Management teams are wrestling with the question, “Should we start a group of specs now so they will be completed before the tax credit expires?” It’s a great question. What builder would choose to opt out of an opportunity to sell homes when demand may be at its greatest?

High demand and low inventory takes pressure off the need to cut margins by offering significant incentives.

In our organization, we have discussed just such a strategy for months. Our thought was to start a group of spec homes in July and August so we could assure each of these homes is completed prior to the expiration of the tax credit. It seemed like a no-brainer.

Now I’m not so sure.

During the past two months, I have noticed a significant number of “see through” homes in our competitors’ communities; completed homes with no one living in them. To the completed-unit count, add the significant number of homes under construction with either an “Available” sign in the front yard or no sign at all. Nothing more than this exemplifies the problem with our industry.

Home building is a highly fragmented industry. Each builder identifies demand, but if multiple builders build homes to meet this same demand, too many units are built. Excess inventory puts pressure on pricing. The only way to compete when supply significantly exceeds demand is to lower prices. There are other risks as well, if one decides to get aggressive and build specs in preparation for the expiration of the tax credit. What if the tax credit is extended?

The justification for building specs to meet the demand created by the expiration of the tax credit is that the tax credit will create a sense of urgency. If the tax credit is extended, builders could find themselves with significant spec inventory as buyers lose this sense of urgency. What if interest rates spike and consumers believe interest rates will fall. While $8,000 is a great deal of money, if interest rates spike, some buyers may believe it is less expensive to forfeit the tax credit and wait for lower rates.

This leads us to game theory. Game theory is used in economics to analyze competitive situations where the players of the game (companies) attempt to maximize their performance in strategic situations. Their success depends on their choices and how their competitors react to their choices and make choices in response.

For instance, if all builders build a large number of specs to address the expected demand from the pending expiration of the tax credit in aggregate, too many specs may be built. If too many completed specs exist in November and beyond, sales prices--net of incentives--will fall, pushing margins lower.

On the other hand, if builders fearful of having too many specs in the market don’t build specs and only a handful of builders build specs, these builders will capture profits forfeited by others. The risk may be asymmetric.

Asymmetric risk is where the distribution of risks and rewards is not normally distributed; it is skewed, and therefore the payoffs (rewards) are skewed. A classic example is that of an airline flight. If you get to the airport 30 minutes too early, you waste some time; you make some phone calls or catch up on some reading. If you get to the airport 30 minutes too late, you miss your flight. The cost associated with being 30 minutes late is far more significant than the cost of being 30 minutes early.

Most likely the risk associated with the decision to build specs is also asymmetric. If builders don’t build too many specs and the tax credit is not extended and interest rates don’t jump to such a point where buyers are willing to forgo the tax credit hopeful of lower interest rates in the future, then building specs should generate additional profits.

If on the other hand, builders build specs and too many are built or the tax credit is extended or interest rates rise to the point where buyers leave the market temporarily, then builders could be in a difficult situation. Standing unsold and completed inventory may pressure banks to demand repayment on the related construction loans. In addition, builders may need to heavily discount their spec homes as all competitors will be struggling with excess inventory and the need to discount the price of their homes.

So the choice is yours. What will your competitors do? If you don’t participate in spec building, you may forgo incremental profits, but if you participate and too many specs flood the market, the risks could significantly outweigh the benefits. Finally, if you decide to build specs and the majority of your competitors forgo building specs, you could be enjoying a great fourth quarter of revenues and profitability at a time when you desperately need it.

Game theory and asymmetric risk: Home building used to be simpler.