Beware the Escalation Clause: a Hidden Pitfall in New Construction Contracts 

Competing in a Hot Market

In this hot real estate market, most agents have become familiar with escalator clauses that some buyers will submit along with their offers. In short, they allow a buyer’s offer to match any higher offer presented to a seller while the seller is deciding which offer to accept. In that context, an escalation addendum can be a valuable tool for a buyer. In the context of new home construction, though, escalation clauses are invariably bad bad bad for a buyer.

Why are Escalation Clauses Included in New Construction Contracts?

Contracts for new construction can structure pricing differently. The most common structure that builders use for residential construction is a “fixed price” structure, which obligates the buyer to pay a sum certain, and binds the builder to complete construction for that amount. Using that form of contract, the builder assumes any risk that the cost of materials will increase before the job is complete, which would ultimately cut into their bottom line.

Until COVID hit, that structure was generally OK for most residential construction. The cost of materials was not particularly volatile, builders could accurately gauge their project scheduling, and they were willing to undertake a certain associated risk level. Post-Covid, however, is a different story. Materials commonly used in construction can jump significantly in a short amount of time, and scheduling is unpredictable, wreaking havoc on a builder’s budget and profitability.

Their solution? Escalation clauses. While it is impossible to capture all of the different flavors of escalation clauses builders will insert into their contracts, they all serve one purpose: to shift some or all of the risk of material cost increases or construction delays from the builder to the buyer.

What is an Escalation Clause?

There is no standard-form escalation clause that builders use. A typical example will identify discrete categories of materials, identify their price-per-unit as of the date of contracting, and state that if the price for those materials increases by more than XYZ percent as some specific date, the buyer will be responsible for that increased cost. Other versions of this clause may give a buyer the right to cancel if the escalation clause is triggered. Still, others may allow a builder to reprice the entire job to current rates if construction hasn’t begun by a specified date. In short: every builder’s escalation clause looks quite different, and each requires careful review for risk analysis.

What does an escalation clause mean for a Buyer?

 That “fixed price” contract may not be so fixed after all! Depending on the form of escalation clause used, a buyer may be contractually obligated to pay much more than the amount they (thought that they) agreed to. If they can’t afford the increase, the typical result is that the buyer forfeits some or all of their deposit, which is often a very substantial sum. On the other hand, even if a buyer can afford the price increase, it may be a huge surprise to them that they are obligated to pay it. And if they have the right to back out of the contract due to an escalation clause, the buyer may find they are in a much more expensive real estate market than when they signed on with the builder.

How can a Buyer Negotiate an Escalation Clause?

 Most buyers shouldn’t. The language is typically nuanced, and most buyers should ask an attorney to help them understand and assess the clause’s effect and negotiate it with the builder. Here are some ways to reach an agreement on an escalation clause:

  1. Some builders are agreeable to simply removing them. These clauses are only now becoming de rigueur in residential construction contracts, so some builders are cooperative to contracting them away.
  2. If the contract does not provide the buyer a right of termination, the agreement can include the ability to recoup its deposit. It’s not a perfect solution, but it serves to limit downside risk effectively.
  3. Add a provision that causes the parties to share some or all of an increase in material costs.
  4. Revise the escalation clause to become ineffective if construction does not commence on time. A buyer should not have to bear the brunt of increased material costs they could avoid if the builder started work faster.
  5. The clause can be revised to apply to only specified materials or to impose a cap on the amount of increase that may be imposed.

Summing Up

We’ve written several blogs reminding buyers that a home purchase is likely to be one of the most significant financial transactions of their life; it behooves them to retain an attorney to assist them in that process. The same applies to new home construction! There are several portions of a new build contract that require careful review. Still, escalation clauses are likely one of the most surprising to an unsuspecting buyer and one of the provisions that can substantially negatively impact. As always, should you have any questions, don’t hesitate to get in touch with your local real estate attorney.

 

Sincerely,

Daniel Guarnieri, Esq. dguarnieri@berlinpatten.com

Daniel has broad-ranging civil experience including complex commercial litigation, real property disputes, commercial collections, commercial foreclosures, local government representation, construction litigation, and maritime litigation.

 

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