5 Key Construction Contract Terms
Main topic: Key business terms of a construction management agreement.
Construction management agreements are complex and challenging to navigate, even if you have experience with them. In this newsletter, I discuss five key business terms that every project owner should be familiar with.
These terms are some of the foundational building blocks of a contract, so they are an excellent introduction to the more detailed provisions typically built over them. Think of these terms as the bare minimum you should know to have a good grasp of your agreement strategy.
As always, I recommend that you have construction counsel review language and assist in negotiating agreements; after all, construction management agreements reign how you spend what is likely the most significant capital outlay in a project.
1. General Conditions.
“General Conditions” is a broad category for everything the construction manager or general contractor needs to supervise and administer the contract that cannot be categorized into a particular trade. General conditions typically include brooms, ladders, a field office, printing, temporary toilets, site protection, trash removal, etc.
Although it seems like a wide-ranging category, it is not a catch-all for every expense the GC/CM can imagine. There are industry standards for things that should and should not be included.
There are some gray areas regarding what is and isn’t included in General Conditions. This is where setting clear expectations is essential. Some would argue that the management staff's cell phone bills and car allowances are general business costs and not attributable to the specific project-- especially if that staff is also working on other projects.
Regardless of people's thoughts about what should or should not be included in the general conditions, it is undoubtedly a negotiation that requires some attention to determine whether the expenses enumerated by the contract, especially if proposed by the CM/GC, are acceptable. One way I recommend thinking about it is whether you would be comfortable explaining an expense to your capital partners. If it does not seem justifiable and is not industry standard, then request that that item be removed from the list. For extreme clarity, you can ask to see a General Conditions list as an exhibit of your agreement, where things are clearly itemized and not generally referenced within a few lines of the contract.
Often, General Conditions may be quoted as a total percentage of the overall cost of the work. While this is an acceptable method during the budget phase, General Conditions should always be itemized and billed as used, especially on projects with cost-plus contracts.
2. Fee.
Most projects fall into two fee structures: lump sum or cost plus. (For detailed descriptions and other types of contract structures, see last week's newsletter)
In a lump-sum contract, the parties agree to an ‘all-in’ price. This includes all project costs, including general conditions, fees, insurance, and trade work. Lump sum contracts typically follow the market price per square foot for the specific size and type of project. Since the project cost is fixed*, lump-sum contracts are often referred to as ‘closed book’ agreements where the counterparty is not allowed to audit the project to see how much each of the parts and pieces costs. This usually means the project owner does not know the material markups and fees.
On the other side of the transparency spectrum, a cost-plus agreement is considered ‘open book.’ If the costs rise, so does the fee, and while this requires complete transparency, it also presents an apparent conflict of interest. Usually, cost-plus agreements contain clauses that attempt to better align project interests by creating performance incentives, given that the cost-plus strategy seems to encourage higher costs at first glance. This is one of the premises that can make cost-plus agreements much more complex than lump sum contracts.
The neat thing about cost-plus agreements is that after a certain amount of the trade pricing is locked in, the parties can shake hands and agree to a guaranteed maximum price. This is the golden standard in commercial development, the much sought-after “GMP,” which is an amendment to a cost-plus agreement, not a type of contract.
Regardless of the structure, the fee is always a negotiable term. (In the case of the lump-sum agreement, the whole number is negotiable). The fee is one of the few true ‘negotiables’ on a project if we follow the premise that trade work within a particular market is likely to be comparable regardless of who the construction manager is**.
For this reason, I always encourage project owners to actively negotiate the fee. Accepting the first number you receive is a sure way to leave money on the table. Especially in the case of a cost-plus agreement, where there are numerous clauses related to contractor compensation, negotiating those terms in conjunction with the fee is key to establishing clear project expectations and ensuring you are getting a reasonable overall price for the project.
*The cost is fixed based on the contract documents. If any work must be performed beyond the scope of the documents, then it will follow the terms of a change order. Usually, all construction management agreements contain change order terms that, among other things, define what is considered a change order and how much the CM is allowed to charge a markup on the costs.
**If you are in a situation where one CM has lower total pricing than others in the same market, I would ask many detailed questions to understand the reason behind the pricing difference. Either they made some mistakes, or they need to be more honest when presenting the pricing--either regarding their relationships with those subs or their methods of determining said pricing.
3. Contingency.
Contingency is one of the most misunderstood terms in a construction management agreement.
There are two types of contingency for most development projects using a cost-plus contract. One held within the construction management agreement, which applies specifically to the costs of the work. The other type is the owner’s contingency, held outside the construction contract.*
The contingency within a construction management agreement is a percentage of the cost of the work added to the contract to cover any costs the construction manager left out of the project scope in error.
Contingency terms usually include information regarding what the GC/CM can and cannot use the contingency for. For example, most agreements cap how much of the contingency can be used for general condition costs associated with the contractor’s scope errors. So, in the case of a project schedule extension because of a contractor’s error, some or all the resulting general conditions costs, like project management payroll, temporary facilities, etc., may be excluded from the expenses the contingency can cover.
As with all other terms in a contract, the percentage and what is or isn’t included are negotiable.
Lenders may want a specific percentage allocated to the contingency in the construction manager’s agreement. Checking with the bank regarding terms they will be looking for in the contract can give a project owner some context before entering negotiations.
