A Homebuilder's Dilemma: How Much Spec To Build For 2024?

As the Fed pivots from a willingness to increase its policy funds rate to more of a wait-and-see about when to cut, one of the big questions among homebuilders we're listening to centers on spec.

In 2022, when builders, by and large, had to meter sales because the supply chain collapsed, heavying up on spec starts was a masterstroke of genius. This time a year ago, when the residual effects of the supply chain were still playing out and every time you turned around interest rates were jumping up another 25 or 50 basis points, a spec strategy was the smart thing to do.

But this year, as the clock ticks away to Spring Selling's unofficial opening on the day after Super Bowl LVIII – and as it looks surely like it's not a matter of "if" but "when" and "how fast" the Fed eventually starts to cut its funds rate and take new policy measures to spur economic activity – how many specs should an operator put out there?

Consider the sentiment of one homebuilding executive we know:

The biggest concern for our organization over the next 6 months is sales activity through our typical Spring Selling season. Mortgage buydowns are the new normal, and rates are trending downward slightly, but will overall demand persist or improve this spring, or will resale inventory grow and dilute the demand for new homes?"

Add to that concern, traditional lending sources for acquisition, development and construction financing have become more reluctant – and more expensive – participants in homebuilding's development and construction value cycle. While some banks have more accommodating covenant policies on spec vs. build-to-order inventory levels, overall, this conventional channel for capital has tightened up and virtually closed off to homebuilder borrowers.

So, "What is the optimal scale of spec inventory?" With economic signals sending mixed messages, a thin line separates maintaining sufficient inventory to meet demand and avoiding the financial strain of having too much. 

At a high level, a healthy pipeline of ready-to-own homes, especially ones value-engineered, designed, and priced to attract first-time and entry-level homebuyers driven by life stage events in their careers and family formations, make a whole lot of sense against a broad backdrop of uncertainty and volatility.

Builders have the ability to help with the rate issue with buydown programs, etc., an option that re-sale participants do not have," says Brad David, EVP, Development/Construction for Snap.Build, one of The Builder's Daily's supporting partners. "Spec will continue to be the more attractive option for home buyers as a result."

In light of an "it-could-go-either-way" macro and housing economic backdrop, let's call 2024 the year of "smart spec," underlined by real-time market feedback data and information, nimble and agile response to sales pace and conditions, and operational excellence on the execution front.

Here's a framework to approach an aggressive, growth-focused mindset on spec development and starts tempered by a need for options should the market behave differently than expectations.

Best Practices for Strategic Spec Inventory Management

Aggressive yet Nimble Planning

Best-in-class builders enter the season with an assertive spec inventory plan. However, agility is paramount; they stand ready to recalibrate in response to real-time market feedback, avoiding the pitfalls of overextension.

Feedback Systems and Technology

Innovative feedback mechanisms and advanced technologies are non-negotiable for contemporary builders. These systems should facilitate informed decisions, allowing builders to synchronize inventory levels with fluctuating demand patterns dynamically.

Risk Mitigation through Responsiveness

The capacity to swiftly adjust spec inventory strategies can serve as a bulwark against market downturns. Proactive management of spec inventory is essential to avoid the financial burdens that accompany unsold units. 

The Changing Tide of Construction Loans

Historically, local and regional banks have been the financial bedrock for homebuilders, providing the bulk of project and construction loans. However, the landscape underwent a seismic shift following the collapse of several large regional banks. The resultant financial tremors have caused a constriction in lending practices, with the remaining banks imposing stricter loan conditions and higher costs.

The Climbing Costs of Capital

As the costs of loans ascend, directly linked to the banks' higher capital costs and interest rate exposure, builders find themselves in an increasingly precarious position. The financial strain introduced by these rising costs necessitates a strategic financial pivot for managing spec inventory without compromising operational liquidity.

Diversification of Capital Sources

In response to the lending squeeze, forward-thinking builders have begun exploring 'alternative sources' of capital. These avenues include private funds that recognize the industry's financing vacuum and offer tailored capital solutions for construction, project, and land acquisition.

Operational Excellence and Financial Agility: A Symbiotic Relationship

Capital Access Fuelling Operational Focus

Best-of-breed homebuilders leverage robust capital access strategies to ensure their operational focus remains undivided. By securing stable financing, they can concentrate on operational excellence, competitive product offerings, and cultivating relationships with potential buyers.

Reducing Financial Distractions

In a tightened lending environment, the ability to streamline capital financing processes—reducing the “time, worry, and ongoing bandwidth” on such activities—can provide a competitive edge. This enables builders to respond more swiftly to market signals, adjusting spec inventory levels accordingly.

A New Paradigm for Spec Inventory Financing

Predictive Financing Models

Adopting predictive financing models that incorporate economic indicators and market trends could serve as a buffer against financial instability. This would enable builders to anticipate and plan for shifts in lending practices and capital costs.

Strategic Partnerships and Innovation

Forming strategic partnerships with financial entities and innovating in financial instruments could prove pivotal. By working closely with capital providers that understand the homebuilding market's intricacies, builders can negotiate terms that better reflect the cyclical nature of their business.

Reimagining Financial Strategies for Market Resilience

In the face of a transformed financial landscape, homebuilders are compelled to reimagine their strategies for managing speculative inventory. The cornerstone of this new approach is financial diversification, which, when executed with precision, can underpin operational excellence and market responsiveness. Builders that successfully navigate this complexity will not only safeguard their operational imperatives but will also be poised to capitalize on the spring selling season's opportunities with a well-calibrated spec inventory reflective of the market's realities.

Toward a Balanced Spec Inventory Approach

As homebuilders gear up for the 2024 spring selling season, the right amount of spec inventory becomes a strategic fulcrum. The industry's winners will be those who blend assertive inventory strategies with the flexibility to pivot as market conditions evolve. The intelligent application of feedback systems and predictive analytics will be pivotal in striking a balance that not only withstands potential turbulence but also capitalizes on emerging opportunities.