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18.05.2022

Alert

Construction cost increases—what are your options?

As the cost of carrying out construction continues to rise, there has been a sharp focus on what price increases builders can and can’t pass on to the client. In many cases, builders’ clients are agreeing to fund extra costs, notwithstanding they have no obligation to do so. In this article, partner Kristy Dorney provides some practical tips if you are facing a request to fund construction cost increases.


Need to know

  • Before agreeing to pay a price increase, it is important to determine whether you are contractually bound to do so.
  • Where the contract is truly a fixed fee contract with no price adjustment provisions, there is no obligation on the part of the client to increase the price.
  • If an arrangement can be made whereby the builder and client share the burden of a cost increase, in some cases this may prove a far better outcome than holding the builder to the fixed price.
  • Any agreement to pay an increased price should be carefully documented.
  • If you are unsure whether a request to increase the price is valid and how to respond, get in touch with partner Kristy Dorney or a member of our Real Estate team.  

Why is the cost of construction increasing?

A perfect storm of events (think COVID, floods, war) has led to disruption in supply chains and a shortage of materials, coupled with a surge in new builds and renovations (driven in a large part by government incentive packages). This has driven up the cost of materials and labour and created uncertainty as to whether either of those will be available at the times needed to meet agreed program milestones and dates for practical completion. The reality of market forces means it also provides an opportunity for participants in the market to increase prices to take advantage of the high demand for their products and services.

The rate of material cost increases is unprecedented and volatile. This means a quoted price is at risk of being out of date much quicker than usual if subcontracts for materials and labour are not locked in at the date of tender (which they generally are not).

The other key factor impacting the cost of construction is a matter of timing. Contracts usually require the builder to commit to reach practical completion by a nominated date. If the works are not completed by that date, the builder is usually liable to pay liquidated damages at a daily rate until the works are completed. Supply chain, labour, and materials shortage issues can to some extent be managed if subcontracts and supply contracts are locked in early. However, it is otherwise not possible to accurately forecast those delays in the builder’s program. Builders must either take the risk of liquidated damages liability, contract out of it, or increase their contingency or margin in the fixed price to hedge against the risk.


How is this being managed?

For new contracts, price adjustment provisions are getting a lot more attention when reviewing tenders and drafting and negotiating construction contracts. We are not seeing a sharp shift to ‘cost plus’ contracts, with fixed price remaining the preferred option for clients and their financiers for the moment. However, price adjustment clauses in fixed price contracts are being more widely used. This includes an increased use of ‘provisional sums’ where an element of work can be repriced and adjusted at the time it is actually undertaken and also, the introduction of more bespoke ‘rise and fall’ clauses which allow the builder to pass on the actual cost of certain materials at the time they are ordered, which may trigger either a rise in the fixed price quoted or a fall if the cost of materials has dropped.

The period for acceptance of a quoted price is also likely to be shorter. In the past, developers and investors could generally expect little movement in a quoted construction price during the (often lengthy) period between the initial feasibility report and committing to the construction contract. Now, builders are seeking to reprice to capture material price increases at the time of signing, causing a late review of the project metrics and negotiations between clients and construction funders.


How to respond to a price increase request

Before agreeing to pay a price increase, it is important to determine whether you are contractually bound to do so or if the request is the start of a commercial negotiation.

Where your contract includes a provision allowing a price adjustment, the devil really is in the detail drafted at the time the contract was signed. A good material cost rise and fall clause needs to identify the specific materials for which it applies, the cost of those materials already provided for in the agreed fixed price, and the method for adjusting the price, including if both a rise or fall is to be passed on and what margin the builder can apply. Responding to a price increase request requires dusting off the contract, following the agreed methodology to adjust the price and, at times, ensuring adequate disclosure of pricing has been provided to support the increase request.

Where the contract is truly a fixed fee contract with no price adjustment provisions, there is no obligation on the part of the client to increase the price. Any agreement to do so will be voluntary on their part.

Recently we have seen an influx in claims for ‘variations’ in the residential development space which seek consent from the consumer to pay some or all of the builder’s cost increases. All construction contracts include a ‘variations’ clause which allows the builder to claim additional costs if the scope of work originally agreed is varied, costing the builder more money. However, an increase in the anticipated cost of materials is not a ‘variation’ in that sense. The ‘variations’ we have seen recently are in fact requests by the builder for the client to voluntarily agree to contribute to all or part of the builder’s increased costs.


Voluntary agreements

Having determined the builder is not entitled to claim any additional monies for material and cost increases, some clients are voluntarily agreeing to contribute to the builder’s cost overruns.

You might wonder why they would do this. Altruistic reasons aside, in many cases the alternative could prove more costly and inconvenient than agreeing to pay the additional amount.

The increase of builder insolvencies is on the rise and the common reason put forward by builders is the inability to manage the enormous increase in construction costs. Although the client may have remedies against a builder to recover loss it incurs in engaging another builder to complete the works, this remedy may prove worthless if the builder is insolvent and in liquidation. It is also likely to cause a significant delay to achieving practical completion. If an arrangement can be made whereby the builder and client share the burden of a cost increase, this may prove a far better outcome than holding the builder to the fixed price.

It is an entirely commercial decision which must be weighed up with many other considerations, such as the accuracy of the information supporting the request, the likelihood of the builder going into liquidation in any event, and how best to secure the payment.


Price increase agreement

Any agreement to pay an increased price should be carefully documented. Whilst the default position may be to simply agree to increase the fixed price, we recommend a careful review and consideration of other alternatives. Matters which should be considered include:

  • Timing of the payment.
  • Security for the payment—is it possible to attach the payments to immediate transfer of title to materials?
  • Enforceability of the increase if the builder later breaches the contract.
  • Possible legislative limitations on security if the payment is treated as an increase to the already agreed contract sum.
  • Retention and project trust account obligations.
  • Whether any similar commercial conversations will occur down the chain, such as with buyers and tenants.
  • What disclosure or authorisation might be required from project financers?
  • Liquidated damages—what is the builder’s exposure and the parties’ intention?

Next steps?

Understanding your contractual entitlements and obligations is critical.  If you are unsure whether a request to increase the price is valid or how to respond, get in touch with partner Kristy Dorney or a member of our Real Estate team.


Authors

Kristy Dorney

Kristy Dorney

Partner

Contact McMahon Clarke

Brisbane
T +61 7 3239 2900
A Level 7, 100 Creek Street, Brisbane Qld 4000

Melbourne
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A Level 2, 696 Bourke Street, Melbourne Vic 3000