It is entirely possible to control costs in a custom home build, if you have these 3 must-haves in your construction contract. Once in place and used the right way, the game changes in favor of the homeowner. Otherwise, the door is open to misuse of change orders by the builder, which can quickly add up to big dollars.
The 3 key must-haves are:
- A correct Allowance Schedule, with clear definitional language.
- A proper Schedule of Value (for draw requests), with clear language.
- Change Order language that is clear and strong.
Why do I even bring it up since all construction contracts have some variation of these three elements?
I bring it up because it will NOT play out equally for all owners in their home building process if these elements are not done right. Please bear with me as I helicopter up a moment to talk about why that is and what you can do.
A great contract (with the right language and exhibits) is super important. You’ll refer to the contract as situations pop up with your builder (and they will). You’ll certainly need a strong contract if you were to end up in a court of law. Please know, however, that simply having a solid contract is not enough to ensure a great home building experience which I define as one that is on time, on budget and built with good quality.
What improves your odds of having a great building experience?
What I’m about to suggest here goes against the grain (meaning it is not commonly suggested), yet it comes from my 20+ years as a GC and investor. I’ve also thought long and hard about what it takes for a homeowner to thrive during their custom home building project.
It comes down to this…it is YOUR level of knowledge. Owners who are well informed (far in advance of the need) can navigate the building process in a much more empowered way. The game changes entirely when you know what you are doing!
Back to the contracts. The owner is the one who will actually negotiate all of the contract terms with the builder. Or should be negotiating versus just signing the contract provided to them! You’ll need to know where your lines in the sand are, for every aspect of the contract that is important to you and especially negotiate the 3 elements touched on in this article.
By the way, regarding the time frame of contracts, you may want to read The Most Broken Part of the Home Building Process.
Even after the contract is signed and once construction starts, you’ll find these 3 contract elements come up again and again. The more knowledgeable you are about these elements, the more empowered you’ll be. Hopefully, enough to stand up, face to face with the builder and say no to an unfair change order. You do that because you absolutely know what the truth is (per the contract and within the industry). Sadly, owners all too often pay unfair change orders because they simply don’t know any better. And, importantly, you can be fearless about saying no because you have an effective draw schedule in place, and the builder is not ahead of the project financially.
So now onto the magic keys….
KEY NO.1 – A correct Allowance Schedule, with clear definitional language.
You may want to read a more in-depth article about Allowances.
The goal here is for the owner to understand what an allowance item is and how they are treated–per industry standard (as used by the AIA American Institute of Architects and NAHB National Association of Home Builders). I mean really understand it! Some variation of the following definition should be included in your contract. Without definitional language in the contract, then what is or isn’t an allowance is left up to your builder to decide, often on-the-fly once construction starts.
Allowances refer to the parts of the house that Owner: (1) must specifically select and (2) the cost is unknown at the time of the signing of the contract, since the final selections have not been made by Owner and (3) the total amount of all Allowances is included in the Contract Price (for fixed price contracts).
A guess will be made as to what the actual cost will be, which is the Allowance Amount (a placeholder dollar amount) for every line item. Later, it will be the Owner’s final selections that determines the Actual Cost of all allowance items. The allowances are shown on the Allowance Schedule, attached as an exhibit to the contract. Later, Actual Cost must be evidenced by a written copy of the actual receipt from the supplier or sub.
I use the word specifically with real purpose. Allowances are literally those items an owner will look at and say ‘I choose that’…that pendant light, bath tub, tile, etc. Contractors misuse allowances by telling owners that certain items are an allowance item when they should not be. I call these ‘random throw-ins’ and one I’ve seen repeatedly thrown in change orders is the main breaker panel and breakers. That’s an item an owner would never select.
Don’t leave it up to a capricious builder. Spell it out in the signed contract, with details and clarity. This is what I mean by clear definitional language. Details matter and the more you have, the better it is for you. Spelled out, in the beginning, closes (or narrows) the door to misuse.
Below are brief snapshots of 3 different allowance schedule scenarios to illustrate what is typically done and other options. Mostly, I’d like to illustrate how having more detail serves the owner in many ways.
A typical builder-provided Allowance Schedule, for a couple line items looks like this:
Electrical – $15,000 Tile – $8,400 Hardware – $2,400 plus more items…
I shudder when I see a schedule like this with only a heading and an amount, that’s all. It’s unbelievable to me that this is common practice. It leaves the door wide open to whatever interpretation the builder wants it to be. What is even included? Material only? Which materials? Any labor? As one example, labor will vary by the complexity of the tile layout in a shower. How is that to be treated?
