Preferred Type of Custom Home Construction Contract

virgilcarterNovember 16, 2013

This forum has good discussions from time to time about the various types of construction contracts for construction of a custom home.

Since there are experienced architects, designers and builders on the forum it seems to me that it would be useful if folks would identify the preferred type of contract they would use for their own custom home, and also describe why plus some of the key characteristics of the chosen contract.

I'm not asking anyone to simply identify all of the types of contracts--every experienced person already knows about them. I'm asking for experienced folks to identify for everyone else the ONE type of contract they would personally use for their personal home and why.

I hope this generates some useful knowledge and reference material.

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GREAT topic but one thing...... not all of us are experienced and know about all the different types of contracts so I for one, would also appreciate information about the options before we even hear about pluses and minuses. Thanks for starting this.

This post was edited by dlm2000 on Sat, Nov 16, 13 at 12:49

    Bookmark   November 16, 2013 at 9:03AM
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We're on our third custom build in addition to having renovated three homes, and we're most comfortable with a fixed cost contract.

We have a solid handle on project specs and what allowances should be and know that any increases to our budget are 100% our decision due to upgrades we choose.

We have great confidence in our builder and have worked with him in the past, so choosing him was a no brainer as long as his quote was reasonable and his schedule allowed him to complete our project.

We did receive bids from other GCs who use both cost plus and design build approaches, and their bids were significantly (very significantly) higher.

    Bookmark   November 16, 2013 at 11:00AM
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OK, for those who may be early in their journey for the design and construction of a custom home, construction contracts include terms, conditions and costs for labor, materials and the builder's profit and overhead. It is important to understand that there is risk to both the owner and the builder in a construction project. The differences in construction contracts are primarily due to: 1) who takes the major risk; 2) who has to pay for cost over-runs and how cost is determined; 3) who keeps the savings if the project costs less than the estimate and how savings are determined.

Here is a brief summary of the major types of construction contracts:

--Lump sum or fixed price: This is the simplest type of contract which consists of a total fixed price for all construction related activities. There may be cost saving provision for early completion and a cost penalty provision for late completion. This type of contract is often used when there is a very clear construction scope and when a clearly defined quality of work, materials and schedule have been agreed upon.

--Guaranteed maximum sum: costs are estimated as in a lump sum contract, but builder profit is limited to a specified amount. There may be a financial incentive to share savings, If actual costs are lower than GMP, but if costs are higher than GMP the builder pays the difference and the profit is reduced accordingly.

--Cost plus: This type of contract consists of actual costs or expenses directly from the construction activity. Important for these contracts to include specifics about builder's overhead (including material, labor and insurance costs) and profit. Cost plus contracts may be: 1) Cost plus fixed fee; 2) Cost plus fixed percentage; 3) Cost plus w/guaranteed maximum price; 4) Cost plus with guaranteed maximum price and bonus for savings below GMP, among other types of cost plus contracts. This type of contract requires the owner, or owner's agent, to monitor and manage the contract much more closely than the previous two types of contracts.

--Time and materials, or unit price: May be used when/if project scope is unclear, not defined and/or for limited trades. Seldom used for an entire project, but may be common for some limited subcontractor work, i.e., painting, flooring, etc. Time and materials contracts must include a mutually agreeable hourly or daily rate, including applicable additional expenses that may arise. Unit price contracts, like a lump sum contract, pay a subcontractor an agreed upon price, regardless of the actual cost to do the work. For T&M contracts, owners may wish to establish a cap or project duration that must be met in order to minimize owner risk.

Every builder has their own experience and preferences, so for the best owner-builder relationship, the type of agreement must be acceptable to both parties.

The issues of allowances and changes in scope, resulting in change orders, are common to all types of construction agreements and these conditions should be covered in carefully and thoughtfully delineated terms, no matter the type of contract. Obviously, the best situation is a project with no allowances and no change orders, but that is seldom practical and realistic.

Now that we have covered the issue with a broad brush, we can return to sharing experiences about which ONE type of construction contract is preferred and why.

    Bookmark   November 16, 2013 at 12:19PM
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For me, the best contract type depends on the nature of the project, specifically the complexity and the time available for producing full design documents and the management skills of the contractors. A Stipulated Sum contract would be at one extreme and a Cost Plus a Fee contract would be at the other. For projects in the middle the choice is much more difficult since it is inevitably a compromise.

I've never heard of a Guaranteed Maximum Sum contract nor do I understand how it works.

A Time and Materials contract would only be appropriate for a very small project with a single contractor and no subcontractors which makes it virtually unusable for a house. It simply compensates the contractor for overhead and profit in a fixed hourly rate.

    Bookmark   November 16, 2013 at 1:13PM
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So, Reno, for your own custom house which you designed and completed the contract documents, which type of contract would you prefer?

Come'on, none of this "it depends"...:-)

What would you do for yourself?

    Bookmark   November 16, 2013 at 3:21PM
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All project delivery methods have their place; it always "depends."

As for me I would use my favorite contractor as a consultant during the design phase and negotiate a fee and hourly rates for his forces. I would not ask for a GMP because I would be working closely with the contractors to control costs.

I would not recommend that method to an owner without the involvement of a professional designer or manager unless the owner had a lot of building experience and had worked with the builder on a similar or larger project. I suspect that would rule out most of the projects we see on the forum.

    Bookmark   November 17, 2013 at 3:42PM
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Do I understand you to say that you would use a Cost Plus Fixed Fee type of agreement with your builder?

If so, that makes good sense for those owners, such as yourself, who are experienced in construction administration/observation when working with a reliable and trusted builder. Unfortunately, as you suggest, many owners may not fall into this group.

