Price escalation clauses have never been more important than in 2021! Recent weeks have shown a decrease in futures trading for the lumber market. Nevertheless, a downward trend in pricing remains weeks to months away. During this time, builders must still write contracts and sell homes. Questions looming over contracts include: Have we reached the peak in prices? Will prices come down or go up significantly? When can we expect this relief? How do I write contracts in the meantime?
Lumber Prices Soar
2020 saw a complete interruption in the supply chain for homebuilders. The hardest-hit area was felt directly in the pocket as lumber production has yet to fully recover. Homebuilders have had to scramble to protect their businesses. Most have struggled to do it in a way that avoids buyers walking away from the table.
Some builders report 3,000 sq. ft floor plans that had lumber costs under $25,000 a year ago, now cost almost $100,000 for the same amount of lumber! That’s a staggering 400% rise in costs. Stretch that across multiple projects and losses on bids can be in the millions quickly.
An NAHB study found that 1 in 5 single-home builders have been forced to delay construction on multiple contracts! For many builders, pausing construction is not an option. Here are some solutions to consider as you face these unprecedented times.
Price Escalation Clauses
The same study found that almost half of single-home builders have addressed soaring lumber prices by using price-escalation clauses in their contracts.
The positive side of escalation contracts is they protect the builder from the extra-ordinary rise in supply or building costs during the course of a project. While we are talking about lumber in today’s market, there are other materials that can create large increases in builders’ costs. These can include steel, concrete, bricks, or masonry, stone, and semiconductor chips. Even fuel price hikes can be felt by builders as delivery costs are spread out across the entire supply chain. When projects can last for months, these fluctuations represent a great deal of financial exposure and risk.
Price escalation clauses prevent a builder from shouldering increases in construction costs alone by shifting all or part of the increase to the client. If you had not been using Price Escalation Clauses prior to the lumber shortage, it has undoubtedly revealed the wisdom and importance of a well-thought-out plan for such contingencies.
There are challenges that come with these clauses as they can make clients or buyers nervous. Most companies cannot afford a quadrupling of expenses in the building process on multiple projects, similar to what we have seen with lumber. In the same way, single families are no better equipped to deal with a $75,000 price fluctuation. Not to mention, banks that now see they could be underwriting a project the client ultimately might not be able to afford.
Cost Sharing Clauses
Another type of escalation clause works to mitigate the risk for both parties. NAHB found that during this lumber crisis, 1 in 10 builders have utilized cost-sharing clauses. Typically the builder will assume the cost up to a specified threshold. Once this amount is exceeded, the ongoing escalation is then paid by the buyer. For skittish buyers, this can help mitigate some of their fears.
We are hopeful lumber prices will soon begin to fall. Nevertheless, this crisis has revealed a gap in the system for some home builders and buyers. If there is one thing we know after 2020, it is that markets will be fluctuating for the next few years. As a result, if you are looking to the future and want to ensure you have contingencies in place for these rises and falls, contact Board Certified Construction Attorney Joe Tolbert. Our team has the experience and the know-how to help protect home-builders without scaring clients away from the contract.
If you have any questions, you can reach our attorneys at 817-338-1700.