With nothing more than ‘Electrical’ do go by in the Allowance Schedule, what happens? The builder can send a change order, with whatever they want on it. They could bill for the electrical fixtures that you end up choosing, plus throw in ‘breakers and main panel’. You might think it is fishy, but you have nothing to rely on. Once the contract is signed with a schedule like this one and you receive that change order, then your only option is to argue with the builder. Guess who usually wins? Or perhaps you don’t argue because you don’t even know that those throw-ins are not part of a standard allowance.
All allowance items have 2 parts: fixtures for the owner to select (the allowance items) and installation materials provided by the builder (or the trade through the builder), which are NOT part of the allowance dollar amount but are included in the contract price for the contractor to provide.
Remember the example of a breaker panel being thrown in as an allowance item? It’s electrical for sure but the truth is that owners never select breaker panels. Would you know how many amps, slots and breaker types are in a panel? Of course not. It’s the licensed electrician’s job to make those selections and therefore would not be an allowance. It is part of the installation required to install the electrical but you don’t select it.
This is a teeny example on one electrical item. Think about all of the allowances, some with high dollar amounts (like cabinets or flooring). If there are no real details to guide the allowances then you could be hit with many change orders. No wonder $200k is the new normal. Well, maybe not that much, but who wants to pay for something twice?
A much better Allowance Schedule looks like:
Electrical fixtures – $15,000
Allowance items are fixtures only: fans, all light fixtures, recessed trim (not cans), all-in-one recessed lights, LED lights, floods, HVL (not switch), under cabinet lighting, all bulbs, doorbell and button.
Hardware – $2,400
Allowance items are material only. All door knobs, locks, deadbolts, cabinet pulls and knobs, tv mounts, address numbers, mailbox. Hinges are part of doors, not separate hardware.
Notice the word ‘fixtures’ and how an actual list of the types of items that are included as allowances could go a long way to closing the door on change orders? It doesn’t solve the problem of a builder throwing in something like a breaker panel because he could call that a ‘fixture’. However, in conjunction with the definitional language in the contract, combined with your very pointed conversations during negotiation of the contract, then those types of what I call ‘random throw-ins’ can be avoided.
The best Allowance Schedule has a column labeled – Contractor to Provide (not an allowance item):
Electrical fixtures – $15,000
Allowance items are fixtures only: fans, all light fixtures, recessed trim (not cans), all-in-one recessed lights, LED lights, floods, HVL (not switch), under cabinet lighting, all bulbs, doorbell and button.
Contractor to Provide as part of contract (not an allowance item): Installation and other materials including (but not limited to): HVL switches, recessed cans/housing, dimmers, smoke and carbon monoxide detectors, attic light/outlets, waterproof outlets, all panels & breakers, switches, outlets, devices and all rough-in materials (mounting brackets, wire, outlet boxes, etc).
KEY NO. 2 – A proper Schedule of Value (for draw requests), with clear language.
A Schedule of Values represents the cash flow of a project. It’s a list of the phases of construction work with value (a dollar amount) for each, based on the % of what that phase represents of the total contract price. It is made part of the contract (attached as an exhibit) and forms the basis for the draws (how money is paid to the builder).
Draws are requested, based on: (1) the scheduled value and on (2) how much work has been completed (as a %). Example: framing might have a scheduled value of $120,000 (includes mat and labor). The draw request might be for 50% complete, so 50% of that scheduled value is $60,000.
The right way for a Schedule of Values to be used is two part (and is commonly not done this way):
- Use a Schedule of Values with each phase having a value that is close to the actual construction cost for that item. In the framing example $120,000 should be close to what it actually costs to buy the lumber and pay the framer.
- Draws are paid for actual ‘work in place’ (no preset draw amounts or deposits). The actual amount of work completed is verified by a professional 3rd party inspector (an architect or bank’s inspector). The bank only pays per the inspector’s report, regardless of what is asked for on the draw request.
In the above example, 50% complete will only be paid if the framing is close to what is actually installed (not lumber stored on the site or what will be finished by the end of the week) when the inspector arrives.
Done this way, the project is not overpaid and there is always enough money left (with the homeowner or the bank) to finish the job.
It is very easy for builders to get overpaid, very fast. It’s the typical game that is played. The real downside to this is that you lose your ability to push back too hard (on unfair change orders or poor workmanship) because the threat of your builder walking off the job is real. What if he has $50k or $100k or $150k or more of your money which would walk off with him? You’d have to come out of pocket to make it up. I’m not making up those 3 numbers-they come from real people that I’ve advised and overpayments to builders are far more common than it needs to be.
