Inflation seems to be the news of the day no matter where you turn. There is no doubt that it is certainly affecting everyone; no sector of society is untouched…including construction.
Inflation in construction is having a huge impact on some very big-ticket items…whether it’s a home (most likely the largest investment any of us ever make) or a commercial project. When you’re trying to finish construction on time and within budget, inflation only makes everything more difficult.
In this post, we’ll explore some of the reasons that building costs have increased and what you, as a contractor, can do to help your clients avoid sudden sticker shock.
Construction Cost Inflation
The National Association of Homebuilders says that building costs have skyrocketed over the past 12 months. A recent survey shows that costs have gone up by an average of over 26%…the largest increase ever reported!
The result has been fewer homes and buildings being built, especially entry-level homes where inventory is already extremely low. Additionally, the National Association of Realtors reports that existing home sales for April 2022 are down 2.4% as well, the third month in a row they’ve seen a decline. (For further reading, the NAHB Eye On Housing Blog has an article detailing how existing home sales decline as low inventory continues to push prices higher.)
If contractors are able to manage costs effectively and successfully deliver completed homes in this current housing market, it could be really good for business. With such a low inventory of homes and record-high prices, anything you can manage to build will instantly be in high demand!
Why Have Building Costs Increased?
Several factors have combined to create the current construction environment. First, low availability of materials has driven those costs up. That’s a simple supply and demand situation. What can be found is wanted by a lot more contractors than before.
Secondly, a shortage of construction labor has made it more difficult to get projects completed. Many people simply took themselves out of the workforce over the past couple of years and chose to receive COVID relief payments from the government.
The Street gives 3 more examples in their article on why a new house costs a lot more in 2022:
- “The Producer Price Index for steel mill products rose 127.2% over the last 12 months.
- The index price for plastic construction products rose 34% over the last 12 months.
- The index for lumber and plywood rose 12.7% and 17.6%.”
The situation is clear from any angle that inflation, material costs, and labor shortages have combined to make building anything right now much more expensive.
Construction Cost Index
One way that construction industry professionals can stay on top of ever-changing numbers is to regularly check a Construction Cost Index. They measure the cost changes related to multiple aspects of building a structure: material, labor, equipment, transportation, etc.
Data from markets around the country is recorded and made available by several organizations. Two that are reliably dependable are:
By consulting these charts, you can make sure you stay informed on the cost trends that will have a direct impact on your bottom line.
Can A Builder Increase The Contract Price?
Inevitably, no matter how well you plan a construction project, something unexpected happens that impacts the final price. Many times, it’s something minor that the contractor is willing to “eat” by taking a lower profit than what they originally expected.
It is also common for things like final finishes, structural changes, or other change orders to raise the price beyond what was originally agreed upon. When the buyer initiates those kinds of upgrades, it’s usually not a problem for them to be willing to pay more.
However, there are times (especially during economic situations like the one we’re in now) when the cost to build the home or building goes way beyond the contractor’s ability to absorb. In those situations, they have to go to the buyer and negotiate an updated price that reflects the new reality.
When a builder has to dramatically increase the contract price, buyers generally aren’t very happy about it. For that reason, many contractors include an “escalation clause” to protect themselves legally and keep from having to build a house that cost them more than they’re being paid.
What Is An Escalation Clause In a Construction Contract?
“Escalation clauses” (or “escalation addendums”) are a little-known addition to building contracts that construction companies have been using for a while, but they grew in popularity after lumber prices rose so high a couple of years ago.
An escalation clause covers unexpected spikes in material costs after the contract is signed and passes them on to the buyer.
In 2020, when COVID-19 first hit, many real estate and construction industry professionals expected a slow down in the housing market. They anticipated reduced demand as people across the nation “locked down” in response to the new and uncertain pandemic.
The lumber industry agreed and essentially shut down as well, closing mills and reducing their workforce. So did many of the companies that support the construction industry.
None of them expected what actually happened, though. People responded by increasing their demand for home materials! People were spending much more time at home, so many of them either wanted to increase their square footage, build something new, or move to a better location.
As a result, the price of lumber soared, and builders who based contracts on 2019 prices suddenly found themselves losing a lot of money. So they began incorporating escalation clauses into contracts.
Current supply chain issues (and all the factors we’ve discussed already) are only continuing to make material costs extremely hard to predict. An escalation clause helps keep the builder and the buyer on the same page.
Here’s an example of an escalation clause that the NAHB created a few years ago.
There are many ways to write one, and every project may be different depending on its scope and the willingness of the buyer to absorb different levels of additional cost. Some clauses state that the builder will take on added costs up to a certain percentage above the agreed-upon price, but beyond another percentage, the buyer has the option to either pay the new higher price or void the contract.
Let Us Be The CPA You Expect More From
In our 40+ years of business, we have worked with many contractors and construction companies to help them manage their finances and grow their businesses through our CFO Consulting Services. When things get crazy, it’s good to have someone outside your business that you can count on to guide you and give you solid advice.
You may be surprised at what we can do to help you with your business! To find out, schedule a call with one of our team today!
