The Expert Podcast

So how about this nightmare scenario? You are a home buyer in this crazy 2022 building crisis market, real estate crisis, and you have been priced out of many resale homes. But luckily for you, you have a contract with a builder on a new home, and this has given you a sense of security because you probably had this contract in place for many months, maybe a year. Maybe your build was delayed because of lockdowns or pandemic. And now comes time to where you're getting closer to your move-in date. Maybe the framing is done, maybe the roofing is done, the dry-in is complete, and you start to see your contracted property look more like a house. It's real.

At some point prior to closing, usually it's when the house is becoming finished — there may be sheetrock, electrical, maybe even cabinets are being put in — and you get a call or contact from your builder that says, by the way, we're canceling your contract on your house, on your build, or we're changing your price. The prior contracted price you had locked in, maybe 350, 400, 425, it's going up 25 or 30 percent.

What would that be like as a home buyer? If this has happened to you or you know somebody, put in the comments below, let us know if this is something you're familiar with, you have seen. It's not uncommon. Here's an article from North Carolina where some home buyers thought they found their dream home. They had rented a house for a long time and wanted to settle down. They went to a development down the road, they signed a contract for a new construction home. Their other houses started getting built in the neighborhood, but the progress stalled on their house, and then they received a request for an additional thirty thousand dollars. They were getting really excited about the process and then the brakes get slammed.

Seems like it comes as a surprise because they signed a contract. However, most new home contracts have either an escalation clause or a builder withdrawal clause, meaning that if the builder decides at some point that the market has changed, the prices have gone up, the materials have gone up, they can either exit the contract or raise the price. Now, this obviously sounds very unfair to the buyer because number one, you signed a contract for a price. Number two, you're looking forward to this house, you probably cancelled your lease or maybe sold your previous residence. You need a place to live and this new house is going to be the next place you're landing. It's going to be your exit strategy. And now all of a sudden to find that either the contract is cancelled or the price is higher can be a gut punch. It could be a very serious blow and really it's life altering.

So whose fault is it? What can be done about it? What are the laws? Well, we're not attorneys, we can't give you legal advice. But even in this article, they interviewed a real estate attorney. He's seen some builders asking six figures more — a hundred thousand plus — and a lot of it has to do with a perfect storm of labor cost overruns and increases, but also the cost of the land went up. You may think that the builder should honor their contract and you know, maybe they should.

But when a builder says, why should we build a house for this price, because they can breach and build it for somebody else at a different price. And here's one of the reasons why the builder might not even offer to sell it to the existing contracted owner for a higher price: because if they just take it off the market, not only can they sell it for a higher price, but the bigger factor is they don't have to customize it. When a person signs a contract for a custom house or even a designed house — not a custom floor plan, it's one of their off-the-shelf floor plans — but they design the interior, certain cabinets, certain floors, certain windows, that's a big obstacle for the builder. That's a big inconvenience.

When a builder can just build everything the same, not customize anything, it's a lot easier to build. Sometimes the materials aren't even available. There are certain appliance packages that you can't even get from the appliance manufacturers right now; they're on eight to nine month delay. So for the builder, sometimes it's easier just to start out with a clean slate. You don't have that animosity back and forth with the existing buyer complaining over the price, having a bad experience, bad taste in the mouth. You're starting out with a new client that's very happy to pay the higher price for a more basic house. It's going to be a positive experience for that client. You're not going to get bad reviews, you're not going to have other things come up.

For example, if you are a homeowner who had a contractor, let's say at $380,000, and all of a sudden now your builder says you have to pay $460,000, you're probably going to find more problems with the house that they have to fix under warranty over the next year. You're probably going to have a more animosity-filled relationship with that builder. So the builder is just going to expect that it's going to be a high-maintenance buyer. So they're probably more likely just going to cancel the contract and start fresh with a new buyer.

The new buyer probably doesn't even think that that lower price is available. So them paying $460,000 or $470,000 to them is just fine because it's a clean deal. So why are the builders doing this? They probably wouldn't intend to do it, but builders are having their own problems. Builder confidence is at a low. Why is that? Well, there's a rise in materials, there's a rise in labor, there's difficulty getting different products through the pipeline — maybe it's supply chain issues, maybe it's delivery issues.

The bottom line is that building company or that general contractor has to look at what is possible for them to deliver. If the materials and the labor have gone up so much that the prior price of $360,000 or $380,000 is just not doable, the math doesn't pencil out. They can't afford to deliver that house and stay in business in some cases. Is there price gouging? Is there inflated prices? Is there builder opportunistic profiteering? Certainly. But most building companies really wouldn't want to cancel a contract unless it's a last resort.

Most builders don't want to go through that process because it's toxic for them too. It creates problems for their employees who have to deal with this, it creates difficulty in the marketplace with the realtor, there may be even costs involved with doing this. So it's not really their first choice. But when they look at their cost being up, but also the market giving them more opportunity — where instead of selling it for $380,000 they can sell it for $460,000 or $470,000 — they're going to take that opportunity.