Use a fair, accurate schedule of values and have the bank do inspections. Easy to put into place in the beginning and have signed in your contract. Even if you pay cash, you can set it up with inspections and/or your banker to get the control in their hands and out of yours.
It’s how investors (single family homes) do it because commercial lenders require this approach. The commercial side of the bank only means that the house is not a primary residence. Banks require it to protect themselves and the owner.
When you have strict bank inspections – look at how easy it is! Let the lender be the bad cop. No difficult conversations or decisions to make. When the builder puts in a draw request, trying for more than earned (which he will) then you, as the owner, have no say in the matter. The bank is in charge of payments!
Here’s a little known secret too…it keeps the project on schedule!
One of the largest levers you have to keep the project moving along at a good clip is to ‘Dangle the Money Carrot’ in front of the builder at all times! The beauty of the money carrot approach is that it drives the project based on COMPLETIONS. There is motivation to push (get it done) because the inspector’s coming and he is strict (only pays for work complete)!
KEY NO. 3 – Change Order language that is clear and strong.
Standard language regarding what a change order is, how contractor markup is applied, etc. can be found in industry documents by the AIA (American Institute of Architects) and NAHB (Nat’l Association of Home Builders). What I offer below is even stronger language to have in your contract to help prevent problems (from experience!).
I don’t feel like any of these suggestions are unreasonable to require from your builder and they protect you. Especially the 30 day part. It’s common for builders to hit owners, at the very end of the project, with a change order that has a whole list of charges that happened weeks or months prior. I have heard this story (and from personal experience) many times. It’s too hard at the end of the project to do much about it if you are ready to move in, close on the loan or have other deadlines. Also, you have very little negotiation power at that point in time. Plus, who remembers details of something that happened 7 months ago?
I am NOT offering legal advice. I strongly encourage you to engage a qualified attorney to review your contract. These are ideas for you to consider, to negotiate with your builder and to have your attorney draft the correct language for. Please think about these ideas and how they might help to close the door to misuse.
Owner will NOT pay any Change Order:
- That was not approved by Owner, in writing prior to ordering the item or starting the work. The change order must list ALL necessary items, with exact costs.
This is to avoid many examples like this one: owner wanted to add an ice maker after slab poured and asked about the cost. Builder sends a plumber quote of $650 and the owner says yes. Weeks later, the change order comes in at $3650 because there is $3,000 to bust open the slab and run a drain and water line.)Of course, the builder knows that the slabs need to be done, he just forgot to include it in the quote. Personally speaking, ‘I forgot’ is not acceptable.
- If Owner receives a written change order (or evidence of CO) beyond 30 days from the date of ordering the item or starting the work.
You don’t want lingering change orders as it affects your ability to budget accurately, for one.
- That does not include evidence of the actual cost. Evidence being the actual written quote from the supplier or subcontractor or other vendor.
- Change orders will not be paid outside of regular draw requests. They must be incorporated into the draw request itself.
I share my personal experience on the more functional side of things. Obviously there are no guarantees that these suggestions will actually prevent problems but, hopefully, go a long way to improving your cost control and your overall building experience.
Please know that the topics covered are complex and involve much more than has been touched on here in this introductory article. Keep digging and researching until you have a very good understanding of each topic.
Also please recognize that it’s not just the language or a schedule to insert into a contract properly. Each of these topics are also strategies that need to be employed the entire time. Therefore, the more you know about them the better. My best advice is to dig deeper and research it further. Hire advisors, look online and/or use my training.
A recap:
I strongly encourage you to engage a qualified attorney to review your contract and to advise you.
Have a lot of detail for every allowance item. Make sure all items that Owner’s will select are included on the Allowance Schedule (there might be 30+ items). The contract should have clear definitional language as to what allowances are and further, how they are to be paid, how markup is treated, and even trade discounts should be addressed. Do more research to understand how they are used, and importantly, how you can employ them as a strategy for interviewing your potential builder.
A proper Schedule of Values should be attached as an exhibit to the contract with language stating that payments will be made in accordance with the schedule, but only as approved by the bank inspector. Get your lender on board. They can help come up with the proper schedule and strict inspectors.
Get strong, clear definitions for change orders as you negotiate with your builder, then have those incorporated into the construction contract.
This guidebook is 20 pages long and can save you tons of time and money. In it, you'll find some very unique ideas. Click here for Free Guide to Making All of Your Selections Hope this helps and happy building! Julie You've got this! Remember..
of what you want and how you want it done.
