Earnings Call Transcript - TOL Q3 2025

Operator, Operator

Good morning, and welcome to the Toll Brothers Third Quarter Fiscal Year 2025 Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Douglas Yearley, CEO. Please go ahead.

Douglas C. Yearley, CEO

Thank you, Drew. Good morning. Welcome, and thank you all for joining us. With me today are Marty Connor, Chief Financial Officer; Rob Parahus, President and Chief Operating Officer; Wendy Marlett, Chief Marketing Officer; and Gregg Ziegler, Senior VP, Treasurer and Head of Investor Relations. As usual, I caution you that many statements on this call are forward-looking based on assumptions about the economy, world events, housing and financial markets, interest rates, the availability of labor and materials, inflation and many other factors beyond our control that could significantly affect future results. Please read our statement on forward-looking information in our earnings release of last night and on our website to better understand the risks associated with our forward-looking statements. Before we jump into our quarterly results and our outlook for the remainder of fiscal 2025, I'd like to take a moment to thank Marty for the enormous contributions he has made to our company since he joined us in 2008. As we announced in July, Marty plans to retire from the CFO role at the end of our fiscal year in October. During his 17 years with Toll Brothers, Marty has been an outstanding leader, business partner, financial steward and good friend. He has played a central role in enhancing value for our stakeholders and helped shape the financial strategies that have been such a vital part of our success. Marty, your intelligence, wit and the spirit of fun you bring to the office every day will be missed by all of us. On behalf of the entire Toll Brothers team, thank you. Of course, one of our responsibilities we take very seriously here is developing talent. We have a very deep bench in our finance group, which includes Gregg Ziegler, a familiar name to many of you on this call. I am pleased that Gregg will be stepping up in November to become our next CFO. He has a wealth of experience, including 23 years at Toll Brothers and an unmatched understanding of our business. I look forward to working with him in his new role, and I'm confident that he is the right leader to continue our track record of financial success. With that, let's turn to our third quarter results. I'm very pleased with our performance in the quarter. In a difficult market, our balanced operating model, broadly diversified luxury business and strategy of prioritizing price and margin over pace continues to pay dividends. In the quarter, we delivered 2,959 homes at an average price of $974,000, generating record third quarter home sale revenues of $2.9 billion. Our adjusted gross margin of 27.5% exceeded guidance by 25 basis points, and our SG&A expense was 8.8% of home sales revenues or 40 basis points better than guidance. The outperformance on both our top line and in our margins contributed to third quarter earnings of $370 million or $3.73 per diluted share. We also returned approximately $226 million to stockholders through dividends and share repurchases in the quarter, positioning us to deliver another year of healthy profitability and solid returns in fiscal 2025. In the quarter, we signed 2,388 net contracts for $2.4 billion. While units were down approximately 4% year-over-year, dollars were flat due to an increase in average sales price to just over $1 million. Our ASP was up 4.5% versus the third quarter of fiscal 2024 and up 3% versus last quarter. We are pleased with the resilience of our luxury business and more affluent customer base. While our contract ASP was up and our margin outperformed, our sales volumes have been impacted by the softer market. As a result, and given our strategy of balancing price and pace, we now expect deliveries to be approximately 11,200 homes for the full year at the lower end of our previous range. We are maintaining all other key guidance metrics, including a full year adjusted gross margin of 27.25%. In this environment, we continue to actively manage our spec starts and inventory levels on a community-by-community basis to match local market conditions. In some markets, especially in the North region, where inventory remains low and demand is strongest, we have increased spec production. Overall, as local markets evolve in the coming months, we will be making decisions as to how many spec homes to start as we plan ahead for fiscal 2026. In addition to the 3,200 specs that are in various stages of construction, we have another 1,800 building permits ready to go. As we see market improvement, we have the ability to quickly ramp up our spec production. Remember, our spec business model is differentiated. We sell our spec homes at various stages of construction, all the way from foundation poured to finished home. This offers some of our spec buyers the opportunity to personalize their homes with features and finishes that match their tastes as choice remains a key pillar in the Toll Brothers buying experience while also providing us a faster and more efficient construction schedule. From a pricing perspective, we modestly increased incentives in the third quarter. The average incentive in new contracts was approximately 8%, up from approximately 7% in the second quarter. At third quarter end, our backlog stood at 5,492 homes valued at $6.376 billion with an average sales price in that backlog of $1.16 million. We are pleased with both the average sales price and the gross margin embedded in our backlog. We also have 3,200 spec homes at various stages of completion. Our cancellation rate was 3.2% of beginning backlog as compared to 2.4% in last year's third quarter and 2.8% in the second quarter. Our cancellation rate remains the lowest in the industry, continuing to reflect the financial strength of our buyers and demonstrating that they remain comfortable and confident in completing their home purchases. About 26% of our buyers paid all cash in the third quarter, consistent with recent trends and well above our long-term average of 22%. The loan-to-value ratio for financed buyers was approximately 70%, highlighting the strong financial profiles of our customers. We continue to make progress improving construction cycle time. Overall, we have not seen any significant impact on build costs from tariffs, and we do not expect to see any this fiscal year. In fact, we are anticipating that build costs will come down modestly in the foreseeable future. We ended the third quarter with 420 active selling communities. We remain on track to end the fiscal year with 440 to 450 communities, representing 8% to 10% year-over-year community count growth. Our land position remains strong, and we continue to prioritize capital-efficient deal structures that support long-term growth. In the quarter, we spent $433 million on new land. We remain disciplined in our underwriting and focused on securing high- quality land at attractive returns with a continued emphasis on keeping land off balance sheet as long as practical to enhance capital efficiency. At quarter end, we owned or controlled 76,800 lots, 57% of which were controlled and 43% owned. This land position allows us to continue to be selective, disciplined and focused on efficiency when we assess new land opportunities. With that, I'll turn it over to Marty.

