Featured Story: What’s going on with escalation clauses in today’s market?
One of the greatest traits we possess as humans is resiliency and the innate ability to adapt to change. This instinct has manifested itself in countless ways throughout the recent pandemic, including helping us navigate a heightened desire for home while the industry surrounding residential real estate has been disrupted in unprecedented ways. Skyrocketing material costs. Delivery delays. Labor increases. How do you establish pre-sale pricing on new construction with these variables in constant motion?
Enter the escalation clause. In today’s market it’s being used by developers to inform their buyers that the contract price may increase prior to delivery due to unforeseen changes in materials and labor. We sat down with two @properties Development Group clients, Tom Drake, CEO of The Drake Group, and Hank Luwisch, Managing Principal of Norso Companies, to understand how they are choosing to consider escalation clauses as part of their pricing strategies for pre-sales.
Tom Drake explains, “We’ve been building in the Chicago market since 1999 and we have never had to consider an escalation clause in any purchase agreement. Historically, the costs for labor and materials have been predictable. Pricing for lumber, for example, has been relatively stable for the past 20 years, running around $375 to 400 per thousand board feet. It stayed in that range until April 2020 when it spiked to over $900 per thousand board feet. And even that was temporary. It went down to around $500 and then back into the $900 range at the end of the year. I remember thinking, ‘Let’s not buy lumber now. This is unsustainable. The price will certainly go down after the first of the year.’ But it didn’t. It kept going higher and higher and eventually hit over $1600 a board foot and it’s been volatile ever since. Now it’s around $1300 per board foot — a 350% increase that nobody could have predicted.”
Drake continues, “As we have started to understand how some of the biggest expenses like lumber and concrete are likely to behave, we’ve been able to factor the volatility into our pricing. The vulnerable places for us and for our buyers, however, have been cabinetry and appliances, which continue to wreak havoc on our cost estimating and scheduling. So instead of using a blanket escalation clause, we have a clause that focuses specifically on cabinets and appliances.”
In the Atlanta market, longtime developer Hank Luwisch has taken a different approach. He shares, “I don’t think anybody ever anticipated the drastic impact the pandemic would have on the real estate industry…sales slowed down, building slowed down. As the market recovered quickly and the demand for housing increased, we found ourselves in the unprecedented situation of enormous instability as it related to both access to materials and their cost, where for the first time in decades, we couldn’t predict what it would cost to deliver new construction.”
“So today, as we’re building in Atlanta, New York and New Jersey, we’re using escalation clauses to manage unpredictability during the presales process to allow for the often-daily surprises we’re experiencing in pricing and delay of materials.”
“Our buyers are informed from the start about the clause, and the brokers and attorneys are also in the loop. We have included the option to increase prices up to 10% to account for unanticipated changes in our building material costs that we will pass on to buyers — without any margin or profit added. This includes lumber, concrete, windows, cabinets and appliances where we are seeing the greatest volatility in pricing. In the event we experience upcharges in excess of 10%, we give our buyers the option to cancel their contracts without penalty.
Luwisch says, “Using escalation clauses is a necessary response to current volatility, but we don’t like it. We don’t want to lose buyers, we don’t want to price anyone out of the market, and we don’t like not knowing what our costs are. But this is the world we’re living in today, and it’s our responsibility to make the best of it on behalf of our customers.”
Drake has another insight to share. He offers, “The gift of choice was always part of the magic of buying a new home. And the idea today that you have to strip away options in order to deliver the project on time and on budget certainly changes that dynamic. Luckily, instead of people losing appetite for the new, even with limitations and extra cost, we’re seeing that demand is even greater.”