Understanding Building Contracts

In my last few posts I reviewed the key points to consider when selecting a lot for your new home. Now that you have found your ideal lot, and hopefully have selected a reputableLouisville Builder, you’ll have to sign a contact with that home builder. Before you sign, be sure to understand the basics when it comes to building contracts. To help with this, I will explain the high-level points to consider, but feel free to contact me if you have a contract you would like to review more in depth, as I have seen all kinds in my 30+ years experience and I’m happy to help.

First, there are three kinds of building contracts that are generally used – Fixed-Cost, Cost Plus, and Design Build. I’ll review each so that you understand the differences.

The Fixed-Cost Method

This method is typically used when there is a complete understanding of the plan and specifications. This normally occurs under two different scenarios:

The first is when the home to be built is a “production” home. This is a home plan that has been built by a builder many times and the client has had the opportunity to walk through a model home and make their selections. Typically there are very few changes after the start of construction.

The second is when the buyer makes all of their selections prior to the start of construction and/or has good knowledge of what the “allowances” should be, so there should not be many changes after the start of construction. If this is a custom “one-of-a-kind” home, the home builder will need to do a complete “job cost” and review it in detail with the buyers so there is a complete understanding of expectations by both parties.

Advantage: By going with a fixed-cost, a properly prepared buyer can be comfortable knowing the final cost of the home should be close to the fixed-cost amount.

Disadvantage: A fixed-price contract has possible disadvantages for both builder and buyer. The downside to a fixed-cost on a “custom” home is the home builder may add dollars to the contract to cover areas he is not certain of, thereby possibly increasing the total cost. If something costs less than estimated, the builder gains, if it is more, the buyer gains. If something is not clearly addressed in the plans or specifications, the buyer could face unexpected cost over-runs. Also, changes made on fixed-price contracts typically carry a builder’s fee. This fee and how it is figured should be part of the contract.

Therefore, the fixed-price method works very well on production homes and not always well on custom homes.

The Cost Plus Method

The cost plus method is a contract where the buyer receives billing for all of the invoices involved in the cost of the home, plus a builder’s fee. This method is commonly used for complex custom homes with more options and customization. The buyer typically works directly with an architect to design their home from start to finish and create a set of plans and specifications. Sometimes the buyer will find a home in a magazine, or on a website, and then have an architect modify/customize it to their needs. Once the plans and specifications are finished, the project is bid out to multiple builders and a builder is then selected to build the home. In this method, the home builder is not involved with the process until selected to build the home.

Advantage: Going with a cost plus approach gives the buyer a lot more flexibility to make changes as the home progresses. The buyer is also more involved in the decision making process, including which subcontractors, vendors, and products are used, etc. This method allows the buyer to be as involved with the entire process as they wish to be.

Disadvantage: The major disadvantage with this approach is usually connected to the “allowances” established on the front end of the project to cover costs such as: cabinets, tile, flooring, appliances, light fixtures, windows, etc. As there is a broad range of products available for these elements of a home, the cost can also range greatly. Therefore, if the buyer does not establish, or verify adequate allowances to suit their wishes, the budget will likely go over the initial plan.

It is important for the buyer to spend time putting together proper allowances prior to bidding out the project to the builder(s) to put into their estimate(s). This will result in more accurate estimates for the cost of building the home and help reduce the chance of budget over-runs. In a nutshell, it pays to do your homework up front.

Additionally, if the builder you choose is not experienced in building “custom” homes, he or she may not properly estimate the costs, which are not covered by buyer allowances. These costs would include: cost of the foundation, framing, roofing, HVAC, plumbing, electric, etc. If the budget is wrong, the buyer is ultimately responsible for cost over-runs. This is the main reason the buyer must be very careful to choose a builder with experience in building custom homes and one with a good reputation for “bringing the home in on budget”.

Finally, do keep in mind that the final estimate of the home may be much higher than the buyer’s budget, as the costs are unknown until the bids come in from the builders. This could result in a long delay while the plans and specifications are changed to fit the buyer’s budget.

The Design Build Method

The last type of contract is Design Build. This type is reserved for the truly custom home. The home builder is involved from the beginning, guiding the client through the building process from lot selection, financing, working with the architect and designers, budgeting and allowances, and continuing through the construction of the home.

Advantage: With the builder involved in the design of the home from the beginning, the costs are most likely to reflect the wishes of the client while staying within the proposed budget. This results in the absolute best home at the best price for the client. For example, the builder will work with the architect/designer and share with the client the cost difference for each style of home being considered, then give guidance as to the design/layout/size allowed to stay in their desired budget.

Additionally, the builder would guide the buyer on all allowances to ensure they get products that will reflect the level of finish they want while staying on budget. There is a very broad range of products and finishes available on the market and a good builder will help the buyer understand what selections to make based on their needs. In a nutshell, the builder works with the buyer and their architect/designer on every step of the process, so when bids come in, the buyer can have confidence the total cost will be within their budget.

Disadvantage: The disadvantages are few, as the buyer will be involved as much as they choose, while the home builder’s job is the most difficult of the three approaches due to the time invested prior to start of construction. Builders who offer this approach tend to be more personally invested in the quality of the home and in meeting the specific needs of the client.

As every client has different wishes for their new home (or remodel project), there is no one ‘right’ approach to contracts. Regardless of the approach chosen, it is important for the buyer to understand the process, know what is expected of them, and feel confident in the relationship with their home builder. At Sterling Development Group, we work with each client to determine which approach best suites their project and their comfort level with the process.

In short, know what you’re signing and understand why it’s a good fit for your new home or remodel project. In my next post I will discuss cash flow and financing of your home construction project.

If you are looking to hire a builder or remodeler and need help understanding the contract for your project, contact me to discuss reviewing it together.