Martin P. Connor, CFO

Thanks, Doug. I appreciate the kind remarks at the outset and want to express my sincere gratitude for the opportunity afforded to me to be Toll's CFO for the past 15 years. It has been a real honor, and I'm proud of all that Toll Brothers has achieved over the past 1.5 decades. I would also like to express appreciation for the great teams I have here at Toll as well as at home. I'm proud and pleased that Gregg will be picking up the reins when I step down. Gregg and I have worked closely since my first day, and I have the utmost confidence that Gregg is the right person for the job. Turning back to the numbers. It was a great third quarter. We significantly exceeded our guidance with earnings of $500 million before taxes and $370 million after or $3.73 per diluted share. As Doug mentioned, we delivered 2,959 homes, generating record third quarter home sales revenues of $2.9 billion. This was a 5% increase in units and a 6% increase in dollars compared to last year's third quarter. The average delivered price of $974,000 was in line with the midpoint of our guidance of $975,000 and included approximately $207,000 spent on lot premiums, structural options and design studio upgrades which are highly accretive to our margins. We signed 2,388 net contracts for $2.4 billion in the quarter, a 4% decline in units, but flat in dollars compared to Q3 2024. The average price of contracts signed in the quarter was $1.010 million. The average price in our backlog is even higher at $1.16 million, which includes $234,000 of lot premiums, structural options and design studio upgrades. Our buyers continue to demonstrate their financial strength and the value they place on their homes with the significant investments they make. Our third quarter adjusted gross margin was 27.5% or 25 basis points better than we had projected and guided. The outperformance was spread evenly across products and regions, and it was attributable to both greater efficiency in our homebuilding operations and favorable mix. SG&A as a percentage of revenue was 8.8% in the third quarter compared to 9.0% in the third quarter of 2024 and compared to our guidance of 9.2%. SG&A came in better than expected, primarily due to increased leverage from higher-than-forecast revenues as well as cost controls. We remain very focused on efficiency, and we continue to see the benefits flow through our results. Third quarter joint venture, land sales and other income was $15 million, ahead of our breakeven guidance as we realized gains and income related to several joint ventures in the quarter and saw better-than-forecast earnings in our mortgage operations. Our tax rate in the quarter was 26%. I'll turn it over to Gregg to review our balance sheet, financial position and liquidity.

