In any business you have honest people, and you have crooks. The real estate business has its fair share of crooks. You must learn how to protect yourself. In every sector of the real estate business you have people plotting to beat you out of your money. At times this may include the mortgage broker, the real estate attorney, the home inspector and, of course, the contractor!
When I use the word “contractor” I'm referring to general contractors, sub-contractors or any other person you hire to do work on your rehab project. This article will help you spend your money with contractors so you always maintain your leverage. I had to learn this important point the hard way.
One of the schemes to be on the look out for with contractors is the “deposit scheme”. Many contractors require a deposit before they will start working on your project. I am now very hesitant about giving a deposit to a contractor unless he has proven himself to be honest. The deposit request varies; some ask for 10% down, others ask for half of the total contract.
Half of the contract amount can turn into a sizable sum of money; particularly before they get started and for someone you barely know. If you give in, you expose yourself to a lot of financial risk and take some of the contractor's incentive away for getting a fast start. If the contractor runs away with your money you've probably blown a significant portion of your profit margin. If you feel uncomfortable (as do I) paying such a high deposit to a contractor here are some things you can do.
Negotiate: Explain to the contractor that you feel uncomfortable given him such a hefty down payment. Ask if he is willing to reduce the deposit.
References: Ask him to produce references/phone numbers for some of his customers. If he can not, don't use him. If he can provide you with references I suggest you call the people and ask them about the contractor's honesty, timeliness, quality, responsiveness, etc. Given the opportunity, I also suggest you go by their house to find out what kind of work he does.
Pay By Progression: This is the best way to protect yourself from being beat out of your money. Tell the contractor that you are only willing to pay after you have inspected the work and determined it is of the quality you expect. If the contractor's issue is covering his upfront out-of-pocket expenses (permits, drawings, etc) pay him when he produces receipts. If he has no “working capital” (credit or cash) to cover these expenses for a few days, his cash management is poor and other aspects of his operation may be poor. Once he agrees to accept the pay by progression method you need to set up logical inspection and payment intervals. It may work to both parties advantage to do it more frequently in the beginning in order to establish communication and reasonable expectations. For example, the terms may specify that he work for 3 full days, after the 3rd day you will inspect the property and cut him a check based on the amount of work he has performed.
Most importantly you always want to be in a position of leverage. (Leverage, according to the American Heritage Dictionary: having the positional advantage.) Having the positional advantage is exactly where you want to be when dealing with contractors. How else do you accomplish this? Retainage, and here is how it works. When you retain a contractor to do a complete renovation job you will agree to pay him at different stages. For instance when the framing is completed you will forward him a draw. When the drywall is completed you will forward him another draw, and so on. Each project will require a series of draws. For example, you may agree to forward him $2,000 after the framing is completed and inspected.
Here's another way retainage plays its part. To remain in a position of leverage you may want to include in the contract, a Retainage Clause. This clause will state that you hold back 10% from each draw. (If the framing draw is for $2,000, this means you will hold back $200). Plan to withhold a retainage from every draw, before you know it you will have a sizable amount of money owed to the contractor. The more money you have retained from the contractor over the life of the job the more leverage you will have.
Importantly, under no circumstances is this money released to the contractor until the job is complete. If he quits, is fired, or cannot finish the job this money is yours to keep. Warning: do not use this leverage unfairly or your poor reputation will begin to cost you money. This technique should only be used to protect your investment.
Another variation on retainage is a simple technique of making it a habit of paying less than the work performed until the job is completed to your satisfaction. Let's say the contractor is charging you $1,000 to tile your kitchen floor. It's Friday and he requests a draw to pay his workers. The kitchen is only 50% completed. Under this situation you should only pay him $400. This means you are $100.00 in debt to him. It's better this way than having him owe you money or work. If he abandons the job you are slightly ahead. Under this situation he has a sense of urgency to finish the job and is less likely to abandon it because you have some leverage.