Navigating Construction Contracts
Pricing structures, change orders, and mechanic liens
Last week we discussed the critical role of contractors. I also reiterated the process of adding value to your real estate investment by taking the time to:
Understand your goals.
Focus (aka think).
Talk with experts.
Get a budget.
Develop a game plan.
I wrote about the importance of talking with experts and budgeting.
This week is about navigating the process of executing a binding document with a contractor to do the work.
It builds on the contract fundamentals I discussed in Vendor Service Contracts: What You Need To Know. Today we will expand our scope from a service contract to the specifics of construction contracts.
With the exception of the initial purchase of your investment property, construction will be where you spend the most amount of money at a single point in time. Understanding the components that make up contracts and where the risks are is critical.
Today we will cover:
Contract fundamentals.
Specific components of construction contracts.
The four types of pricing structures.
Being clear on the scope of work & navigating change orders.
Understanding mechanic liens and retainers.
Best practices.
As always, we will walk through the jargon of commercial real estate to understand the fundamentals and empower you with knowledge.
Let’s dig in.
Contract Fundamentals
The newsletter on vendor service contracts is a useful reference for some of the core components that will go into a construction contract. These components include:
Owners - both property owner (i.e. you or your entity) and vendor / contractors.
Scope of work.
Whether there is a warranty.
Cost and payment timing.
Duration, frequency, and termination.
Insurance.
Construction contracts build off of these components.
Specific Components of Construction Contracts
All the components above will exist in a construction contract with some caveats:
Cost: there are four alternative types of pricing structures to define the cost.
Scope of Work: this is critical to define clearly and include in the contract.
Payment Timing: how payments are managed is more nuanced. This process includes risks and leverage.
Let’s break down these additional components in the following sections.
The Four Types of Pricing Structures
The construction industry has evolved to have four fundamental pricing structures that each have pros and cons. Different circumstances lend themselves to individual pricing structures. The pricing structures are:
Time and materials.
Lump sum (aka stipulated sum).
Cost plus.
Guaranteed maximum (aka GMAX).
Let’s break down each one.
Time and Materials
Best For: small jobs with a single contractor (no subcontractors).
Pricing structure: based on number of hours at an hourly rate plus the cost of materials.
Example: electrician at $120 per hour for 6 hours = $720 in time plus $480 in materials = $1,200.
Pros: minimal paperwork to get contractor started. Sometimes you don’t even use a contract. The contractor just bills you for the work. Fast and efficient.
Cons: pricing uncertainty until the job is done.
Lump Sum (aka Stipulated Sum)
Best For: jobs where the scope of work can be clearly defined in advance and the cost is more than $5,000 or so.
Pricing structure: fixed fee for a defined scope of work. The contractor has taken the time to understand the scope of work and given you a fixed fee to complete this work. Sometimes they give you a breakdown of the costs by line item including their general conditions and profit (see role of contractors). Other times they just give you a single amount with no backup. Either way, they are saying they will do the work for that price.
Example: general contractor will clean up the interior of the suite / unit including paint, carpet, lighting, plumbing fixtures, and electrical improvements for a fixed price.
Pros: clarity in the scope and costs.
Cons: takes more time as the contractor needs to bid the work. This takes even more time for you as the owner when you are getting and comparing bids from multiple contractors.
Cost Plus
Best For: custom remodels where price is less important OR the scope cannot be clearly defined up front.
Pricing structure: whatever the general contractor pays their subcontractors PLUS agreed upon general conditions and a percent profit.
Example: a unit renovation where the owner or their designer is actively involved in each step, figuring out the materials and scope of work in real time as the job is being completed.
Pros: owner sees the cost impact of each decision but does not unfairly put the price increase risk on the contractor. This would be unfair because the scope has not been clearly defined. The contractor can’t accurately bid the work without a clear scope.
Cons: price uncertainty until the job is complete.
Guaranteed Maximum (aka GMAX)
Best For: very large jobs.
Pricing structure: similar to lump sum with transparent subcontractor costs BUT costs are tracked on an ongoing basis. At the end of the job any cost savings against the original contract are shared between owner and contractor at a pre-agreed upon split.