Gregg L. Ziegler, Senior VP, Treasurer and Head of Investor Relations

Thanks, Marty. I'm honored to be the next CFO of Toll Brothers and appreciate the confidence you and Doug have shown to me. As we announced earlier this month, in the third quarter, we issued $500 million of 10-year senior notes at a 5.6% coupon. At the same time, we called $350 million of senior notes that were scheduled to mature this November. With the issuance and redemption, we extended the weighted average years to maturity of our senior notes from 2.5 to 4.8 years. This comes on top of the refinancing of our credit facilities in our second quarter, which pushed out a revolver and term loan by 5 years and increased the size of the revolver by nearly $400 million. We now have no significant bank or senior debt maturities until March of 2027. We finished the third quarter with a net debt-to-capital ratio of 19.3%, $852 million in cash and equivalents and $2.2 billion available under our $2.35 billion revolving bank credit facility. This year, we expect to generate another $1 billion in cash flow from operations. In the quarter, we spent $433 million to acquire 2,755 lots. We paid a dividend of $24.2 million and repurchased $201.4 million of common stock at an average price of $112.40. For the full year, we've repurchased approximately $402 million of common stock at an average price of $111.08. We continue to project $600 million of share repurchases for the full year. To summarize, our balance sheet, financial position and liquidity are as strong as they've ever been. They provide us ample flexibility to both invest in the future growth of our business while also returning capital to stockholders. This has been a pillar of our overall financial strategy for at least the past decade and will continue well into the future. Marty, I'll turn it back to you to address guidance.

Martin P. Connor, CFO

Thanks, Gregg. As usual, our outlook is subject to all the caveats regarding forward-looking information and the assumptions, risks and uncertainties inherent to projections. Based on our backlog, recent sales activity and the number of spec homes completed or currently under construction, we expect to deliver approximately 3,350 homes in our fourth quarter, which comes to approximately 11,200 homes for the full year. The average price of deliveries in the fourth quarter is expected to be between $970,000 and $980,000. We continue to expect the full year average delivered price between $950,000 and $960,000. As Doug mentioned, we continue to balance price and margin with pace. This strategy, combined with the gross margin embedded in our backlog gives us confidence in maintaining our full year projected adjusted gross margin of 27.25%. For the quarter, we expect adjusted gross margin to be 27%. We expect interest and cost of sales to be approximately 1.1% of home sales revenues in the fourth quarter and for the full year. Fourth quarter SG&A as a percentage of home sales revenues is expected to be approximately 8.3%. For the full year, we continue to expect it to be between 9.4% and 9.5%. Other income, income from unconsolidated entities and land sales gross profit for the full year is projected to be $110 million. For the fourth quarter, we expect it to be approximately $65 million. We project the fourth quarter tax rate to be approximately 25.5% and the full year rate to be approximately 25.1%. Our community count at quarter end was 420 compared to our guide of 430 as we move some openings into the fourth quarter. We continue to expect 440 to 450 communities open by the end of the fiscal year. Our weighted average share count is expected to be approximately 98 million for the fourth quarter and 100 million shares for the full year. Putting this all together, we expect to earn approximately $13.75 per diluted share in fiscal 2025, achieve a full year return on beginning equity of approximately 18% and bring our book value to approximately $88 per share at year-end, which would cap off another great year for Toll Brothers. Now let me turn it back to Doug.

Douglas C. Yearley, CEO

Thank you, Marty. Our results in the third quarter and our projections for the full year reinforce the strength and resiliency of our business model. They prove out our ability to successfully navigate changing market conditions while still delivering attractive returns to stockholders. This is the result of the hard work of all of our Toll employees. It is their passion for our business, dedication to our luxury brand and commitment to our customers that will ensure our continued success. With that, let's open it up for questions. Drew?

Operator, Operator

As a reminder, the company is planning to end the call at 9:30 when the market opens. The first question comes from Stephen Kim with Evercore ISI.

Stephen Kim, Analyst

Congrats to Gregg and Marty. I guess let me just start off with a simple one. Your cash flow from operations, I think you guided to greater than $1 billion. What was it year-to-date because I didn't see that in the release? And then if I could also ask you, you mentioned construction costs you expect to decline in the near term. I was wondering if you could kind of give us a breakdown on what components you're expecting to get some betterment.

Douglas C. Yearley, CEO

Sure. Gregg?