Your comment about working with your "favorite contractor" should convey to readers a strong message about the importance of a builder's skill, experience and integrity.

The part about hourly rates for all of "his forces" (whom you do not control) is a way to achieve maximum quality in custom work by each skilled trade, but it's also a potential money pit as far as I can see. With the large number of trades who work on a custom house, the work and expense may not be fully managed in real time. Managerial review of the time and compensation due an hourly trades person (and comparing percentage complete) can only be achieved a week or two later when time cards are assembled, received and reviewed by the manager.

Alternatively, unit prices, rather than hourly rates, may allow one to at least see the maximum expense for a given trade to complete their work.

For owners less skilled in construction administration, or whom do not wish to assume a disciplined weekly management responsibility during construction, they might consider a Guaranteed Maximum Price with a 50-50 sharing, between owner and builder, of the savings for a completed project which fall below the GMP (assuming the builder is comfortable with this approach).

Reno, yours is very good advice for those experienced owners who may be in a situation similar to yours. Many thanks for sharing!

    Bookmark   November 17, 2013 at 6:56PM
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If you read the AIA Cost of the Work language I quoted earlier you will see that in a Cost of the Work contract a subcontractor's work is not allowed to be based on the cost of his materials and labor so the only time records that would appear in a GC's request for payment would be for the GC's own on-site employees which is why their hourly rates are normally stipulated in a Cost of the Work contract.

A unit price would be used for identified materials for which the quantity was not known. That same information would also appear in the Budget so there would not be much reason to use them in a Cost of the Work contract.

A GMP with Shared Savings would add considerable complexity to the administrative task since any owner-accepted subcontractor or material price greater than the lowest bid would be reconciled by a Change Order.

I once used a GMP with a Shared Savings on a house renovation and was gratified to see that it helped to control costs and maintain quality just as it had in the past on large commercial projects. Unfortunately, at completion when the Savings amount was announced, I learned that the owner did not understand that he would have to pay the contractor an amount greater than the actual cost of the project plus his fee. So everyone was mad at me and my profit was reduced considerably for the additional administrative time and heated arguments. I won't be doing that again.

In commercial work, an owner expects to pay for any and all benefits received whether they be materials, labor or administrative services but in residential work an owner usually expects to pay a bottom line price with everything included as they would in a retail purchase. I find it is pretty much impossible to get around that approach.

I have been waiting for a survey to be finished in order to get a building permit. The owner has told me that the delay is UNACCEPTABLE! The contract requires that he provide me with a survey; I am only responsible for giving the surveyor the final design drawings and that had been delayed by a 20% increase in the house area a week before the survey had been promised. I doubt the owner has even read the section titled: "OWNER'S RESPONSIBILITIES".

So, for me the greatest variable in contract writing for residential projects is the level of design and construction sophistication of the owner and the contractor which I have found to vary greatly. I can see why a typical home builder would want to submit a proposal on his letterhead for a fixed price with lots of allowances and include administrative, quality/cost control and design services ... for free!

    Bookmark   November 18, 2013 at 7:52AM
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I just realized that I quoted Exhibit A of the AIA A107 Cost of the Work with a Fee contract on another thread instead of this one. Here it is:
"Those portions of the Work that the Contractor does not customarily perform with the Contractor's own personnel shall be performed under subcontracts ... The Owner may designate specific persons from whom, or entities from which, the Contractor shall obtain bids. The Contractor shall obtain bids from Subcontractors and from suppliers of materials or equipment fabricated especially for the Work and shall deliver such bids to the Architect [or to the Owner if there is no architect]. The Owner shall then determine, with the advice of the Contractor and the Architect, which bids will be accepted. The Contractor shall not be required to contract with anyone to whom the Contractor has reasonable objection."

"Subcontracts ... shall not be awarded on the basis of cost plus a fee without the prior consent of the Owner."

The way to understand contracts is wise to read them very carefully and to note wording you don't fully understand and then research it. Much of a well written contract appears superfluous and unnecessary but it is not. Contracts are legally binding agreements and should be approached with great care and a bit of research or review by an appropriate professional.

    Bookmark   November 18, 2013 at 9:26AM
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Great points, Reno. Reading and comprehension are such important skills which tend to be forgotten in our Play Station/Game Boy world, it seems.

For owners who do not like to read or pay attention the only appropriate construction contract may be the Lump Sum/Fixed Price type. Even this type of construction contract won't protect an owner if it's loaded with allowances or doesn't include the entire scope of Work.

And of course, unwary owners may not understand that builders protect their risk in Lump Sum/Fixed Price contracts by including a substantial contingency sum, perhaps 20% or so, depending on complexity of the project and/or the owner's personality.

    Bookmark   November 18, 2013 at 10:02AM
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I know this is an old thread, but as a beginner in this process, this post is one of the best and most helpful I've read on here so far. Thank you to virgilcarter and Renovator8 for taking the time to put this discussion on here.

I'm hoping that by commenting on this, this post will be more visible to others in a situation similar to mine.

    Bookmark   January 18, 2015 at 7:21PM
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I would like to add that the distinction between types of contracts is not as clear in normal use as it might be in these discussions.

For instance, when Allowances are used in a Lump Sum contract, they are essentially little Cost of the Work contracts lurking inside the Lump Sum contract. However, they are inherently more dangerous when used in this way because they are rarely properly described in the Lump Sum contract; the associated GC fees are rarely properly explained; and the allowance materials will probably be provided by sub-contractors or suppliers already selected by the GC during the bidding process so there is no bidding and therefore no cost control.

IMO the most common contract used for houses is the worst possible contract especially when it is written by the GC and omits the Owner protections found in standard industry contracts.

    Bookmark   January 20, 2015 at 6:17PM
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