Before selecting a home builder, it is of the utmost importance to understand the differences in builder contracts, and how these choices may affect the overall building process. Blindly accepting any contract offered could make a difference between a positive or negative experience.
Fixed-Cost Contracts
This type of contract gives the buyer a firm contract cost for the home. In order for the builder to offer this contract, the builder must establish his/her actual cost of construction. If construction costs increase, the builder is forced to absorb the increases out of his/her potential profit. If construction costs decrease, the builder will benefit, and subsequently increase profits. Of course, change orders are always possible, and will increase or decrease the construction cost. Most builders will include allowances for finish items if they are not selected prior to entering into a contract. Such items may include cabinetry, floor material, and landscaping,
In order for a builder to offer a fixed-cost contract, the builder must have a complete set of construction plans and specifications, and be familiar with the building site. The builder must bid the cost of the house with all of his/her sub-contractors and material suppliers to be certain of the construction cost. A specific time frame for construction is also included in this contract. Depending on the size and complexity of the project, it usually takes about two weeks for a reputable builder to bid the work and arrive at an accurate cost of construction to be included in a fixed-cost contract.
The fixed cost contract is the most traditional form of construction contract used. With a complete set of construction drawings and specifications, it affords less uncertainty in the building process and outcome. Nevertheless, it is still critical that one thoroughly checks out the builder and his/her references.
Cost-Plus Contract
The cost-plus contract has become more popular over the past few years because it allows the builder to spend less time bidding the work and guarantees the builder a specific profit. In most cases, the builder will agree to build the house for a set dollar amount strictly based upon their experience using a generalized cost per square foot. Typically, there is a clause that refers to the price as an estimate, and acknowledges that costs may increase due to a list of variables. Then the builder adds a percentage amount for profit. This amount can range from 10 to 25% depending upon the builder, the size and complexity of the house, and site location. So if the builder estimates the house cost at $350,000 and agrees to pay the builder a 15% profit, the owner will pay the builder $52,500 to build the home. But, if the house ends up costing $415,000, the owner will pay the builder $62,250 in builder profit. Sometimes this type of contract is referred to as an “open-book” contract.
This option may not be the wisest choice for a buyer if they have little free time, a tight budget, or adversity to stress. It usually requires the buyer to meet with the builder periodically to review all of the invoices, pay all of the bills, and make sure excess materials are promptly returned for proper credit. Every time the bills are paid, an additional check is paid to the builder for the agreed upon builder profit percentage as agreed.
This type of contract diminishes the builder’s incentive to control costs. After all, the more the house costs, the more the builder makes! It allows the builder to spend less time negotiating their actual costs with sub-contractors and material suppliers, and it gives the builder less reason to expedite the construction process. In my opinion, a cost-plus contract strictly favors the builder rather than the owner. The actual cost of the home to the owner is not known until all of the bills are paid. Often times, this type of contract results in builder/owner disagreements, bad feelings, and possible legal action by either party. Imagine having a $350,000 budget, and having to pay $415,000 or more for the home when it is complete.
Cost-Plus Fixed Fee
This contract is similar to the cost-plus contract, except the owner and builder agree on a fixed fee the builder will receive to construct the home. For example, the owner agrees to pay a $50,000 builder fee regardless of what the home ends up costing. The upside to this type of contract is the builder has the incentive to complete the project as quickly as possible to maximize profits. The negative is that the builder has no incentive to control costs. The builder gets paid the same.
In some instances, a “not to exceed” cost provision is added to the cost-plus or cost- plus fixed fee contract. This may not be realistic or practical depending upon the project. The only way to be reasonably assured that the home will cost what you expect is with a fixed-cost contract.
Regardless of the contract you select, you MUST have complete construction drawings, and detailed specifications for your project. This will eliminate many of the variables in the construction process and reduce the unknown. It is also imperative that the owner spend time interviewing the builder and obtain customer, supplier, subcontractor and banking references. It is important that as the owner, you have the highest level of confidence and trust in your builder before entering into a contract. If one spends the time upfront, it will pay off in the long run.