Example: major renovation (or even new construction) where the pricing is in the millions.
Pros: owner has a cap on their costs with the ability to see some cost savings.
Cons: only appropriate for very large jobs. You are unlikely to use this as a new or smaller real estate investor.
As I said earlier, the characteristics of the work will lend themselves to a specific pricing structure. You will likely use time and materials or lump sum 90%+ of the time.
Many contractors have their own contract forms or use the AIA templates. This is fine. Just read the contract before you sign it to understand what you are agreeing to.
Regardless of which pricing and cost structure you choose to proceed with, you will still have the risk of change orders. This is where we will focus next.
Being Clear on the Scope of Work & Navigating Change Orders
What is a change order? Have you heard of one? Does it make you squirm?
A change order is your contractor asking for more money to complete the work than already agreed to in the contract. [Note: this is not applicable for a cost plus structure. A cost plus contract is set up so everything is a change order because you are figuring out the scope as you go.]
A change order is a 1-3+ page addendum to your construction contract that adjusts the scope and cost. It must be signed by both the owner and contractor.
Change orders occur when (a) the owner changes the scope of work or (b) the contractor finds an “unforeseen condition”. Let’s give an example of each.
Example 1: Owner Changes the Scope of Work
At the start of the job the scope has been defined, the contract has been signed, and the work has started. You (the owner) see the work as it is being installed and you are having second thoughts. Maybe you don’t like the paint color or the broker gives you new information on something at a competitive building that is being well received by tenants.
You decide you want to make a change.
The contractor may be able to make the change without disrupting the timeline, but they will charge you for it.
This is fair and appropriate. A change order will be created.
Now let’s discuss the second example.
Example 2: Contractor Finds an Unforeseen Condition
The contractor is proceeding with the work and comes upon something unexpected. Maybe the wood framing is rotted out when they remove the drywall or there is a sink hole discovered under the flooring.
The contractor would have had no way of knowing this without tearing up the unit in advance. These are legitimate change orders. These are risks you take on as a real estate investor.
That being said, not all contractor initiated change orders are that clear. Sometimes you will have contractors issue a change order for something they should have known in advance or because the work is taking longer than they thought.
These are not always legitimate and you should push back on them. Discuss them with the contractor and work together to come up with a fair solution.
The best defense against all change orders is to be clear on the scope of work. If you want the job to be on time and on budget, define the scope of work in advance and stick to it.
Let’s move on to paying your contractor. This is where you have some leverage if you have a disagreement.
Understanding Mechanic Liens and Retainers
Contractors need to get paid for the work they do. In order to protect themselves from owners not paying them, there is the lien process.
A lien is a document filed against your property with the county when there is a payment dispute. This tells anyone looking at the title documents of your property that you have a dispute, which will affect your ability to sell or finance your property.
Bad news.
Avoid this.
Here’s the sequence of steps.
Your contractor sends you a preliminary notice saying that they are performing work on your property for a specific dollar amount. Some larger material suppliers will even follow this same process.
You pay them for the work. Keep evidence of your payments. You could even consider asking for a lien release for larger jobs. Once complete, move on.
If you don’t pay them for the work, the contractor could decide to file a lien which will be recorded against your property.
As long as you pay the contractor, all will be fine. For larger jobs there is the risk that the contractor doesn’t pay one of their subcontractors and the subcontractor files a lien. This is unusual, but does happen. Just keep careful record of your payments.
The flip side of this process is that not paying your contractor can be an effective tool for the owner. Just be careful and reasonable with this.
Large jobs with multiple payments made over time have a built in mechanism for this: the retainer.
A retainer is an amount that is not paid to the contractor. Example: 10% of each bill. It really only comes into play when the job is long enough in duration that there are monthly payments. You are unlikely to see this much if at all, but the concept is useful to discuss.
As soon as you pay your contractor for 100% of the work, you lose any leverage you had.
Why is this relevant?
Let’s say the job is 95% complete. Everything is done except for the final light fixture installations. The contractor tells you the work is basically done and the light fixtures will be installed in 2 weeks when they arrive. They ask for full payment.
