Once you sign a real estate contract, your price is set in stone. Right?
There are many cases where the contract price can change. An appraisal or home inspection issue can cause a re-negotiation of the contract price.
New construction homes also routinely go up in price after you put a contract, as you choose to add options and pick different levels of finishes.
But there is another, lesser known reason that the contract price could increase: a unforeseen spike in the cost of building materials between contract signing and closing.
Many builders, large and now even small, add what is known as a escalation clause to their contracts to build/complete homes.
This escalation for material cost is common in very large commercial construction projects.
But did you know that it may be inserted into your contract if you are buying a new single family home, townhome or condo?
This article will cover what it is, why it is common and what it means for you.
Lumber, New Home Values, Covid-19 & The Year 2020
In early 2020, the coronavirus was declared a global pandemic.
The expectation from many real estate experts, myself included, was that we were heading toward a period of reduced demand, decreased home values, decreased building and less new homes being sold.
Based on my conversations with builders, the lumber industry had a similar outlook. Many decided to cut their supply and workforce in the anticipation of possible recession.
The same went for other companies that provided home building materials (cabinets, counters, etc.)
What followed could not have been farther from the expectations.
The government and federal reserve stepped in and stimulated the economy with direct payments, forgivable loans to businesses, cut the interest rate near zero and more quick and drastic measures.
Many homeowners were also now confined to their home for extended periods due to lockdowns.
So what happened? The prices for lumber and other home building materials skyrocketed.
The increase was driven by more demand from easier access to cash and a desire to do home projects (because owners were home all the time).
Couple the demand with the decreased supply, and the natural economic course is a spike in prices.
There was similar demand to purchase homes. Many buyers, spending so much time in their house during quarantines, decided they wanted something bigger or in a different area.
So the demand also went up for builders to build new homes. New home values began to also sharply increase, especially single family detached homes and larger townhomes.
The Builder’s Challenge
Demand increased. Prices increased. But the price of lumber also was increasing at a rate that the homebuilding industry had never seen.
Let’s say you and the builder enter into a contract for a certain sales price. Then, the builder starts to build your home.
They go to order the lumber, cabinets, etc. and realize that the prices are up 30%, 50% or even more since they built their last home.
Suddenly, the builder may not be making any money on your home. In a worst case scenario, they may lose money on the project.
The Builder’s Escalation Clause
The solution to the increase in material cost? Many builders started to turn to the escalation clause to cover volatility in the material costs.
These clauses will vary by state, by builder and possibly for each home/project.
This clause is different than the escalation addendum that is used when competing offers are on a property. This builders escalation clause can escalate your price after you are under contract.
Here is an example builder’s escalation clause released by the National Association of Home Builders.
Although 2020 was a catalyst, the trend of these clauses continued. Builders want protection from a similar unforeseen event that changes prices.
What the material escalation clause says is essentially this: you will cover a portion (or all) of the increase of cost of building materials that occurs between the execution of the contract and the ordering of any relevant material.
Option to Void
In some builder’s escalation clauses, you as the homebuyer could have an option to void the contract in the case of a sudden increase in material’s cost.
This option most of the time will kick in if the increase is above a certain percentage of the original contract price.
So, let’s say you have a contracted price of $1,000,000 with the builder, and an option to void if the increase is more than 5%.
If the contract increases $30,000 due to material, you will automatically increase your contract price to cover that difference.
If it increases more than $50,000 however, then you will have an option to either cover the difference, or void the contract.
These numbers are just an example. Your contract could vary.
List of Materials
Some of these addendums will also give you a list of what materials the builder will be buying and the current price of the materials at the time of the contract.
Also, they can provide the companies from which they are buying materials.
This will give you a baseline to refer to in case there is a change in price.
Reputable builders would not just create fake material increases to make a profit. This is fraud. But if you are thorough and like to have a paper trail, this is where you will refer to.
Builder contracts are notoriously written to favor the builder. And an attached addendum will be similar.
Building a home involves a large amount of financial risk for the builder. The contract is written to give the builder more control over the process than the standard seller.
If you go into the process knowing this, you can take an objective look at what the builder is asking you to sign. Every escalation addendum may vary depending on your area, builder, type of home, etc.
The key is to read the contract, go over it with both the builder rep and get your own representation.
This way you can go into the process knowing what to expect, knowing what could happen and knowing what your rights in different parts of the process.
The builder’s escalation clause is now a common part of new home contracts. It protects the builder in case of a sudden increase in the cost of materials. The increase will most often be covered by you as the buyer.
It can also give you some protection as the buyer by giving you an option to void if the increase is too significant.
Each addendum is likely to different as each builder customizes it.
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