If you're a real estate investor who's in the market for a new income property, you may be having a hard time navigating today's housing market. The reason? Inventory is extremely limited, especially for starter and moderately priced homes.
For this reason, many investors are turning to new construction. But that may end up being a more expensive option than some are bargaining for.
Builders are passing higher costs on to buyers
For months, builders have been grappling with a major lumber shortage that's caused its price to skyrocket. Last year, lumber prices peaked in September, according to the National Association of Home Builders (NAHB), but at this point, they're even higher than their September peak. In fact, in a recent NAHB/Wells Fargo Housing Market Index survey, builders say that the price and availability of construction materials is the top challenge they face today.
Builders, however, aren't just eating the cost of more expensive materials. Instead, 47% are passing that cost onto buyers via escalation clauses in their real estate contracts.
An escalation clause allows a builder to impose a certain sale price but also raise that price if, during the construction process, the costs of the build come in higher than anticipated. A new home might sell for $400,000, for example, with a 10% escalation clause, in which case the buyer could end up paying $440,000 for that property after all is said and done.
Should you agree to an escalation clause?
In an equalized housing market -- one where neither buyers or sellers have a clear advantage -- it's more than possible to strike an escalation clause from a real estate contract. But in today's market, many investors are likely to find that getting rid of escalation clauses just won't fly.
It's estimated that the rising cost of building materials is adding close to $36,000 to the cost of new construction on average. That's an expense builders just can't afford. And given the heavy demand for housing inventory right now, there's no reason for builders not to charge more for newly built homes, especially when they're paying more to source materials to construct them.
That said, there may be some wiggle room to negotiate escalation clauses on a percentage basis. And investors who are cash buyers will generally have an easier time pushing back than those seeking to mortgage their new construction purchases. But for the most part, right now, escalation clauses are probably here to stay, and buyers who don't want to get stuck paying extra for a new build may need to limit themselves to existing homes.
The Millionacres bottom line
Building a home is more complicated and expensive than ever. In addition to lumber prices, the cost of steel and copper has also risen. If you're looking to add a new-construction home to your real estate portfolio, be prepared to have a builder pass those excess costs onto you -- and make sure they're worth paying before locking yourself into a contract you later regret signing.