Don’t pay them yet.
Pay them an amount equal to the percent of work complete.
You want to hold back some money until the work is 100% complete so you can keep some leverage. Contractors are busy. Once you pay them 100%, their natural inclination is to focus on the next job.
But…a contractor’s profit is often tied to the last dollars of payment. Be fair, but don’t give up this leverage to make sure the job is completed in a timely manner.
Now it is time to wrap all of this up in some best practices.
Best Practices
Construction is risky, whether it is a renovation of an existing property or building a new one. It often involves multiple trades and work on parts of the building you can’t see until you open up walls, floors, or ceilings.
This is the risk of being a real estate investor.
Here are some best practices to reduce your risk.
Define scope clearly in advance of bid(s). The only thing more important than having a clearly defined scope of work included in the contract is picking a contractor you trust.
Pay attention to payments. Track the cost and invoices in excel. Check that the amount you are being asked to pay (a) ties to the amount in the contract and (b) reflects the scope of work that is complete. Visit the property to verify this or have the contractor send you pictures.
Having pictures and notes sent from the contractor to you each week is an excellent protocol, especially when you are not able to get out to the property regularly.
Be clear on start date and duration. You want this in the contract. I once agreed to the scope and cost of a roof repair in the summer, signed the contract in September, but the contractor didn’t start the work until November at the start of the rainy season. It was a nightmare! Put the target start date and duration in the contract.
Manage the punch list. A punch list is a list of items that need to be fixed once the work is substantially complete. It could include paint touch up, missing electric outlet covers, or other small items that the contractor needs to fix at the end of the job. Walk the job with the contractor when the job is complete to agree upon the punch list items. Don’t pay them 100% until the punch list is complete.
Warranty documentation. If there is a warranty, make sure you get the documentation of this warranty from the contractor.
Watch out for liens. Keep records of your payments and the invoices. Consider asking your contractor for a lien waiver for larger jobs.
Make sure you get the contractor’s proof of insurance.
Work with a contractor you trust. This is the most important thing you can do. Things happen. Work with someone you trust so you can fairly navigate issues as they come up.
As always, keep learning. Increase your knowledge. Ask good questions and treat others fairly.
You got this.
Understanding the Critical Role of Contractors
How to know enough to not feel like an imposter
Last week I shared the many ways you can add value to your real estate investment: asset class by asset class.
Today I will discuss the critical role contractors play in helping you understand costs, refine your business plan, and execute your value add initiatives.
Contractors are the key player in bridging the gap between what you think you might want to do and what you can afford to do.
Have a vision of an amazing new porch on your 6-unit apartment or a new facade on your industrial building? It is all just a concept until you have a realistic sense of costs.
Contractors give you these costs.
Today we will get into the details. You don’t even need to know what a “contractor” is. I will explain it all including:
General contractors vs contractors vs subcontractors.
The role of a general contractor and how they make money.
How to find a contractor and the key questions to ask them.
How to go from an idea to a price estimate to a real bid.
Signing a contract and navigating change orders.
Best practices.
By the end of this newsletter you will know enough to work with a contractor without feeling like an imposter.
Let’s dig in.
General Contractors vs. Contractors vs. Subcontractors
These terms are used casually and often incorrectly. Let’s get them straight.
General Contractor (GC)
A general contractor is in the business of managing construction work across multiple disciplines. Disciplines refer to things like painting, asphalt, electrical, plumbing, etc.
The key word is “general”. They are generalists as opposed to specialists.
They typically don’t have a huge team that does all of the work across disciplines. It is more likely that they subcontract out some or all of the work to others.
Subcontractors
A subcontractor is someone who specializes in a specific discipline such as painting, electrical, or asphalt.
Sometimes they are hired by a general contractor. Sometimes they are hired directly by an owner.
They are specialists in one or more discipline. They are the ones who will actually do the work.
Contractors
The word “contractor” is used as a general term to refer to someone an owner is hiring to do construction work. For example: “We need to find a contractor who will help us with our value add plan.”
It could either refer to a general contractor or a subcontractor.