Because in their world, they're having their own financial problems. They may not be able to afford payroll, they may not be able to afford their insurance or their bonds. There are many, many builders going out of business even in this crazy real estate environment. Many general contractors are reducing their footprint, slimming down their operations because the market has a lot of price sensitivity, but it also has a lot of cost increase.

When you have to pay more for every single thing on your financial statement — insurance, rent, taxes, labor, subcontractors — you have to restructure your business to be able to stay in business. Because if you can't generate enough revenue to cover even your fixed expenses, you're going to have problems remaining a viable building entity. Unfortunately, the consequences of that flow down to the retail buyer. And even though the face of that consequence is the builder, the only person you know about is the builder, there's many things going on behind the scenes that kind of force the hand of that builder.

Doesn't make it any better. Maybe the builder can handle it in a different way, better bedside manner. But there are other factors that the builder has to deal with, because they may not be able to find labor for less than seventy or eighty dollars an hour in some cases. They may not be able to find electrical subcontractors or tradesmen in plumbing or HVAC, where in the past, putting together electrical on a 2,500 square foot home might have been $17,000 or $18,000, now it might be $26,000 or $27,000 — an extra $10,000 per trade: $10,000 for electrical, $10,000 more for plumbing, $10,000 more for HVAC.

So now you all of a sudden have $30,000 more just in labor, plus your materials, your lumber package is $20,000 or $30,000 more. By the time you add it all up, now you're $40,000 or $50,000 more in cost, plus your fixed costs are now higher. Your work comp, your liability insurance, your bonds, your equipment — maintenance and repair on excavators is also higher, tools are higher.

So now your cost basis on the house that you're going to sell for $380,000 might have been maybe $300,000. Now your cost basis is $360,000. So after you sell it for $380,000, minus commission and closing costs, you're negative. So you almost have to do this if you want to remain in business. It's just a math problem. It's not anything personal, it's not anything harsh or animosity towards the buyer. It's just math of keeping that business afloat in many cases.

Whether it's a small builder or even large builders, they all face the same thing. Large builders may sell more houses, but more cost multiplied times hundreds of houses actually makes the problem worse for larger builders.

So if you're a home buyer, the problem you run into is even if you want to pay the extra amount, unless you have it in cash, your lender might not approve the higher amount. They already have you approved on a mortgage. Let's say if it's a $380,000 house minus 20% down, maybe you're financing $310,000 or $315,000. Now you're going to ask them to finance $400,000 instead of $315,000. Their appraisal on the house might not be higher, but also your approval based on your income might not be that much higher. Especially when the rate has gone up. When you were originally approved, the rate might have been 3.2%. Now it's 5.5%.

So add the extra principal, you add the extra interest calculation, and now your mortgage payment might have gone up $700 or $800. Is that still within the debt-to-income ratio on your approval? I don't know. But those are another reason why sometimes builders are just willing to flat cancel the contract, because they're worried that the buyer might not be able to get approved even on the higher amount. They don't want to waste time waiting for that buyer to go through the approval process. They just flat cancel, start over with a new buyer that can get a new approval at the higher amount, or pay cash for that matter.

Look at our future videos too. There's another phenomenon happening where there's a lot of investors buying these houses direct for rental, not just buying it to live in. They're just investment companies buying brand new homes to rent from day one. And the good thing about that for a builder is that when an investing fund buys these homes, they don't need custom furnishings, they don't need every last thing customized that's maybe unique to one person's taste. They want a very generic — what they call builder grade — home that they can rent out to a tenant.

And a builder grade home is much easier to build for the contractor. Not only is it cheaper in materials, but it's cheaper in labor because it can be done in a more cookie-cutter, assembly-line fashion. Anytime you have to customize something — even moldings or finish out a doorway a different way, or put the cabinets in to some home buyer’s specific tastes — now you're slowing down the building process. In this day and age, with labor the way it is and construction workflows the way they are, any deviation from a very efficient standardized building process is going to cost that builder money.

It's going to slow them down getting to the next project, it's going to slow them down getting to the next trade to come in to do their work. Even the quote from the electrical contractor — if they have to put in a custom wire run because the buyer wants something very specific with outlet placement or low voltage wire placement — it's going to just slow down the process and cost more money.

So when a builder sees an investment company will come in and just buy it as a builder grade standardized package, you don't have to change the floor plan, you don't have to change the blueprints at all. It makes it much easier for that builder to proceed, get the job done, lower their cost of materials and for their labor.

So if you're a home buyer, keep this in mind. Make your plans flexible if possible. It might give you better results with your new home purchase and dealing with a builder or a contractor getting a new house delivered to you for a place to live. Again, put the comments, let us know what you think, what your experiences are, or if you have other questions we can put in our next video.