It can be a sub-domain (since using a dreamhosters sub-domain won't cost you anything). If you already have your domain name hosted with DH you can just make a sub-domain of it too. If not just use a dreamhosters sub-domain instead. What I did initially (many many moons ago) was to add my domain name mysite.com and make it fully hosted (with nameservers not currently pointed at DH since I had the site hosted elsewhere but was not ready to make the switch). Then I created a dreamhosters sub-domain (mysite.dreamhosters.com you get the idea right?) and make it a mirror of mysite.com instead of being fully hosted. This way you can work on mysite.dreamhosters.com all you want and when you finally get ready to make mysite.com point to DH servers you will be all set. You would just need to change some configuration files to make them point to mysite.com instead of the dreamhosters sub-domain afterwards though but its not a big deal.
So just to make sure you are following I would do whats stated above with the sub-domain. Install WP to it and add your custom theme and any other content. Then once you are satisfied with what you have change the nameservers to your domain name to point to DH and edit your config files accordingly and you will be good to go.