If you (as owner) hire a “subcontractor” to paint your building, you would likely refer to them as a contractor. They only really become a subcontractor when hired by a general contractor.
Now let’s discuss how a general contractor makes money.
The Role of a General Contractor and How They Make Money
Let’s use an extreme, but not that unusual example, to explain how a general contractor (aka GC) makes money. In this case the GC doesn’t do any of the work. They have a very small team and hire subcontractors to do all of the construction work.
They will typically add one or two line items to the cost reflecting money that is going to them as opposed to the subcontractors.
General Conditions or Overhead and Supervision: this reflects some allocation of their team that will oversee the work on a day-to-day basis.
Profit or Fee: this is the profit they will make on the job.
Combined these two line items will reflect a 15% to 20% increase over what the GC is paying the subcontractors. Example: if you have a $30,000 job, expect to pay an additional $4,500 to $6,000 if you hire a GC. [Pro tip: if you have a much bigger job - example $500,000 - you will likely be able to negotiate a lower percentage.]
So what to you get for this additional cost? Two key things:
Subcontractor Relationships: GCs work with lots of subcontractors. They know the good ones and the bad ones. They can put pressure on one when needed as they may be giving them work in the future. As an owner with one property, you don’t have the same leverage.
Project Management: the GC will manage the day-to-day project. This includes obtaining and evaluating bids, creating subcontracts, and managing the work. The painter doesn’t show up? The GC will deal with it. Timing and coordination issues? The GC will deal with it.
Many owners think the GC earns their fee. Others want to manage the subcontractors themselves.
My perspective: when there are multiple disciplines (aka trades) required such a painting, asphalt, electrical, drywall, and plumbing, I prefer the GC route. When it is only one discipline (ex. painting), I am more likely to go direct to a painter.
Your property, your choice.
Whichever route you take, there are some key questions to ask a potential contractor.
How To Find a Contractor and The Key Questions To Ask Them
Let’s say you have your first property and some value add ideas as discussed in last week’s newsletter: The Many Ways You Can Add Value to Your Real Estate Investment.
Ask your broker and/or property manager which contractors they have worked with and who they would recommend. Then pick one or two to talk with to ask them the following key questions.
How long have you been in business? You want at least five years. Longer is generally better as it shows they run a fair and profitable business.
Are you licensed and insured? It is risky working with a contractor who is not. You could also consider asking for references to speak with.
Is this type of work typical for you? “This type of work” refers to your specific scope of work for your property. You want a contractor who is comfortable with both the scope and size (aka cost) of your job. Don't work with a contractor who only does $500,000+ jobs if you have a $30,000 job.
Do you have in-house design capabilities? Maybe you want to do an exterior renovation that includes painting, wood, and metal work. Many contractors have in-house design teams that can come up with a plan so you don’t have to hire a separate architect or designer.
What components of my scope will require a permit and what is the permitting process? Not all work (ex. painting) requires a permit. Some permitting is fast. Some is slow. Some triggers other upgrades. You want to understand this.
How soon could you get started and what would be your estimated timeline for the work? You don’t want to spend a bunch of time with a group only to learn that they can’t get started for 6 months.
What is your level of interest in working together? You want someone who wants to work with you.
You can see by this list that there is more to selecting a contractor than only costs.
But costs are important so let’s transition to pricing.
How To Go From an Idea To a Price Estimate To a Real Bid
As I described in the last newsletter, there are multiple steps in going from ideas to pricing, most notably understanding what you can afford. The steps are:
Understand your goals.
Focus (aka think).
Talk with experts.
Budgeting. This is where we will focus now.
Develop a game plan.
There are two main stages of budgeting and understanding how much something will cost.
Stage 1: Price Estimate or Rough Order of Magnitude (aka ROM)
This is when you are in the early stage. You need some general sense of how much it will cost to paint vs. redo the parking vs. renovate a kitchen.
A contractor will help you do this, but they will be spec’ing their time to do so without a guarantee of getting the work.
Be mindful of this dynamic and don’t abuse it. Only work with one contractor at this stage.