Gregg L. Ziegler, Senior VP, Treasurer and Head of Investor Relations

Yes. I was trying to find out 9 months to date. This is a little rough. It's probably somewhere in that $400-plus million. So we do expect to see a lot of that pickup happening in Q4 to get to that $1 billion for the year. Which is a result Q1 relatively negative, Q2 starts to even out, Q3 positive.

Martin P. Connor, CFO

Building costs are either stable or slightly decreasing in the short term. We're starting to see contractors negotiate more than they previously did. We are actively seeking major material supply renewals in the market and are making good progress with pricing. It varies by community and market, but generally, building costs are beginning to decline. I can't specify just one or two factors; it's a mix of subcontractor agreements for our major trades and materials.

Operator, Operator

The next question comes from John Lovallo and UBS.

John Lovallo, Analyst

The only concern we're hearing today is regarding your ability to grow next year. In the past, you've mentioned achieving a sales pace of two homes per community per month on average throughout the year. I want to confirm that there are no changes to that plan, and do you believe this can be accomplished in fiscal year '26 after what seems to be closer to 1.8 in 2025?

Douglas C. Yearley, CEO

We are excited about the growth we'll see in community counts next year and are planning to provide detailed information in December regarding 2026. We anticipate between 20 to 30 new openings in the fourth quarter based on our community count at the end of the third quarter and projections for the end of the year. Recently, we had successful openings, including a community in Philadelphia that received 21 deposits and one in Bucks County, Pennsylvania, that generated significant interest. Our community in Irvine Ranch, Southern California, secured 24 contracts exceeding $6 million in the last month. We have 3,200 spec homes underway and 1,800 spec permits ready for construction as we observe improvements in the market, with some activity already starting in the north. With fewer shares now and anticipated next year, this will positively impact earnings per share. The average price in our backlog currently stands at $1.16 million for around 5,500 homes, which is promising, and homes we are selling now average $1 million. We have reduced build and cycle times, enabling 35% of our communities to complete houses in eight months or less, giving us the ability to sell homes into the spring selling season for delivery by the end of the fiscal year. We constantly assess local market conditions for next summer when many clients aim to close on homes for school terms, making decisions on new specs based on build timelines and market demand. Macro rates have decreased, currently resting at 6 3/8 for Toll Brothers, with short-term rates potentially declining further. This is encouraging, as pent-up demand continues to grow amidst the ongoing supply-demand imbalance. We notice an increase in buyer traffic, both online and at our locations, as we approach the fall, traditionally a stronger selling season. While I refrained from providing specific guidance for 2026, I want to emphasize that we are strategically positioned for success next year, focused on community openings and our spec strategy. Additionally, we are effectively managing SG&A expenses, enhancing our leverage as we lengthen our spec inventory. I feel more optimistic today than in recent months, seeing signs of economic recovery and a resurgence in buyer confidence, primarily among our luxury clientele. We'll see how the fall unfolds, but we are prepared to move quickly and adapt as necessary, and I feel more confident than I did a few months ago.

John Lovallo, Analyst

Yes. That's really helpful, Doug. And that's really what I was trying to get at is the backlog maybe being down a bit from where people would have thought it might be perhaps. You guys still feel comfortable with the community count growth in 2026 and the ability to drive orders to drive growth as we move into the next couple of years.

Douglas C. Yearley, CEO

We do, very much so. And we're really excited about our land positions, and we haven't guided yet. But on the last call, I gave a soft guide that we have similar community count growth projected for '26. I can reaffirm that. We just have terrific land and terrific communities coming. So it's all good.

Operator, Operator

The next question comes from Mike Dahl with RBC Capital Markets.

Michael Glaser Dahl, Analyst

Marty, heck of a run, congrats. And congrats, Gregg. Just a follow-up. Can you help us walk through how sales pace trended through the quarter and maybe elaborate a little more on your August comments? And the follow-up question would be similarly, if you think about the incentive ending up at 8% versus 7%. I think a lot of your peers talked about sequentially increasing incentives through each month of the summer period. So if you could talk about how that shook out for you and whether we should be thinking the exit rate on incentives was higher than that 8%. Sorry, that's two questions in there, but those are my two.

