Vendor Service Contracts: What You Need To Know
A simple contract you will use over and over again
Welcome to another newsletter of Real Estate Investing Explained.
Today’s topic will mark the end of the series on Operating & Managing Real Estate. In this series we covered the foundation of operations including:
Next week we will be moving on to the series on Executing Your Business Plan where we will cover leasing, construction, and ways to add value.
But before we get there we need to cover service contracts. These are legal documents that are used to engage another company to do work at your property. It could be one-time or on a recurring basis.
Examples include landscaping, pest control, cleaning, HVAC service, and many other services.
If you own a home, you might be used to bringing in vendors and technicians to fix something. You are unlikely to sign a contract. You simply pay them when the work is done.
With real estate investment properties, particularly commercial, a better practice is to use a service contract to document the details in advance including:
Who is the owner.
Scope of work. How the work will be performed and to what quality.
Whether there is a warranty.
Costs and payment timing.
Duration, frequency and termination.
Insurance required.
Many other “legal” sections if prepared by a larger real estate company such as confidentiality, indemnities, dispute resolution, notices, limitations of liability, non-discrimination, OFAC compliance, and some others. Don’t worry about these sections for this discussion. You can understand them later if you develop a larger portfolio.
Yes, it is more cumbersome. But a little bit of paperwork up front will save you misunderstandings and problems in the future.
Today I will explain each of these and why they matter.
Let’s dig in.
Who is the Owner
Do you own the property as an individual or through a separate legal entity such as an LLC? There are pros and cons to each.
Individual:
Pros: easier to get a loan for a 1-4 unit residential property. Lower annual tax cost.
Cons: more risk of personal liability.
Legal Entity Such as a LLC:
Pros: additional layer of legal protection.
Cons: annual LLC tax and separate tax return.
Whatever you choose, you need to make sure the service contract lists the “Owner” correctly. If you own a property through an LLC (ex. 123 Main Street Owner, LLC), don’t list and sign the contract under your name individually. Sign it under the LLC. In this case, the LLC is the owner.
Scope of Work, How the Work Will Be Performed and To What Quality
This describes what the vendor is going to do. It might be monthly landscaping or repairing a broken HVAC unit.
A simple approach can be to ask the vendor for a proposal and then include the proposal as an exhibit to the service contract. The exhibit serves as the details of the scope of work. This way, everyone is clear and in agreement.
You could also consider adding language saying something like: “work shall be performed in a professional manner to industry standard quality”. It is not perfect, but it does set some basic expectations beyond what is written in the proposal.
Whether There is a Warranty
Not all work will include a warranty, but some should.
Anything new, such as an HVAC unit, should include a warranty. You want at least one year.
The contract is where you agree what the warranty will be, what it will cover, and how long it will last. The vendor may also give you a separate warranty document once the work is complete.
Costs and Payment Timing
A clearly documented scope of work and list of costs will reduce the chances of there being disputes after the work is complete. They go hand in hand.
If the scope is not clear, the vendor may hit you with “change orders”. Change orders are a fancy way of saying that the vendor is going to charge you more than the amount in the contract for various reasons including (i) increased scope of work or (ii) unforeseen or unanticipated conditions.
Unscrupulous people may even try to hit you with a change order because they feel they aren’t charging enough or this is part of their strategy (low bid to get the work then multiple change orders).
Avoid the risk of change orders by being clear on the scope, the costs, and the timing under which you, as owner, will pay them.
And don’t necessarily take the lowest bid if it is materially below the others. This can be an indicator of a vendor who doesn’t understand the scope.
Let’s move on.
Duration, Frequency, & Termination
This describes how long the agreement lasts and the frequency of the work. This varies depending on the type of work. Examples:
Landscape Maintenance: this could be a one year contract where the frequency of service is bi-weekly or weekly.
HVAC Repair: this could be a one-time service that needs to be done in 30 days, after which the contract is done.
For recurring services such as landscape maintenance, the practical approach is to have a one year contract that can be renewed at an agreed upon rate (example 3% increase) with 30 days notice.
There should also be language that either party can terminate with 30 days notice if one party is not following the agreed upon terms of the contract.
Let’s transition to insurance.
Insurance
We talked about insurance in Real Estate Insurance: The Transfer of Risk.
Any time someone is coming to work on your property, there is the risk that (a) they could hurt themselves or someone else or (b) they could damage your property.
You want to require each vendor to have some basic types of insurance such as worker’s compensation to protect their employees and commercial general liability to protect you and your property. There are many other types of insurance that could be requested, but these are the two major ones.
Now that we have covered the components of a service contract, let’s discuss where to find one and how to use it on a day to day basis.
[Note: I am not discussing the “legal” sections referenced in the introduction as giving legal advice is not part of my scope.]
How to Get a Service Agreement Template
Now that you understand the basics of what is in a service contract, what do you do with the information? How do you get a contract?
As discussed in The Property Manager: On the Front Line of Your Property, I believe there is real benefit to hiring a property manager.
A good property manager will have a standard service contract that they use. The great ones will be able to talk you through their form and explain it to you.
Don’t feel you need to reinvent the wheel. Review their template. If it looks good, use it or make the edits you need to make it work for you.
My Perspective
I believe in using service contracts, but I like them to be short and easy to understand.
I am also mindful that asking a vendor to sign a form they are not familiar with slows down the process. Sometimes the vendor will even have to talk with a lawyer to confirm they are ok with this. This can really slow down the process when you are trying to get work done.
I try to be reasonable.
If the vendor has their own form, I am willing to read it based on the information described above. If it is clear, then I am willing to sign it. Other times I might hand-write edits to the document to make something more clear or to make a small change.
I try not to get caught up in going back and forth on language in a document. I want to focus the majority of our efforts on getting work down at the property, not negotiating documents.
Some might say this is taking on more risk than I need to. Fair enough.
But remember that real estate investing is not risk-free. There are always things that could go wrong. If that scares you, real estate investing may not be for you.
Don’t be reckless.
Be practical and reasonable.
I try to do business with vendors (and people in general) I trust. If an issue comes up outside of the contract, we work it out as two reasonable people.