Stage 2: Contract Pricing
Once you have defined your scope, then you move to getting real bids that you could go to contract on with a contractor.
Some like to get final pricing only from the same contractor that gave you the ROM pricing. Others like to get multiple bids.
Getting multiple bids is more work and guarantees you will have to tell 1-2 contractors they are not getting the work even though they put time and energy into the process.
But there is nothing like getting multiple bids. You always learn something and may find you get better pricing.
You don’t always have to pick the lowest price, but you do get a comfort level that you are not overpaying.
Signing a Contract & Navigating Change Orders
Once you have pricing you are comfortable with, you will move to signing a contract. There are multiple types of contract and ways contractors like to do them.
We will go through all the details of this next week.
Best Practices
So how do you make sense of all this?
Here are what I believe are the best practices.
Interview the contractor. Don’t skip this part. You will learn a lot in the process.
Value their time. Don’t view getting a bid as “free”. It may not cost you anything at the time, but you don’t have unlimited “credit” to exercise contractors for bids forever without at some point paying them to do some work (i.e. giving them a job).
GCs are a good fit when you have multiple disciplines. If only one, consider going directly to a subcontractor.
Don’t pick the cheapest option automatically. There is a saying in the contracting business: Cheap, Quality, Fast. You can only pick two. You may find the cheapest, but you may pay the price with low quality. Look at the total package.
The best contractors are found with experience and repeat business. If you are new, ask others for referrals. If you have a good experience with a contractor, keep using them. Build a win-win relationship over time.
It can be hard navigating your first job, but like anything you will get better with practice and repetition.
Good luck!
The Many Ways You Can Add Value to Your Real Estate Investment
Options for industrial, retail, office, multifamily, and 1-4 unit residential
Last week we kicked off the series on executing your business plan and I discussed the general ways you can add value to your investment: cosmetic and functional improvements that lead to better leasing (and revenue) performance.
Today we are going to get into specifics by asset class.
As discussed in Asset Classes Explained, there are five main asset classes:
Industrial
Office
Retail
Multifamily aka Apartments
1-4 Unit Residential
There are different ways to add value to each of them. The themes are similar, but the details are different.
In today’s discussion, we will focus on improving the physical building(s) in both cosmetic and functional ways. We will go asset class by asset class.
By the end of this reading you will have a clear menu of options to choose from for yourinvestment. You won’t be an expert, but you will know enough to be dangerous.
Let’s dig in.
Industrial
Industrial is the most straightforward asset class. It is basically a warehouse building made out of concrete with a small amount of office inside. Industrial is used for manufacturing, storing, and/or distributing product. Anything you buy online goes through an industrial building, typically referred to as a warehouse.
So if it is a simple concrete box, there is nothing to do right?
Wrong!
There are plenty of ways to add value:
Paint & Asphalt: It is hard to find a better bang for your buck to change the look and feel of a warehouse than painting the building and doing a new slurry coating (aka painting) the asphalt. It does nothing functionally, but it drastically improves the first impression of tenants.
Signage: Adding signs above each suite can give a better sense of identity. You could also add a monument sign on the street with slots for tenants’ names.
Facade Enhancements: There are ways to make a building look more modern and create better suite identity by adding additional material elements to the exterior. For example: wood panels or metal awnings in sections of the building.
Adding Parking or Re-striping Existing Parking: Industrial users often need space to store their trailers and other materials or for more parking for their employees. Sometimes you can expand or reconfigure your existing site to meet these needs.
Warehouse Improvements: Industrial tenants want functionality. Your space will lease faster and at higher rents with increased functionality. Talk with local leasing brokers to understand the local tenant needs. Then consider improvements to lighting, smoothing the concrete floor, air circulation, power, and truck doors.
Office Improvements: Although the office portion of a warehouse building may be a small percentage of the total square footage, it is important to make it clean and functional. Nothing fancy, but nothing too beat up. Your local leasing broker will guide you.
Let’s move on to retail.
Retail
Retail is much more complicated than industrial. It generally includes multiple buildings laid out across a site with ample parking. Example: a neighborhood shopping center anchored by a grocery store with 20 additional small suites such as restaurants, hair salons, workout studios, and various other stores. Customers are coming and going throughout the day, so traffic (and pedestrian) flow is very important.