Douglas C. Yearley, CEO

We experienced our worst month in May, but June and July showed improvement. August has been consistent with the trends we observed throughout the quarter. The incentives have not increased since July or from where they were in May. The rise in incentives from 7% to 8% is mainly due to additional discounting on some finished specs. As we frequently share, our strategy for specs is somewhat unique; we sell some of our specs earlier, allowing clients to engage with the design studio and make upgrades, which gives them the feel of a custom home, even though we initiated the process. This approach is quite beneficial for us, and the margin on those early sales is closer to build-to-order margins. However, we do have several finished specs in some markets facing pressure, which accounts for the slight rise in average incentives. I'm somewhat encouraged, as we've seen incentives on finished specs moderate a bit over the last three weeks. Contrary to what you suggested, they haven't increased; instead, they've stabilized or decreased slightly. We need to wait and see, as it's only been three weeks. Our web traffic in August is up about 5% to 10%, and foot traffic to our communities has risen by around 15%. People are taking more time to place deposits due to caution, but our conversion rate from deposit to agreement of sale is currently around 80%, which is the highest it’s ever been. Historically, that figure has been around 60%. While it takes longer for clients to commit to placing a deposit, once they do, they follow through. We haven't noted any immediate effects from the recent decrease in rates, which dropped from approximately 6.75 or 6.58 to 6.38; that change has only happened in the last couple of weeks. I didn't expect an immediate reaction, particularly from our clients, who aren't inclined to make quick decisions based solely on monthly payment changes. Additionally, with it being August, families are finishing summer plans and preparing for school, so people may be waiting to see if rates drop further. We will have a clearer understanding by September, and I anticipate that as rates stabilize, we will see increased demand from the pent-up interest that has been on hold.

Operator, Operator

And we have a follow-up from Stephen Kim with Evercore ISI.

Douglas C. Yearley, CEO

Stephen, I'm sorry, Drew cut you off.

Stephen Kim, Analyst

I'll get even with Drew later. So question, I guess, on the volumes that we saw the orders. I think last year, Doug, you had referred to the order cadence. I think you had sort of talked about how typically 4Q orders are down about 10% from third quarter. And you had said last year that, that was going to be different and all that. You kind of called that out, if I recall. Can you talk to us about what the order picture you think would look like this year as we move sequentially from 3Q to 4Q? Is there anything that would be helpful for us as we think about your near-term plans on absorptions?

Martin P. Connor, CFO

So I'll take a shot at this, Steve. I think our community count growth in the fourth quarter is going to be outsized compared to other quarters this year and a year ago. So that gives us encouragement. We see rates have dropped 50 basis points as we head to our fourth quarter. That's got to be a positive. We've had some of these new openings that Doug mentioned that have really jump started right out of the gate for the fourth quarter. And as Doug mentioned, he's feeling better than he did a couple of months ago. So all that builds some optimism as we head to our fourth quarter here.

Douglas C. Yearley, CEO

And, Steve, as you know, because you know the numbers so well, our fourth quarter is historically about 4% down from Q3. I've already mentioned that for 3 weeks of August, which is a very short glimpse into what's going to happen, we're about flat to Q3, but that's deposits. That's not even agreements. That's just a couple of weeks of taking the deposit checks. So we'll have to see. What Marty described is spot on. It gives us some optimism, but we'll just have to see how the balance of August and September and October play out. We are well positioned with the community openings we have, with the interest we have, the interest list we have and some of those openings that are coming. But we'll just have to see how it plays out. But historically, it's down 4% and first 3 weeks of August have been flat. So it's trending about where history would suggest it should, but we do have some reason to be optimistic that we could do better.

Operator, Operator

The next question comes from Trevor Allinson and Wolfe Research.

Trevor Scott Allinson, Analyst

I'll echo congratulations to both Marty and Gregg as well. The first question, we've heard a few builders talk about seeing some relief on development costs. A couple of questions around that. Are you guys also seeing some softening on development? How widespread is that? And then if you are, what's the timeline for when that starts to flow through your P&L? And how much benefit do you think you could perceive from that from what you're seeing currently?

Douglas C. Yearley, CEO

Trevor, we have not seen much relief on land development costs. There may very well be some downward pressure if there is less activity for land developers and they become a bit more aggressive in their pricing. But I don't think we've experienced that yet.

