Beginner Series - Negotiating Construction Contracts

The Real Estate Espresso Podcast

Beginner Series – Negotiating Construction Contracts

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Podcast Title: Beginner Series – Negotiating Construction Contracts

Welcome to the Real Estate Espresso podcast, your morning shot of what’s new in the world of real estate investing. I’m your host Victor Menasce. Today’s show is another in our beginner series. Our listeners are sophisticated. Many of you own large portfolios of apartments, but you also have people in your life who are interested in learning more.

Maybe they don’t have access to high quality information. The idea of sending your spouse to a $199 weekend bootcamp for beginners seems unthinkable. So where do you go? Well, look no further, we’re going to dedicate a few shows a month to topics that will accelerate the learning for less experienced investors. This might even give some sophisticated investors a thing or two that they didn’t know.

On today’s show, we’re breaking down the different types of construction contracts that you could potentially sign. Now, let me be clear, I’m not here to offer any type of legal advice. I’m merely sharing our experience when it comes to undertaking different types of construction projects.

So there are several different conventions that are possible. Construction contracts can follow templates, and in the US, the most common contracts are published by the American Institute of Architects. These are the so-called AIA contracts. There’s many different templates. Now, just like the Purchase and Sale Agreement from your local real estate board, these contracts offer a lot of flexibility, and they do need to be customized to get them to say what you need them to say for your specific project.

In Canada, the equivalent contracts fall under the Canadian Construction Documents Committee. These are called CCDC. Just like in the US, there’s many different templates available that reflect the style of engagement you’re undertaking to build your project. First thing you need to get clear on is whether you’re, in fact, hiring a general contractor or a construction manager. It’s a distinct choice.

In either case, there’s going to be subcontractors involved for specific work items. You’ll have different subs for framing, mechanical, electrical, plumbing, concrete, finishing, and so on. Could be up to 20 distinct subcontractors in a typical build project.

The main distinction between the general contractor and the construction manager is who hires the subcontractors, and who carries the liability. You might hire the subcontractors directly and pay them directly if you hire a construction manager. The subs, absolutely, are doing the work under the direction of the Construction Manager. The bids, the schedule, all of those practical elements of the project are still handled by the Construction Management. But the contractual relationship is different. There’s no markup being charged to the subcontractor’s work. You pay the Construction Manager a fixed fee.

Whereas with a general contractor, if you decide that you want to go that direction, you’re going to write a single check only to the general contractor. The GC is responsible for all aspects of the project. In construction contracts, the contract type is crucial for defining cost controls, allocation of risk, and the payment structure. There’s three main types. There’s what’s called a Cost Plus Contract, the Lump Sum or Fixed Price Contract, and then the Guaranteed Maximum Price or GMP contract. We’re looking over through all three of these.

In the cost plus, the contractor is reimbursed for the actual costs, labour, materials, equipment, and so on, plus a fee that’s based on a percentage for overhead and profit. The risk is primarily with you, the owner, as you have to cover all of the costs and those can go up and down. This is ideal for projects where you’ve got uncertain scope, where it’s hard to predict the cost in advance, or if you’ve got a lot of customer specialty construction.

The advantage is you have complete control over the cost breakdown. It often leads to higher quality because a contractor is less likely to cut corners. The advantage is often offset by the fact that costs can spiral out of control because there’s no strict upper limit. Now with a cost plus contract, it is also still possible to have a price that you’re not to exceed as one of the clauses in the contract.

The second type is a lump sum contract, the fixed price contract. In this case, the contractor agrees to do the project for a fixed price, includes all of the costs and the profit. The risk is primarily with the contractor as they will cover the cost overruns, although the owner risks paying a higher initial price to offset the contractors potential risk. In a fixed price contract, there are no guarantees in the same way there that would be with a guaranteed maximum price contract, so there’s still an opportunity for the owner to face increased costs.

It offers a little bit more predictability of costs for the owner but it’s not absolute predictability. The disadvantage is there’s very limited flexibility for changes in scope.

Lastly, there is the guaranteed maximum price contract. This is the most attractive from an owner’s perspective. It’s a cost plus arrangement with a cap. The contractor agrees not to exceed. Now the risk is shared because the contractor absorbs the cost above the guaranteed maximum price, but the owner benefits from any savings below the guaranteed maximum price. It allows a lot of flexibility and transparency while limiting the owner’s maximum financial exposure. The banks particularly like these types of contracts because technically there cannot be a cost overrun. The disadvantage is that it requires a lot of cost tracking and transparency.

The general contractor is going to want to make sure that they’re not left carrying any unnecessary risk. So they’re going to build a fairly high contingency fund into their guaranteed maximum price. That means chances are high, you’re going to end up paying considerably more in that JMP contract than you might with a lump sum contract.

So the biggest item to figure out with each of these model is who’s going to carry the contingency fund. There’s always going to be some variability in construction. The question is who’s going to carry that risk and where’s the money going to come from to pay those costs if and when they arise. Under a JMP contract, it’s still possible for the owner to incur extra costs. These can happen when an owner initiated change order takes place. Now maybe you change your mind and decide you don’t like blue paint all of a sudden and now you want yellow. That change might cost you extra.

But if the change is a result of a subcontractor failing to bid the job correctly, then the GC and the subcontractor have to work it out between themselves, and the owner’s completely shielded from any changes at that level.

Whichever model you choose, there’s definitely pros and cons. Whatever you do, make sure you hire a lawyer who specializes in construction contracts. You may not realize this is an area of specialty in the law, just like real estate and family law and so on, there are lawyers that all they do is specialize in construction contracts, those are the ones that you want working on your team on projects like this. As you think about that, have an awesome rest of your day. Go make some great things happen. We’ll talk again tomorrow.

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