With all these moving parts, there are many ways to add value.
Paint & Asphalt: Same concept as industrial.
Signage: Same concept as industrial, but WAY more important for retail. There should be a universal signage program that works for all tenants. It should look like a cohesive center. This often includes a large monument sign (10’+ tall) on the main road with major tenants listed.
Facade Enhancements: Retail buildings often incorporate lots of interesting architectural elements using different materials and elevations. See figure 1 below for an example.
Adding Parking or Re-striping Existing Parking: Same concept as industrial, but even more important. Few things deter retail customers from coming to your center more than not being able to find parking. Get the most parking you can.
Suite Improvements: Most retail tenants want their suite to be a clean, functional box to work with. Retail suites tend to be fairly consistent in size and shape, so national tenants are used to working with these sizes. They will then customize their improvements inside that consistent shape. Go into a few Subway sandwich shops or postal annex stores and you will see what I mean.
Amenities: Retail is about place making. The longer customers stay at your center, the more likely they are to buy from your tenants, and the more rent you can charge. The best retail operators figure out ways to make their centers inviting by adding things like outside seating, fountains, water features, fire pits, and other attractive amenities. They create places people want to hang out in.
Figure 1: Example of a Retail Facade
Let’s move on to office.
Office
When I refer to office, I am referring to buildings where people generally work on computers. I spent 20+ years of my career working inside office buildings. They can be a single building or an office park.
Here are some ways to add value.
Paint & Asphalt: Same concept as industrial, but not always an option. Many times an office building is made of a stone material and the parking is in a concrete structure. In these cases, there is little to be done.
Signage: Monument and building signage can be very valuable to tenants. Sometimes you can charge extra for these.
Adding Parking or Re-striping Existing Parking: Parking can be very important for office tenants. Sometimes you can even charge more for covered parking (in a structure or under a carport).
Suite Improvements: Office suites, particularly larger ones, are usually customized to the individual tenant needs. It is expensive and wasteful. Imagine if you remodeled an apartment every time a new tenant moved in. Welcome to the wonderful world of office! If you have a vacant suite, work with your leasing broker on a plan to create a clean, functional layout that will work for most tenants.
Amenities: Same concept as retail. Office tenants need to attract employees. Good amenities are appreciated by employees. They include workout facilities, coffee shops, attractive seating for lunch, and anything else that feels inviting.
Let’s move on to multifamily.
Multifamily
Reminder that multifamily is a fancy way of referring to apartment buildings. This could be a single 12 unit apartment building or a 10+ building community with 200+ units or a downtown tower with 300+ units. The higher the number of units, the more likely there are interesting opportunities to add value.
Paint & Asphalt: Same concept as industrial, but apartment buildings are often made out of wood. Sometimes the wood siding needs to be replaced.
Facade Enhancements: Same concept as retail. The more interesting and inviting you can make your apartment community look, the more likely you are to attract tenants.
Adding Parking or Re-striping Existing Parking: Same concept as office, including the potential to charge for covered parking.
Unit Improvements: Here’s where things get different than the other asset classes. Apartment tenants don’t have the ability to customize their space. They “get what they get”. The best multifamily operators do two things to their units that give them pricing power and reduce maintenance costs: (a) they put in the amenities that tenants want the most such as in unit washer & dryers, newer appliances, new cabinet doors, and new countertops and (b) they put durable materials in place that last longer such as luxury vinyl plank (LVP) flooring. These improvements command more rent, lease faster, and cost less to maintain when a tenant moves out.
Amenities: Just like retail and office, multifamily is often about place making. This is where people literally call home. The best operators add amenities residents want most such as secure dog parks, workout facilities, nice pools with seating, BBQ areas, and business centers.
Now let’s see how 1-4 unit residential compares to multifamily
1-4 Unit Residential
Let’s remind ourselves why this is a separate asset class. It is driven by the way it can be financed. Lender’s will consider giving you a loan for your property based on your personal credit. For all the other asset classes, they evaluate and underwrite the propertyperformance. This personal credit evaluation can mean it is an easier entry point for investors.
