5. On Construction contracts

This is part of a Series in eight parts. Here are the other posts.

  1. On commercial Real estate
  2. Defining project Value in CRE
  3. Identifying Risks in RE
  4. Sample table Project development
  5. On Construction contracts
  6. Essential types of project development
  7. Capital funding
  8. Components of project development

Last time I was asked a very simple question, which threw me completely off balance. The question itself was: what is my favorite type of contracts in construction. A very simple question but when it is asked in English to someone working in Germany, it is actually very hard to answer.

I had to research it. I found out some new contractual types, before unbeknown to me. The US system has some specialities. The contract types can be packed into two categories: performance- and costs-based contracts. In Germany I am familiar with just one subtype of price-based contract, the common unit price contract. The rest was all new. Let me quickly present my findings. I will be comparing just USA and Germany.

USA

As said, the basic division goes down Price and Performance based contracts. Price contracts are subdivided into Lump-sum (Pauschalierung) and Unit price contracts (same as german Einheitspreis, LV). Lump-sum is very useful if the planning is done right, as the constructor carries all the risk for the project. They will bid one single price for the whole project, so there must be no room for errors. Unit price contracts determine costs per each work or material unit. Lots of room for price negotiation, but very little room for planning mistakes.

The performance-based contracts try to solve this issue, so the construction can start before the planning is completely done. This is very useful for big projects. Cost-plus contracts are of a very open type; Constructors are paid based on the actual costs + overhead. It is impossible to estimate the final costs of the project. The second is the Target-costs contract. The same as before, but with a final target of how much should the project cost. The contractor takes the risk if the project costs exceed this number.

On this blog I found this very useful table:

Cost based ContractsPerformance based contracts
Point of DifferentiationLump Sum ContractUnit Price ContractCost Plus ContractTarget Cost Contract
Advantages with respect to the contractorIncentives for early finishLow riskNo riskRewards for any savings between actual and target cost
Disadvantages with respect to the contractorHigh riskNo incentives for early finishNo incentives for early finishShare risk with the owner
Advantages with respect to the ownerNo risk – Total cost is defined at early stagesShare risk with the contractorCan start project without finishing designsTarget cost is defined at early stages
Disadvantages with respect to the ownerContractor desire to decrease costs may be to detriment of qualityTotal cost is uncertain at early stagesHigh risk – Total cost is uncertain at early stagesShare risk with the contractor
Flexibility of design changingLimited flexibilityHas flexibility to change designMore flexible to design stagesLimited flexibility

If you have a finished and a good plan, the best way are the lump-sum contracts. If you don’t trust your plans or are in a hurry, go with the performance based contracts.

Germany

There are two regulations on contracts: the general obligations law and the unofficial industry standard, VOB: Contracting rules for the procurement of public works (VOB/B). The law is applied automatically for all projects, the VOB must be agreed on.

Performance – based contracts are very rare. I have never seen them in my praxis, yet. Unit price contracts ( Einheitspreis ) are an industry standards. Some of the positions are sometimes averaged (in the direction Lump-sum). Whole lump-sum (Pauschalpreis) projects are also relatively rare, usually only in turnkey projects. Hourly rate-based projects (Stundenlohnsätze) are only paid if expressly agreed in the contract beforehand. So far I have seen them in used on a very small scale for some art details.

But I have found a list of all possible contracts in Germany. It looks very similar to the US one. Here is the whole list of all available contracts in Germany.

  1. Unit price contract (Einheitspreisvertrag).
  2. Detailed average price contract (Detailpauschalvertrag): all the works and materials (quantities) are in detail prescribed. The contractor carries the quantity determination risk, but not the “completeness” risk.
  3. Lump-sum contract (Globalpauschalvertrag): The contractor issues one price for the whole building. They carry both the quantity determination risk and the “completeness” risk.
  4. Costs plus contract (Stundenlohnvertrag). Very rare, used only if the planning is not yet clear.
  5. Maximum price guarantee. (GMP-Vertrag) : Planning and construction is done jointly (optimisations). GMP is a cooperative form. The saved costs are split between the partners accordingly. Similar to the Target costs contract.
  6. Public Private partnership.

Conclusion

To recapitulate quickly. Maybe there is not much difference between the US and the German system as I thought. It is just that I was not familiar with the international terminology and that in Germany Unit price contracts re probably used in the vast majority of projects. Let’s go through my list of + and -.

Unit pricing contracts – Einheitspreisvertrag 

+ good and easy to execute, if the planning is done right and there are no unplanned works. 

– a nightmare if the plans are bad and there are any changes during the construction (“Nachträge”- added costs contracts).

Lump sum contracts – Pauschalvertrag

+ good if you trust your plans, as any unplanned works will go out of the contractors pockets.

– the final price of works must be well negotiated. 

Time contracts – Stundenlohnverträge

+ good for all the works, which cannot be described in LV. Small final works, unique details, art. Works, which need many corrections and cannot be easily described.
– expensive, as contractors are not motivated to finish early.

Sources:

https://www.dlapiperrealworld.com/law/index.html?t=construction&s=legal-framework&c=DE

https://www.thebalancesmb.com/common-types-of-construction-contracts-844483

https://theconstructor.org/construction/types-of-construction-contracts-comparison/14268/

https://www.lexology.com/library/detail.aspx?g=c78f124b-b166-49a0-ba4f-58dac596557f

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