Keep the client’s bank happy without breaking the law

We all know about the conflict of interest that arises between the builder and the homeowner’s bank when it comes to the contract price. The bank wants the cost of the project fixed, whereas the builder wants to be able to pass on cost increases that would otherwise erode his or her profit. And the homeowner ends up in the middle trying to please both parties.

Let’s start with the builder’s position (just for convenience I’m assuming the builder is a “he”). There are only so many projects he can do per year, and those projects produce the income from which he pays his staff, suppliers and subcontractors, buys his vehicles, tools and equipment, services his mortgage, feeds his kids, and hopefully has a few holidays along the way. The builder budgets on earning a certain amount per year to fund those activities, and there are two ways in which he can ensure that he comes in close to budget.

Even if the bank can accommodate some variations, the contingency is still a problem, because it involves a gamble. The builder may have overestimated it, in which case the homeowner will have paid more than the true cost of the project. The owner could always ask for the surplus contingency to be refunded, of course, but the builder should never agree to that. That is because the builder may equally have underestimated. And the homeowner is hardly likely to agree to pay him a top-up, if that happens. Refunding or topping up contingencies would just convert the fixed price contract into a cost and mark-up one.

First, he could charge on an “open book” basis, which essentially means cost and mark-up. That means he gets his guaranteed profit, and the homeowner pays the true cost of the project as it progresses. It’s riskier for the homeowner (and the owner’s bank) because it’s hard to predict what the ultimate cost will be. However, homeowners can manage that risk by having a quantity surveyor price the plans at the outset, and having a reserve fund to cater for any budget blowouts that may occur.

Alternatively, the builder can price his jobs on a fixed price basis. That gives the homeowner slightly more certainty than a cost and mark-up project, but only “slightly” because the price can always be increased – as a result of variations, and (if the building contract provides for it) provisional sums and cost fluctuations. Consequently, there is really no such thing as a true fixed price contract. On those rare occasions where a builder might agree never to increase the original contract price, he would have to pre-purchase materials, build in a substantial contingency to cover cost increases, and prohibit variations altogether.

And that is the point that the banks seem to miss. Paying huge contingencies and giving up the right to request variations is not a reasonable thing to ask of homeowners. Sure, it suits the banks, because they know the total amount they will be required to lend, and they will have satisfied themselves that (a) the property is worth way more than the total amount of the loan, and (b) on current income the homeowner can meet the required repayments no problem.

You have to have some sympathy for the banks. They are trying to stop their customers over-extending themselves, which ultimately might jeopardise the recovery of their loan. But the answer isn’t to get the builder to pay the increased costs of the project out of his own income, or to gamble that he’s got the contingency right. The answer is for banks not to lend to homeowners who don’t have sufficient financial resources on top of their bank loan to cover any potential budget blowout.

Unfortunately, most bank staff don’t get this, and they adhere rigidly to Head Office instructions to insist on fixed price contracts. That places both the homeowner and the builder in an invidious position. They may both agree that a cost and mark-up approach is the fairest way to price the job in the current economic climate. But if the bank obstinately refuses to lend to the owner on anything but a fixed price contract, then they have a stalemate.

In those situations, the builder can do one of three things:

1. Explain why he can’t afford to do the project on anything other than a cost and mark-up basis and make it the owner’s problem. If they can’t persuade a lender to lend them a set amount on the basis that they can cover any budget blowout from savings, then maybe you don’t want them as clients.

2. Sign up a fixed price + contract that allows for variations, provisional sums, and cost fluctuations. It may also include a suitable contingency but bear in mind that contingencies aren’t so important if you can rely on the provisional sums and cost fluctuations provisions, because they cover the same risk. This option assumes that the bank will see the words “Fixed Price” at the top of the contract, and not look any further. More fool them if they do, as long as you have shown them the entire contract wording. Then the only problem you may have to face, is where there is a budget blowout, and the bank won’t fund the final instalments.

3. Sign up a hybrid contract that fixes some elements of the price but leaves others flexible. For example, a cost and mark-up contract that places a cap on your total labour charges, and/ or requires the owner to down-spec the project if the price to date reaches a certain level. Alternatively, sign up a fixed price contract that limits cost fluctuations to certain building materials (maybe you can pre-purchase the rest), and/or prohibits variations.

There is one other option that is becoming increasingly common, but I’m amazed that builders would even contemplate doing it. And that is colluding with the homeowner to fool the bank. The most common way is to sign up two contracts – a fake fixed price one to show the bank, and a secret cost and mark-up contract which the parties treat as the real one. Another way is for the builder to pay the homeowner some wages for a minimum period so that the owner can persuade the bank that he/she has sufficient income to service the loan – and then get the owner to refund that money later. It’s even worse if they artificially inflate the fixed price above the real cost, so that the owner can use the surplus borrowings to go off and buy a boat.

There are two reasons why the builder would be mad to participate in this. The first is that it is fraud. People seem to think that banks are fair game – perhaps encouraged by the news media – but in fact banks have the same legal rights as everyone else. The fraud might never come to the bank’s attention, but it certainly will do if the owner defaults on the bank loan. And then it’s not just the homeowner who the bank is suing, and the Police are prosecuting – it’s the builder too.

Secondly, if the builder has a falling-out with the homeowner and has to recover some unpaid instalments, then the resolution of the dispute gets very messy. Each party will rely on the contract that suits them best, and the cost of sorting it all out is three times what it would normally cost, with no certainty of getting the right outcome at all. Furthermore, a disgruntled homeowner might choose to say it was all the Licensed Builder’s idea, and complain about him to the Building Practitioners Board, based on a breach of the LBP Code of Ethics. You can imagine what the Board would do to your licence if that was to happen.