All the same concepts of multifamily value add apply to 1-4 unit residential, but the smaller size will likely limit the number of amenities you can add.
Now that we have covered all the asset classes, let’s touch upon some additional items that apply to all asset classes.
All Asset Classes
Sometimes you will be faced with the decision of whether to repair or replace a building system. Repairing will be significantly cheaper but replacing will last longer. If a building system is too old or has been left without proper maintenance, replacement may be your only option. This can be true with parking lot asphalt, wood siding, and HVAC units.
There are also two potential value add options that are applicable across all asset classes.
Convert the Use: Your property may be worth more if you convert the allowable use to a different asset class. Example: industrial to multifamily. It is not fast or easy, but can add a ton of value. You could then sell the land/building or redevelop it yourself.
Parcelization: This is the process of dividing an existing piece of land (aka lot or parcel) into two or more legal lots so they can be sold individually. You may have a property with a lot of excess land. Divide it into a separate parcel to sell or redevelop it.
How to Bring it All Together
We have covered a lot. Asset class by asset class. Many ways to add value.
So how do you make sense of it all?
Here’s the formula:
Understand Your Goals + Focus + Talk with Experts + Budgeting + Develop a Game Plan = Setting the Property Up for Success
Understand Your Goals: start here. Re-read Stop Chasing Every Deal: Why Successful Investors Pick a Niche. If you don’t know your goals, you will be lost at how to address each decision.
Focus (aka Think!): now is the time to focus on the list of options within your asset class. Which are most appealing to you? Drive the neighborhood your property is in and look at what your competitors are doing. Take pictures and keep notes.
Talk with Experts: this is the most important step where theory meets reality. Share your ideas and brainstorm with the local team (brokers and/or property managers) that will lease your building. They are the market and leasing experts. Ask them what they think of your property. Ask them to rank the list of options I gave you in order of priority and impact. Ask them what else they recommend doing. Check back on You Don’t Have to Do Everything Yourself: Building Your Real Estate Team to understand how to build the right team around you.
Budgeting: once you have narrowed and ranked your list of initiatives, it is time to start getting a rough sense of cost. You need a budget to work with. This is where contractors come in, which is next week’s topic.
Develop a Game Plan: Finally, look at all the information together and come up with a game plan. Don’t hesitate to circle back with the leasing team to re-visit the list now that you have a better sense of costs.
You may need to stagger your plan over multiple years due to construction lead times, seasonality, budget constraints, or timing of your leases.
Be patient and realistic.
As with many things in life, it can feel overwhelming. By breaking it down into manageable parts, you can make progress.
You can do this!
Step by step.
One piece at a time.
Stay calm and carry on.
New Series Kickoff: Executing Your Business Plan
From business plan creation through completion
We are making great progress in our journey of understanding how to personally invest in real estate. We have covered four main subject areas so far:
Introduction to Real Estate Investing
Investment Fundamentals
The Acquisition Process
Owning and Managing Real Estate
See the end of this newsletter for the link to all 20+ newsletters so far.
Today we are kicking off a new series: Executing Your Business Plan.
Whereas owning and managing real estate anchors you in the tasks with which every investor will be faced, executing your business plan leads you down a proactive approach to adding value to your investment and making you more money!
This is one of my favorite aspects of owning investment properties. The ability to take action to improve performance and make you more money.
Some like to say that most of the money is made in the buy (aka the acquisition).
I agree to a certain extent.
You can never change your original cost basis or location. These two factors play a huge role in how the property will perform.
But…they are not everything.
Your ability to identify and execute a business plan will play a material role in how well your property will perform over the months and years of your ownership.
In this series we will cover:
Ways to add value to your property.
How to create a property business plan.
Construction.
Leasing.
Investor and lender constraints and opportunities.
Today we will start with an overview of ways to add value to your property.
Let’s dig in.
Definition: Adding Value
The terms “adding value” and “value add” are thrown around a lot in real estate investing. They are very similar terms that mean different things.
