Choosing the right contract for your project.
Selecting the right approach and negotiating appropriate contracts with vendors are important to the success of renovations or new construction projects. Because there are so many related factors that need addressing, including scope, schedule, price, and payment terms, real estate owners, investors and users turn to expert consultants like Real Projectives® to help them and their attorneys prepare and administer contracts for each project.
Based on years of experience, we believe that agreements should live up to their name whereby all parties have discussed their expectations and determined how responsibilities and risks will be allocated between them. Risks should be assigned to who can best control, manage and bear what is acceptable. While there are many ways to structure an agreement (sometimes referred to as delivery methods) this article focuses on the two most common arrangements: fixed price and cost plus. As you might expect each offers advantages and disadvantages.
Fixed Price Contracts
Fixed price may also be called stipulated sum or lump sum. Fixed price contracts are those in which the owner (buyer) and the contractor (seller) agree to a singular price in exchange for completing a scope of work within a certain time frame. The price does not change except for certain unexpected events (force majeure) or the owner electively changes the project. Typically, stipulated sum contracts are best used for projects in which the scope can be clearly defined (completed plans and specs) up front. Otherwise too many unknown variables and poor assumptions can create situations that provoke an adversarial and stressful relationship that often ends with one or both parties suffering financially. This form of agreement was common in prior decades and usually works better for smaller projects.
Advantages for Owners
- Costs are known and set up front (contractor bears overages)
- Risk of execution is shifted almost entirely to the contractor
- Fewer provisions to negotiate
- Provisions are easier to administer
Disadvantages for Owners
- Requires a strict definition of the scope (i.e. completed plans and specs)
- Less visibility into financial health of project and contractor
- No opportunity to gain savings if actual costs come in lower than the price agreed (Contractor keeps savings as additional profit and depending on extent of competition may push numbers up to create a cushion.)
- More adversarial relationship that leads to greater potential for changes and surprises
In contrast to stipulated contracts, cost-plus contracts essentially put the contractor or construction manager in a situation where they are responsible for procuring and coordinating an evolving scope of work and charges for those costs as well as related overhead charges are reimbursed. In addition, contractors earn a fee (fixed or percentage) for providing such services. Frequently these contracts include a cap on costs called a guaranteed maximum price (GMP) that is tied to a target scope and budget. This form allows much more flexibility, which is especially useful when the particulars of the project aren’t or can’t be entirely mapped out in advance.
Advantages for Owners
- Scope does not need to be completely defined up front
- Usually better aligns contractor’s interests with those of the owner
- Can often enter into an agreement much sooner and get pre-construction advice from contractor
- Risks are shared between the parties such that owner may benefit from actual cost savings
- More visibility (open book) into buyout of trades and actual costs against budget
- Should be less padding of numbers such that overall costs are lower
Disadvantages for Owners
- Price and costs are budgeted but not really known up front except for GMP
- Have to be careful when defining scope to minimize weak assumptions and allowances
- Takes more energy, expense and time to negotiate the contract
- Owners take on more risks
- More difficult to administer for both owner and contractor
Real Projectives® takes the time to understand project profiles and compare against risk tolerances among owners and investors to advise on the best approach and contract form that will assign responsibilities and maximize project success. We then facilitate conversations to negotiate appropriate terms and conditions in each contract.
For more information on how Real Projectives® helps real estate owners and investors organize projects, procure good vendors and establish solid contracts, please comment below, send us an email or give us an old-fashioned call. And feel free to share our post on social media.