Trevor Scott Allinson, Analyst

Okay. Got you. Makes sense. And then the second question on the 4Q community count guide. It looks like a really nice jump here sequentially going from 420 to 445. How should we think about the timing of those? Do they come on pretty ratably throughout the course of the quarter? Or is there a good portion that's scheduled to open up near the end of the quarter? And then any regional concentration that we should be considering?

Douglas C. Yearley, CEO

It's spread out evenly without any significant timing concentration. Keep in mind that 445 is a net figure. Some communities will be closing and selling out over the next 2.5 months, so the total number of openings will actually be slightly higher than that 25 increase from 420 to 445 due to these sellouts. Overall, the distribution is fairly even across the country, with no particular regional focus.

Gregg L. Ziegler, Senior VP, Treasurer and Head of Investor Relations

I'm sorry. North Mid-Atlantic South seems to be a little bit of the concentration for Q4 openings.

Douglas C. Yearley, CEO

I like that considering Boston to Washington, D.C. is our strongest corridor. Charlotte. Charlotte has been hot lately. So there you go. A little bit more in the North, Mid-Atlantic and South.

Operator, Operator

The next question comes from Sam Reid with Wells Fargo.

Richard Samuel Reid, Analyst

Congrats to Marty and Gregg. Gregg, looking forward to keeping it going. I wanted to talk cycle times. 35% of your communities can build in 8 months or less. It's a great, very helpful stat. Can you just talk to what cycle times look like across the remaining 65% of your communities? And then when we think about ways to improve that on the spec and build-to-order side, just talk through levers that you can pull to improve cycle times into next year.

Douglas C. Yearley, CEO

So the balance of 65% would be 8 months in a day to probably 11 months. And the 11 months, we'll take the extreme is really big houses that have probably a lot of build-to-order with a lot of money spent in the design studio and maybe a lot of structural options that are being offered and the houses are more complicated. They may very well be in towns that have some difficult permitting and inspection processes that can slow you down a little bit. They could also be in locations where we have significant backlog because we've been hot, and it just takes a little bit longer to build. So every community has its own story, but that is generally the reason why we have some that are still stuck at 11 months. And how do we get better? We just keep doing what we're doing, which is working really hard. We have teams out there that study every home we build, every day, why we lost a day here or there, what we can do to improve it how we make our floor plans and our architecture more efficient, more optimized, how we get people through the design studios faster. We track how many days it takes somebody to get through that design studio and sign off so we can get going. So we are all over it. I am so proud of the progress we've made, and there is more to come. The spec side of the business helps a lot, too.

Gregg L. Ziegler, Senior VP, Treasurer and Head of Investor Relations

Exactly.

Douglas C. Yearley, CEO

As a builder of 50% spec homes now, those houses don't have a buyer yet in the initial phases. This allows us to construct them much quicker because we can choose the finishes and make structural changes ourselves. We can proceed at full speed without waiting for a design studio process or reacting to a client's walkthrough on Sunday afternoon while construction is ongoing. This certainly contributed to reducing the overall cycle time.

Martin P. Connor, CFO

And on the front end, we have that permit sitting on a shelf. We don't have to spend incremental time to go get that permit for those spec homes.

Richard Samuel Reid, Analyst

No, that helps, guys. Really appreciate it. Maybe switching to another line item on the P&L. In the prepared remarks, you alluded to better cost controls behind the SG&A beat versus guide. Would just love a little bit of context in terms of what those cost controls were, how sustainable that is perhaps into 2026? And then thinking about Q4 specifically, you've got a step-up in community count quarter-over-quarter. Would just love to know any grand opening expenses that might be embedded in that guidance for SG&A.

Martin P. Connor, CFO

Sure. So our cost controls span the gamut of cost. We've done a great job of maintaining pretty stable headcount despite growth in community count. We've maintained inside and outside sales commissions at a reasonable level despite the challenging market. And we continue to benefit from the technology investments we've made over the last 6 or 7 years in terms of our systems from a CRM and an ERP perspective and even in HR side. There is pressure on some costs. Insurance costs are pressured. And there are incremental costs associated with community count openings, but they're all baked into our guidance.

Douglas C. Yearley, CEO

And just to remind everyone, one of the primary reasons why the Q4 guide on SG&A is modestly higher is because of all these communities we are opening that have front-end expenses without the revenue coming in yet.

Operator, Operator

The next question comes from Alan Ratner with Zelman & Associates.

