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.