builders do not have this option because cost-plus contracts are illegal in their particular state.
However if you do have the option to choose, there are a couple of important factors to consider.
Sure, it’s hard to lose money with open book projects and yes, there are some clients that actually prefer them.
However, when you follow that model there is only one thing the client focuses on, and that is the price.
Yes, price is also a factor in fixed price contracts but it’s not the main focus for a client signing a contract despite what they may tell you in the negotiation!
The fact is, numerous studies have proven that price is the fifth most important factor in a consumer's decision to choose a builder to construct a home they were intending to live in themselves.
Surprisingly as that may be, it’s the builders that understand this simple concept who are the ones that are able to charge more for their services.
However, it’s not just a case of putting your prices up, margins are linked to marketing which means developing a marketing strategy for your building company is critical.
A recent study of 60,000 building contracts by Coconstruct discovered that projects with fixed price contracts had 28% higher profit margins than cost-plus or open book projects.
And members of the Association of Professional Builders who all work on fixed price contracts typically include a 33.3% markup which results in a 10% net profit margin.
So that is a lot of money being left on the table by builders signing cost-plus or open book contracts in order to protect their downside.
Design & Build Versus Quoting Plans
The third big decision every residential home builder must make is, do they set up a building company, or provide a design and construct business?
On the surface, just sticking to building homes is the far easier option, however the reality is very different because the builders that quote for clients who already have their own plans face increased competition, more volatility on their workflow and lower margins.
Developing your own plan range is a great way to enjoy the best of both worlds however the fact is, almost every consumer who is not building an investment home or is not on a very tight budget let’s say of $250,000 or less, will expect any plan they choose to be customised to suit their block and their lifestyle.
It’s the world we live in, everything has to be customised to suit our specific needs these days or we will go somewhere else and find a builder, car dealer or burger restaurant that will accommodate our demands.
So, that effectively leaves builders quoting plans that have been created by a third party, or managing the design process.
Builders that opt to quote on third party plans are commodities in the eyes of the consumer.
And because they do not possess the skill set to compare two different quotes, they look at the one thing they do understand which is price.
What this means is that the builder has to spend a lot of time educating the prospect as well as pricing the job in the hope of making a sale.
Some builders have learned how they can charge for this process, however their win ratios are still generally lower than design and construct companies, which means they need more opportunities to achieve the same amount of sales.
And because margins are typically lower as well means they also need more sales to achieve the same amount of net profit.
The builders that manage the design process take control of the sales process a lot earlier in the buyer's journey which means they build a relationship with the consumer long before they even consider talking to other builders.
That advantage enables the design and construct builder to build trust and rapport with the prospect which leads to the consumer getting to know, like and trust them long before they would consider speaking to other builders.
This strategy does require a very different marketing approach compared to a typical building company as you are attempting to attract consumers long before they are looking for builders, which means you need to apply an interruption marketing approach instead of the traditional classified advertising method.
So, there’s plenty to consider when deciding which model is right for your particular circumstances, however if you are looking for better margins and an opportunity to grow your building company without taking on investors, then the design and construct on a fixed price business model for consumers who are looking to build on their own land is the best option for you.
To discover the perfect business model from start to finish for custom home builders, check out our latest book, Professional Builders Secrets.
Inside you’ll discover how to generate more quality leads and convert more of those leads into sales at higher margins while improving the client experience.
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