Managing Your Construction Contractor
You want your contractor to provide you the highest quality project, in the shortest time frame for the most inexpensive price. What we call the three-legged stool. Unfortunately, some of these desires are in direct conflict with one another. For example, it is tough to get the highest quality project when the schedule is very aggressive. In my opinion, cash is still king and this post will discuss a number of ways to protect your cash.
Managing Contractor Payment Applications
You typically pay your contractor from a payment application which lists the various work items, their values, the percent complete the work is for this payment period and the amount due on each work item for this pay period. The estimate listing in this previous post is typical of the work items that may be on a payment application. The AIA has a payment application form that is standard in the industry.
The two most important things to get right in dealing with payment applications are:
- Don’t let the contractor “front end load” the payment application.
- Don’t agree to a higher percentage complete for the work items than is actually done in the field.
“Front end loading” is when a contractor puts a higher value on the earlier work items when first filling out the pay application. This allows the contractor to bill more than his true costs and build up a cash cushion. Agreeing to a higher percentage for the work than actually done will accomplish the same thing.
An example of front end loading would be if the site clearing is worth $10,000 and the contractor put the value at $25,000 in the initial application. To do this he would decrease the cost of one of the later work items such as painting. When site clearing is done, you pay him $25,000. He spent $10,000 and he is now ahead of you by $15,000.
Why is this important? Say this contractor now goes bankrupt. You have to hire someone else to take over the work. You just overpaid for the site clearing by $15,000 and the new contractor is sure not going to agree to the lower than market painting value in the old payment application. The whole concept is that you only want to pay a fair value for the work and have enough to finish the project if your contractor can’t finish the work.
Managing Contract Retention
Retention is the hold back of a certain amount of money until the end of the project. This provides the contractor with an incentive to complete the project quickly because a large portion of its fee is the actual retention. It also provides you with a fund of money to finish the work if it doesn’t get completed. In addition, you don’t want to pay the contractor 100% for work completed because it may not have been done correctly and this will not be discovered until various inspections are completed.
Typical retention programs are:
- No retention
- A fixed percentage retention, normally 5% or 10%
- A sliding scale retention, normally 10% held until 50% complete and then no more retention held.
I would personally never agree to a no retention scenario. Again cash is king and I want to guarantee that I will have enough money to complete the project should anything happen to my contractor. Ideally you would want to hold 10% retention. Some contractors will balk at this amount. My fall back position is 10% until 50% complete. This allows me to withhold a significant amount of money up front. Then the effective retention gradually reduces and ends up a 5% retention at the end of the project.
If you are using a typical bank construction loan where the bank inspects the construction and then releases milestone payments, then the bank is essentially doing the top two steps. Don’t worry; they never let a contractor get ahead of them. With this real estate development, our financing was a letter of credit and we were responsible for managing our own money.
Managing Release of Liens
A construction lien or more commonly known as a mechanic’s lien is an interest in the property for a supplier or subcontractor who has supplied labor or materials to improve the property. In plain English, if a supplier or subcontractor doesn’t get paid, they can lien your property and force payment or the sale of the property to force payment. This can happen even if you paid the general contractor for the work!
Let’s say that you have paid a general contractor for installing the roof on your new building. He doesn’t pay the roofer for whatever reason. Maybe they have a dispute on another project. That roofer can lien your property and force payment again! How can he do that you ask? Well most lending agreements require you to immediately remove a lien or the loan can be called. In addition, it would be near impossible to sell or refinance the property with a lien in place. At the extreme, the roofer can force a sale of your building to satisfy payment.
One of the ways to prevent this is require a partial release of lien with each payment application and a final release of lien prior to final payment. The extra effort and paperwork is a burden, but take it from someone with a lot of experience - it is well worth the effort.
Managing your construction contractor and making sure you guard your cash is a very important skill. It will be impossible for you to be a successful real estate developer without gaining this expertise. The purpose of this blog is to show you how someone has actually done it. As I have said before, there is no shortcut to magically becoming successful. Never has been, never will.
