Construction Agreements

Construction Agreements

December 8, 2015

I am often asked about what type of construction agreement is best. Having been on both sides of the agreement, as the property Owner and as a builder, I would like to share my points of view. Given the length of the topic I will split the discussion into sections. First, the basic types of agreements. The basic types are Fixed Contract and Cost Plus. (The Cost Plus agreement can be split into different versions relating to the “Plus”.) Some agreements are cost plus a certain percentage, others are cost plus a certain fee. Each of the agreements have positives and negatives, and also certain cyclical construction periods when they may be better used. As we will discuss in the final section, there are also hybrid agreements that combine many of the positives of both type of agreements.

The first of the agreement types to consider is the fixed contract. The principal benefit of a fixed contract is that all parties know upfront what the project will cost through its completion, if no changes are made to the scope of the work. Changes or allowance overages are usually handled as a fixed cost with an addendum to the agreement. Often the amount or percentage of the Homebuilder’s profit and overhead on these changes is disclosed in the original terms of the agreement.

The fixed contract type agreement best serves the Homeowner when the construction price cycle is neutral or increasing in price. Since the end contract is fixed, the Homebuilder becomes responsible for any cost increases that occur during the project. When homes take 10-18 months, this can be a size-able advantage for the Homeowner. (The Homebuilder will protect themselves by issuing the subcontracts at the time the house is started so as many of their costs are fixed as can be) The fixed contracts also work best when the work can be specified and defined. Ideally the project will have conceptual or working drawings with specifications the homeowner has spent some time reviewing. The more detail the better.

Homebuilders who work on fixed contracts tend to have more experience and ability in organizing and estimating a project. Many will rely on software tools which have real time expense constants built in, others have significant information available from other projects they are involved in, and most will have relationships with subs that allow them to quickly get the pricing information they need to provide the cost of the project. Since most Homebuilders are in some sort of competition, the successful fixed price homebuilder becomes good at what he does quickly. If he estimates the costs too high, he does not get the job. If he estimates them too low, he provides his service for less than he should. Because of this dynamic, and the work associated with providing a detailed proposal, there are many Homebuilders who prefer not to use the fixed contract agreement.

The legal profession by a size-able majority recommends the fixed contract type agreement. This is due to the significantly smaller risk of construction litigation in fixed contract type agreements. In all agreements when things go well there is no litigation needed, it is when things go wrong or are misunderstood that litigation occurs. By the nature of the agreement there are fewer uncertainties in the fixed contract agreement than the cost plus agreement. One of the largest issues in the cost plus agreement is what a cost is. This sound simple, but it is the source of a great deal of misunderstanding.

So, fixed contracts are ideally suited for most new construction, but not for remodeling or projects with many variables and loose ends. Fixed contracts also are not be the best agreement when there is a great deal of uncertainty on final design and finishes. (While unusual, there are Homeowners who wish to get started in the structural part of the construction process, before the interiors and finishes have been fleshed out) The more uncertainty in the project and its scope the more difficulty the buiding contractor has in determining what the costs of the project will actually be and how much of their time will be involved in finishing it, potentially resulting in uncertainties that most likely increase the cost. Since the fixed contract is based on a fair price for a defined amount of work, the uncertainty will usually result in the contractor creating a reserve to protect themselves from loss.

In the next section I will discuss the cost plus agreement and its advantages and disadvantages. I will elaborate on what a “cost” is and how it can lead to misunderstandings if not specifically defined.

Written By,

Stephen Kauffman, CEO of DIVCO Custom Homes