Contractor Pricing and Market Volatility

The materials market, just like any other, contains its own unique set of risks creating volatility. When faced with market volatility, contracts or other financial instruments are created in order to protect an individual or party from downside risk. Some contracts that exist in the materials market are the Guaranteed Maximum Price contract (GMP), Cost-Plus, Time-and-Materials, and Fixed-Price.

A GMP contract protects the consumer from sharp increases in material prices by setting a price ceiling. The Cost-Plus structure will bill a client based on the actual costs incurred plus a set profit, protecting the contractor from any market fluctuations. Time-and-Materials contracts aim to itemize and schedule specific labor and material costs in order to minimize cost variance. The Fixed-Price contract simply charges a predetermined expense for the project and is reserved for more predictable developments.

Multiple contracts exist providing various protections to the consumer and contractor. The choice of contract depends on a multitude of factors such as project timeline, economic/trade conditions, and project predictions.

Guaranteed Maximum Price (GMP)

The most critical point of the GMP contract is the setting of the maximum price. This price ceiling must be reasonable and quantifiable, but most importantly this price point must be agreed upon by both parties. In determining the maximum price, a contractor will analyze a project’s tasks, hard costs, soft costs, and expected profit. The client is often the most protected party in this transaction, so it is critical that the contractor has accurate cost projections. Because of this, contractors often reserve the GMP pricing structure for more predictable projects. In most GMP contracts, the client will pay the at cost price of materials if they are below the set maximum. It is not uncommon for clients and developers to share the cost savings benefit with the general contractor in order to incentivize the contractor to minimize costs. As with any legal contract, they can become infinitely customizable in order to fit all scenarios.

Cost-Plus Pricing

In a Cost-Plus contract the client will be responsible for paying the actual costs of a project as they occur plus a set profit to the contractor. In this model, the contractor is fully protected from any market fluctuations relating to construction costs while the client will bear any volatility in the market. The shift of material risk to the client allows the contractor to develop a project to its maximum quality. For example, In the GMP structure, a contractor is incentivized to reduce construction costs at the expense of quality in order to keep all costs below the set price. This is because any costs that go beyond the GMP will be absorbed by the contractor. This moral hazard, however, is nonexistent in the Cost-Plus pricing model. The Cost-Plus structure works best for projects that are unpredictable from a time-frame and cost perspective.

Time-and-Materials

The Time-and-Materials pricing structure aims to lay out all the costs of a project relating to the labor and materials. The contractor and client will agree upon a predetermined labor rate as well as a materials cost which includes the shipping and processing fees. The pricing plan attempts to create a detailed outline of the development as well as a clearly defined goal. Similar to Cost-Plus pricing, all development expenses are subject to market fluctuations, but a “not-to-exceed” clause can be added that caps the expenses making this contract act like a GMP. Due to its detailed cost allocation, the Time- and-Materials contract is easier to predict and implement while still retaining flexibility in the case of project disruptions.

Conclusion

Construction pricing contracts are an important instrument in hedging against material and development volatility. When analyzing a real estate investment, understanding the construction pricing structure is critical for accurately projecting the construction costs. Without the knowledge of construction pricing structures, the investor could easily find themselves ignoring critical risk factors of the materials industry.

Before founding 3E in 2016, Managing Member Eric Bergin was Director at Rockpoint Group, where he was responsible for for the Finance Group, as well as acquisitions, asset management, and investor reporting activities.