Since the contingency is supposed to cover contractor errors in a cost-plus agreement, the fewer errors the contractor makes, the less that contingency is used. To incentivize fewer errors, the project owner can agree to split leftover contingency with the contractor at the end of a project. This is called “Shared Savings,” and it is one of the most used incentive structures within cost-plus agreements. A fair market split is 60-40 in favor of the owner, but as all terms, this is negotiable. For shared savings to be most effective as an incentive, it is crucial to cap how much of it can be used for General Conditions.
*I always recommend carrying contingency outside of the contracted values. This is intended to cover any project-related overruns and should not be contractually tied to any other party within the project team.
4. Change Orders.
Change orders are also often misunderstood. Simply put, they are things not covered in the “Construction Documents.” Contractually, Construction Documents include drawings, specs, works scopes, and other documents. This means the project scope does not end at the drawings. The best way to minimize change orders is to ensure the project scope is complete. This is why owner involvement in scope review meetings before trade buyouts is crucial.
A significant consideration to remember about change orders is that they are 'contract revisions.' They are legal amendments to your construction management agreement. Typically, the original contract will have change order terms, including markups and timelines.
Markup terms dictate the percentage the contractor can charge over the change order cost. Typically, they charge general conditions, fee, and insurance. Sometimes these percentages match the original contract values; sometimes, they differ. In some cases, these are negotiated out entirely.
If you are curious, there is also something called a "dead band" that I can explain further (email me) that attempts to cap the cost generated by fees related to change orders.
Timeline terms are perhaps the most important yet most overlooked change-order-related terms. Once the contractor becomes aware of a condition that constitutes a change order, there is a limit on how long they must notify, document, and present the change order to the project owner. Otherwise, they waive the right to charge the owner for the work. This provision benefits everyone since it injects urgency into the project and prevents the project team from needing to review change orders retroactively.
It is essential for the person managing the project on the owner's side to know exactly what these terms say. They need to review contract revisions vs. the existing contract terms to ensure they are 1) considered a change order and 2) following the terms of the agreement.
This year I audited a project where the CM charged the incorrect percentage on all change orders for the preceding ten months before we were involved. They also 'double dipped' fees where they included the markups on the COs as a line item in the pay applications but also added fee, insurance, and GCs to the new contract amount. Neither of these was a malicious act-- they were honest accounting mistakes, but it took us eight weeks to detangle them.
We saved the owner about $300K.
Once you understand how change orders work contractually, it should be clear that change orders are not how the contractor generates profit—as a project owner (and as a CM/GC), negotiating fair CO terms is essential to the health of the project.
Bonus: The Difference between when something is a change order vs. when contingency should cover it.
The main classifying characteristic between a change order and something that should be covered by contingency is whether it was in the contract documents. This means that contingency is not intended to cover unexpected existing conditions.
This is a topic where owners and contractors like to split hairs, so establishing these expectations at the contract stage and memorializing them in the agreement is essential. This will get everyone on the same page. Hopefully, everyone will remember what they agreed upon throughout the project so the team can spend time building and not arguing whether something is a change order.
As with all other terms, it is important to ensure that change order and contingency terms are well-defined so there is clear guidance in the agreement should a dispute arise.
5. Indemnification & Insurance.
Indemnity is a standard contract clause, not just in construction agreements. Despite that, not many people understand what it means. When one party indemnifies the other, it agrees to take responsibility for claims resulting from its negligence, even if its insurance does not cover that responsibility.*
Indemnity contract language can be complex since it deals with the circumstances surrounding liability. Because of this, I highly recommend having construction counsel and (if possible) an insurance expert review the language. As a rule of thumb, AIA standard contract language is not sufficient when it comes to indemnity language for commercial projects. So, if you’re using an AIA standard form on a commercial project**, at minimum, you should replace the indemnity terms with better language per construction counsel.
When damages occur accidentally, insurance typically covers it. Understanding what types of insurance are required on a project is the other piece of the puzzle. Generally, development projects require that the owner and contractor both hold specific types of insurance. As a baseline, both parties should carry their own general liability policies. Additionally, the project should be covered with the following:
Builder’s Risk
Worker’s comp
Excess/Umbrella
Subcontractor default insurance or bond
Determining which party holds these policies depends on the team and contract structure, and I covered them in greater detail in a past newsletter that will go out next week as part of the relaunch series.
Lenders typically have some requirements for insurance and indemnity terms, so I recommend running the terms by the lender early in the contract negotiation process.
*Most insurance coverage specifically excludes claims arising from negligence.
**which I don’t recommend.
The main takeaways from this newsletter should be a clear understanding of the basic terms of a construction contract, a general sense of how these contract terms work together, and a good grasp of the need to involve specialized counsel. Elementary knowledge of contract structure (from the previous newsletter) and basic terms can go a long way toward intentionally crafting a contract strategy that best suits your project. The intention is to equip you with language and information that will allow you to actively participate in contract negotiation along with qualified construction counsel.
Not sure where to start and think we can help? You can find us here!
Main topic ideas for future newsletters.
Between conversations with clients, industry professionals (and RE Twitter) these are some subjects we will be exploring in future newsletters.
How to select an Owner's Rep
How to scope out a contract
How to create useful incentives in construction contracts
Have a specific subject you want to see us tackle? Drop us a note!
MADDPROJECT: Professional Project Management.
We offer a wide range of services, all tailored to your project needs. Some of our project management services include:
Comprehensive project management
Zoning feasibility and entitlement assistance
Standalone contract negotiation
These services are offered in different time increments depending on what you need. For more details, check out our site!
Received this link from someone & want to sign up?
Have a specific subject you want to see us tackle? Drop us a note!
If you loved it, you can always share it!