Alan S. Ratner, Analyst

I'll add congrats to Marty and Gregg there. Looking forward to working with Gregg. So on the spec mix, Doug, I think you mentioned it's 50-50 today. Can you just refresh our memory what it was pre-COVID or kind of in more normal times? And what the margin differential currently is on your spec product maybe across the 3 buckets in terms of completion status versus the build-to-order home?

Douglas C. Yearley, CEO

Sure. In the old days, 10% to 15% was our spec business. I remember when I was a kid and I was a project manager in the field, Bob Toll would give us one spec per community. And if we wanted to build a second spec, we had to go see him personally. So...

Gregg L. Ziegler, Senior VP, Treasurer and Head of Investor Relations

What answer would he give you?

Douglas C. Yearley, CEO

He would really put you to the test to ensure you wouldn't come back for more. So, I would say we're seeing a 10% to 15% increase from where we currently are. The difference in margins between spec and build-to-order remains consistent with our discussions over the past few quarters, although it has widened slightly. We're very pleased that the build-to-order segment has increased to over 30%. On the spec side, the timing of house sales during the construction cycle plays a significant role. Recently, as I mentioned, we've had to offer greater discounts on some of our finished specs. However, we genuinely enjoy the business. We believe that maintaining an average margin around 27%, as we've discussed, is the right approach. The spec business offers us substantial capital efficiency, and there are clear opportunities to adapt quickly with the spec permits we possess, should we need to fill the gap in the future when there’s demand for new homes. As we mentioned last quarter, our average margin is around 27%, and we were slightly above 30% for build-to-order, which can be varied by approximately 3 points. Therefore, if it's a 50-50 split, we can expect the spec business to drop by about 3 points on average.

Alan S. Ratner, Analyst

Got it. That's really helpful. And I guess my follow-up is a more difficult question, but presuming you don't maybe get back to 90% build-to-order, it sounds like if you can get that share a little bit higher, that would certainly be a positive for your margin and certainly for the visibility in your business. How do this Toll and the industry get back to a more normal build-to-order or spec mix? I mean it seems like everybody has kind of pivoted very hard towards spec. And during the early stages of the pandemic when resale inventory was so tight, that made a lot of sense. But now it almost feels like builders are kind of forced to keep the spec machine running if they want to maintain growth and have the volume ready to go. So I'm just curious how you see this playing out and what can be done to get back to a more normal build-to-order mix?

Douglas C. Yearley, CEO

It's a good question, and I'm not sure what back to normal will mean in the future because the industry has been committed to some level of spec construction for some time now. As I mentioned, we had very few spec homes, and we feel comfortable at a 50-50 balance even in a somewhat softer environment. Our construction teams are not making the structural changes for spec homes or the finished choices. We have national designers who create curated packages for our model homes, and we market those. These packages are designed to appeal to buyers who love the decorations in our model homes, and we highlight that the spec home they're interested in was created by that designer. We're selling these homes at various stages. I believe in this business. The percentage may fluctuate, moving from 40% to 50%, maybe even to 60%, and then back to 40%. It largely depends on market conditions. However, I don't think we'll return to the days of 90% build-to-order. You're hearing this from a company that did the least amount of spec work. The market is fluid, and it requires careful management. Furthermore, today's buyers, especially millennials who are becoming more affluent, want quicker options. They are not as interested in waiting a year to design their custom home. If we can provide a home they can move into in 90 days to 7 months while still allowing them to choose finishes that reflect their lifestyle and preferences, it's an appealing option. We plan to continue operating within that 40% to 60% range.

Martin P. Connor, CFO

We're generating great returns with this mix. We're maintaining high margins with this mix. I don't know why we would feel compelled at this moment to change this mix based on how we're doing. And I echo Doug's comments, I think there is a greater percentage of consumers that don't have the patience or the desire to wait and spend the time to design, particularly when they walk into some of our highly curated spec homes and say, wow, this is pretty good. Remember, we do this all day long. An individual does it 1, 2, 3 times in their lifetime. So we do it pretty well.

