Construction Price Escalations: How Not to Be Left Holding the Bag
In March, the federal government imposed a 25 percent tariff on imported steel and a 10 percent tax on imported aluminum. The resulting increased costs will likely be passed on to the construction industry.
General contractors typically increase their bid price to account for anticipated cost escalations. For those projects already under contract, however, the pending increases pose a dire threat to profitability. And a looming trade war could impact other materials widely used in the industry. The critical question for those bidding is how to anticipate how far prices will rise and when.
A remedy to this thorny issue is the addition of material escalation clauses to the construction contract. Material escalation clauses provide for the adjustment of the contract price if the cost of a material rises above an agreed threshold. It could state, for instance, that the contract price is escalated, if the price of steel increases over a certain threshold. The contract escalation could cover all or a portion of the price escalation. General contractors and owners would define the baseline as determined by the market value of the impacted materials when the agreement is executed. This mechanism allows the parties to account for this risk at the time the deal is closed, rather than hoping for the best once the work has begun.
The key question is which projects are appropriate for its use. Historically, material escalation clauses for steel were only used for projects involving large amounts of steel or for steel purchased over a substantial amount of time. Typically, the threshold was either purchasing at least a million pounds of steel or a project longer than a year. Currently it is unclear when and by how much prices will increase. But the potential exists for price escalations to impact a broader range of projects than history would indicate. Even non-steel based construction projects, like wooden single-family homes, typically devote a material amount of the total project cost to steel, aluminum and other metals. The percentage devoted to steel in multi-family and commercial buildings is even larger. Steel alone costs, on average, equal to 4.64 percent of the total building cost. A potential 20 percent increase in this cost amounts to a near 1 percent change in the total project cost. While this level of impact is not at the bet-the-company level, many commercial projects have significantly greater exposure. With profit margins of 3 to 5 percent, soaring prices will push some contractors into a danger zone.
Typically, general contractors favor material escalation clauses because they allocate to the owner the risk of price increases above a defined level. On the surface, you would expect that owners would want to avoid escalation clauses for the same reason. But the experienced owner knows that appearances can be deceiving. The success or failure of a project lies in the contractor’s hands. The owner has an immense stake in the contractor’s achievement of project goals, and should be highly motivated to allocate risk fairly to insure that result. As both parties are negatively impacted by a contractor’s default, escalation clauses are in the best interest of both. Crucially, material escalation clauses fairly and equitably distribute a cost factor that is outside of the control of the parties. This enables the parties to avoid the risk of damage to their relationship when neither bears responsibility for the increased cost.
If you are interested in more information or concerned about the potential effects of the recent tariffs, do not hesitate to reach out to Joseph A. Cleves, Jr. in Taft's Construction and Real Estate groups. He or any member of his experienced team can help you determine if a material escalation clause is right for your next project.
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