Adding value is the act of doing something to increase the value of your property. Usually you have to spend some money to create the value, but this is not always the case. Let’s list some examples of adding value:
Cosmetic improvements
Exterior: this could be as simple as painting your property or cleaning up the landscaping. Anything that makes the property look better.
Interior: same concept for the inside of the property. Think paint and carpet.
Functional improvements:
Interior: we are staying inside the building, but we are improving the way the tenant can functionally use the property. Examples could include: improved lighting, an additional room, or new HVAC.
Exterior: same concept on the outside. Examples could include: expanded driveway or a new tenant signage program.
Leasing: sometimes the biggest value creation will be through leasing. This could be through renewing and/or restructuring the leases with existing and/or leasing to new tenants. As we discussed in Cap Rates: The Simple Math of Real Estate Investing, much of real estate value is determined by the NOI. The biggest driver to NOI is usually the rent the tenants are paying.
Improving the interior and/or exterior of a property usually go hand in hand with increasing the rents and driving up the property value.
These are examples of “adding value”. Let’s compare this to “value add”.
Definition: Value Add
Value add is most commonly used as an investment category signifying the amount of risk associated with a real estate investment. We discussed this in The Risk-Return Spectrum: Choosing Your Real Estate Investment Strategy. A quick summary:
Low Risk/Low Return ←――――――――――――→ High Risk/High Return
Core/Turnkey → Light Rehab → Value Add → Development
Core/Turnkey: low risk, low return. You buy a property that is well leased and maintained. There is minimal work to do.
Light Rehab: medium risk, medium return. There is some work to do, but it is mainly cosmetic (paint, carpet, clean up). If you do the work, you can increase the rent and value of the property.
Value Add: high risk, high return. There is a lot of work to do. The property might even be vacant. You will be repositioning it and taking on a lot of risk for superior returns. You will either find a tenant once the work is complete or sell it (fix and flip).
Development: highest risk, highest return. You build something from scratch.
So when someone says this is a “value add” deal, they are usually referring to the risk involved.
Comparison: Adding Value vs Value Add
Even in the lowest risk deals, there are often ways to add value.
However, not all deals with the ability to add value are considered “value add” relative to risk/return.
Again, similar terms with different meaning. Here are examples of how each might be used:
Value Add: “We have a big appetite for risk at our company. We focus exclusively on value add industrial deals.”
Adding Value: “The deal has a ton of upside because there are so many ways to add value in the first few years.”
We will focus on adding value in this series.
A Menu of Options: Choose Your Own Adventure
Those of you born in the 1970s or 1980s may remember a book series called “Choose Your Own Adventure”. In it, the reader started in chapter 1 and was faced with a choice at the end of the chapter. Choose one option, go to page 22. Choose a different option, go to page 45. This continued throughout the book.
Creating and executing your property business plan requires a similar approach.
You start by assessing the opportunity and options available to you. From there, you start executing the plan and adjust as you go.
You have to adjust because (i) you continue to learn more about the property and the impacts of your plan as you go and (ii) the world and circumstances are always changing.
A Variety of Approaches
I introduced the analogy of three types of cars to give examples of types of real estate in Daily Issues You Will Face While Owning Real Estate. They were:
A top of the line Mercedes
A reliable but basic Honda
A car that constantly breaks down
Understanding the type of property you have at acquisition and the type of property you want it to become will guide your business plan.
For example, you may buy a property that is beat up (#3) but have a plan to turn it into a clean, functional property (#2) by executing your business plan.
Or you buy a property similar to a Honda (#2) but plan to not put a dime into it during your hold period knowing that it may get beat up over time (trending towards #3) but you will be able to maximize the near term cash flow.
Your money. Your property. Your choice.
What’s Next
Next week I will expand on the menu of options by sharing specific details of the ways to add value to each of our five main asset classes: 1-4 unit residential, multifamily, industrial, retail, and office.
This will give you a comprehensive “menu” of what can be done to add value.
You will then be able to combine this menu with the characteristics of your specific property and goals to come up with your own business plan.
Get ready to get your creative juices flowing.
This is the fun part!