Douglas C. Yearley, CEO

And the other thing, Alan, just to wrap it up, in many of our communities, we have some very special lots, home sites that generate very high lot premiums. We save those for the build-to-order business. We're not going to spec on the $400,000 lot premium lot because we know the buyer of that lot who's going to put a home on that lot, who's going to load it with structural changes and really load it with design studio changes, all of which are very accretive. And so part of our strategy is more of the vanilla generic lots, not all, but more of them get the spec house and we drive the margin. One of the reasons that margin is north of 30% is because we are saving the better lots for the client who we know will spend more money with the upgrades.

Operator, Operator

The next question comes from Michael Rehaut with JPMorgan.

Michael Jason Rehaut, Analyst

Marty, it's been a pleasure. Best of luck in the future. Gregg, obviously, congrats and looking forward to working with you more.

Douglas C. Yearley, CEO

I met Marty's grand baby Saturday night. And now I fully understand why he's retiring.

Michael Jason Rehaut, Analyst

That's great. That's great. A couple of questions. I guess, first, just on the incentives. It's very helpful, Doug, kind of given the detail that a lot of that increase, 8% versus 7% related to finished spec and maybe that's come down slightly recently. But I think if I'm right, looking back a couple of quarters, your incentives as a percent of sales have increased maybe closer to 200 basis points year-to-date. Obviously, you're expecting a little bit of relief on some build costs, perhaps lot cost inflation would be an ongoing issue on the other side. But it would seem like, again, without pinning it down to '26 guidance, which I know you're not going to give, but is there any reason directionally why we shouldn't expect somewhat of a moderation in '26 versus '25 at this point?

Douglas C. Yearley, CEO

Again, Mike, we will provide all the details in December. You're correct; it is reflected in the numbers. Our incentives in the third quarter are higher than in the second and first quarters. The backlog of 5,500 homes, with an average price of $1.16 million, is high margin, which is reassuring for us. However, I cannot provide guidance on where the gross margin might be in '26 at this time. We will address that in December. There is a lot of time between now and then, and the market will continue to evolve. We discussed our capacity to start all these specifications and be prepared for next summer when people want to move in. We will need to observe the market throughout September, October, and November before the December call to provide a clearer picture. Holding onto a lot of specifications can significantly influence the incentives available under current market conditions. As you may remember, during the COVID years, Toll was slightly disadvantaged because we lacked specifications, and home prices were rising quickly. We sold homes at agreement of sale, allowing homebuyers to benefit from price appreciation during construction. Builders who focused on specifications gained from this appreciation since they did not sell until completion. This situation was atypical. We will have to see how things develop through the fall and stay tuned for December.

Martin P. Connor, CFO

Mike, I'd also point out that our gross margin a year ago for the quarter ended a year ago was adjusted gross margin, 28.8%. And at the end of this year, our fourth quarter, it's projected at 27%. So we've seen a lot of that margin unfortunate erosion already over the course of the past 12 months and the next 3 months in our projections.

Michael Jason Rehaut, Analyst

That's a valid point. Additionally, Doug, you mentioned earlier that rates have decreased slightly, perhaps by about 20 to 30 basis points on a broader market level. You noted that sales pace improved in June and July compared to March and May, as well as in the most recent weeks. I'm curious if you're evaluating the increase in incentives throughout the quarter, potentially aimed at selling finished spec homes. You also mentioned the impact of seasonality. Considering both seasonality and possibly higher incentives, how do you view the effect of the 20 to 30 basis point decline in rates on demand compared to other factors currently influencing sales pace and what we might see into the fall?

Douglas C. Yearley, CEO

Mike, as I mentioned, we haven't yet seen an immediate impact in sales from the lower rate. It will be coming. With every tick down in rate, you're going to have more buyers that step into the market. It's August. I think we just have to wait a little bit and see how it plays out. And we also have to see what the Fed does, and we have to see what the macroeconomic world looks like. There's a lot of moving parts here, and I am encouraged by where it feels like things are headed. But I have no empirical data for you as to what's happened since rates came down, and I'm certainly not going to give you the crystal ball projection on where things go. We'll wait and see. We love our positioning, and I'm feeling a bit better.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to management for any closing remarks.

Douglas C. Yearley, CEO

Drew, thank you very much. We appreciate it. Thanks, everyone, for all your great questions and all your interest. Have a wonderful end of the summer, and we'll see you all soon. Thanks. Take care.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.