In an ever-changing climate of rising building material costs, lenders should pay very close attention to the contract between the borrower and the contractor.

For example, in the US, the National Association of Homebuilders’ Construction Liability, Risk Management and Building Materials Committee recently published a contract appendix for property developers to use in their construction contracts that provides an ‘Escalation Clause for Specified Building Materials’.

These changes to ‘fixed-price’ contracts act more like ‘cost-plus’ contracts where borrowers assume the risk of rising materials costs.

Ultimately, rising material costs threaten homebuilders’ ability to complete the project while maintaining a profit. Thinly capitalized developers may not be able to, or may not want to, absorb additional costs under ‘fixed-price’ contracts, particularly in high-demand markets where there’s an incentive to just walk away for more profitable works.

Generally, there are three ways lenders have adjusted and changed their lending criteria in the face of rising cost of materials to navigate the new more uncertain price environment.

The first way is to require higher contingencies and contingency reserve accounts. The second way it more integration on supply chain and materials used on site (e.g. where are the bricks made in? Are tiles made in Turkey or in the UK).

And the third way is by an increased focus on the financial standing of the borrower’s main contractor. So, our advice to borrowers right now would be: make sure you are using a contractor of fixed price and that you are comfortable the contractor can deliver with that fixed price, make sure that your risk as a developer is one that you are comfortable with, and finally and most importantly, make sure that your numbers are strong enough to sustain sudden and unforeseen price rises.