The Perfect Real Estate Rehab – Tips for Investors

You Can Do The “Perfect Real Estate Rehab”!

 

Single story bungalow home

In this post we will examine what has to happen to achieve The Perfect Real Estate Rehab.

If “street wisdom” and cable television are to be believed real estate investors find real estate rehab, or "fix and flip", especially with distressed housing, is an easy way to create wealth.

It’s not easy, but there are reliable protocols and tools that you can use as a blueprint to make it happen for you.

Whether you come to the table as an investor or rehabber, the challenges are much the same. There are construction techniques and sequences to understand. Investors will benefit from knowing the construction-related issues and methods too often simply left to rehabbers or contractors to work out.

There are overall project management issues to orchestrate to bring the project to the desired profitable outcome. We will take a look at these protocols and tools in this post.

The formula is supposed to be easy: Find a distressed–likely foreclosed–house or 2-flat, hire a contractor, get the work done fast and at a great price, call a broker, get the house sold. Then enjoy your Big Payday!

First of all, we must recognize that investors are not always rehabbers. The reader of this post may or may not have any particular background in the construction industry, in the trade skills. These construction-related issues often confront new investors when purchasing a piece of property with the intention to restore its value and fix what’s “broke” (as we sometimes like to say).

Investors may hire contractors (and spend more)

Construction contractor holding cash moneyInvestors may choose to hire others to do this real estate rehab work. These “others”  include general contractors, perhaps individual tradesmen, and in the end they will often rely on rental or sales agents as well, to advance their program.

As “arms length” investors they will have lower profit margins, less than those enjoyed by investors who personally supervise the rehab of their properties.

To engage and rely primarily on contractors is a business decision to let others share in any project's potential profit margins.

Importantly, in the overall project budget, if you compare the “arms length” investor’s cost to fix with the out-of-pocket costs of the investor/rehabber, there will be a significant difference. The investor has chosen to let others share in the profit margins that might be available to him if he were more actively involved.

By and large, reputable contractors will increase the underlying net rehab costs on the order of thirty to fifty percent. If the net cost of rehabbing and fixing the house is estimated at $27,000, then to enlist the services of a qualified general contractor (G.C.), who in turn hires various tradesmen or has his own team to complete the work, that G.C. will very likely legitimately charge somewhere around $35,000 to $40,000 for that same work (or about 150% of the net cost).

Or you could buy better properties...

If the investor is uncomfortable working with general contractors, or perhaps feels unprepared to do so, then an alternative is to simply concentrate on buying superior properties.

In the Chicago metropolitan area, we encounter many REOs ("real estate owned" properties). Such prospective real estate rehab opportunities sometimes have recently been rehabbed. The prior owner, perhaps an investor, as it happened did not manage the property well or borrowed too much and lost the property through foreclosure. Yet the work in fact is substantially completed.

Rendering of bungalow-style frame home with attached garageOr the property may be a home which was foreclosed upon, where the standard of maintenance was quite reasonable. In such cases the necessary work to bring it to a rental standard might be as little as cleaning up the property exterior, interior repainting, replacing worn carpeting, etc. Essentially touching up and brightening the property.

It will then likely cost more to buy that superior property because the competition will be more keen among similarly motivated investors (hoping to do the least possible work).

And there will be the occasional home buyer who sees that property as an unusual opportunity and understands that the work required may be within his own ability as a so-called “fixer-upper”. All concerned understand the work is so limited that it can be undertaken with very little risk.

Experienced investors will get involved directly

Investor/rehabbers assume a more active role. They tend to personally select the tradesmen involved and detail very closely the work to be done.

There are many benefits to this approach. They gain added control over the process as a whole. They do not necessarily become general contractors, but rather act in a project manager capacity. And they will benefit from having done that.

Investors directly involved in their projects will benefit from enhanced earnings and also, very likely, greater profitability. Such active investors basically get two bangs for their buck: They are being compensated for their actual time and effort, visiting the job, interviewing and screening contractors and handling payouts themselves. And, of course, they also enjoy the entrepreneurial gain that the investor fully expects in a more arm’s-length real estate rehab situation as discussed just above.

Project management tools

Construction contract imageIn order to accomplish these benefits from direct involvement, the investor/rehabber will have learned construction documentation protocols. These protocols are necessary for three reasons:

  • Most important is to prove up their estimates;
  • Secondly, controlling payouts to contractors inherently minimizes risk; and
  • Third, most lenders require understanding and use of these "industry standard" protocols as a condition of loaning the money.

Importantly, these protocols are generally standardized across the country.

The greatest benefit gained from this active role, doing the homework and personally managing the project, is essentially a control issue. Control I believe is most important in this scenario. The main challenge in achieving control is to become knowledgeable in the aspects discussed here.

The primary benefit derived from becoming knowledgeable is that you are not letting your contractors dictate the “scope of work”. And it is that scope of work–the written specification of the work to be done–that in the end should determine the final cost of the real estate rehab.

Project Management and Timing

When it comes to project management, it’s really a matter of not only comprehending the deal, but also managing the timing of the entire process, from initial purchase through completion of all work to be done and final sale or rent-up.

For the active investor/rehabber, it’s important to have a Project Management Plan. This is the sequence, which is generally a perfectly logical sequence, of what trades are on the job first, followed by what other trades, right through to the point of completion.

Your management plan is primarily a schedule. In most cases, the plan calls for starting with demolition and cleanup, which might entail removing wall surfaces in rooms where a great deal of plumbing or electrical work is going to be done, or removing damaged wall surfaces or water-damaged ceilings. Debris and refuse go into on site dumpsters so that, upon completing the initial demolition and cleanup, all the new work to be done is visible and accessible.



VIDEO: How to segment the work in planning your workflow. (From P. Elmes "Project Management for Real Estate Investors)

We like to use the term “broom clean”. Your objective is, at the end of each day, that the building’s interior and exterior are in a clean and safe condition, ready for the trades to move in and do their assigned work.

2 kinds or phases of work to be done

In most trade categories (but not all) there are really two levels of work. One is so-called “rough,” or preliminary work. For a plumber, that’s running the new piping as necessary; we talked earlier about replacing galvanized pipe with copper or, in some locales, perhaps plastic piping.

This doesn’t mean necessarily that the water is running and that sinks and toilets are in place, because that will be the second phase. In most cases the second or "trim" phase is done some days or weeks later, when toilets, sinks and disposals, and nice chrome trim and faucets are installed.

Interior construction site after demolitionThe same holds true for carpentry. If there are any partitions to be created or moved, porches to be rebuilt or made safe, that typically is the work of the “rough” or framing carpenter.

Later on, at the end of the project, when it comes to hanging new interior doors or installing kitchen cabinets, that is a finer level, a more skilled level of work. Typically this is referred to as “trim” or “finish” carpentry.

In the case of electrical work, running new circuits or perhaps even rewiring the house, depending on local code requirements, is often very destructive. Running new electrical distribution throughout the house in the Chicago area requires running wiring in aluminum piping or “conduit”. This is inherently destructive work.

Conduit runs in the walls, behind the wall surfaces, and must be done at the earliest possible time (together with the plumbing). In this way, when all the wiring and plumbing are in place, it is then appropriate to close up the walls, to hang the drywall or repair the plaster.

Finishing the rehab phase of your project

With these tasks done, you are approaching the final completion of the real estate rehab project. As you review these various activities, you can see that they are logical; they are sequential. The rough work will always come before the trim.

Floor refinishing or carpeting will follow painting and decorating lest the painter’s carelessness spoils the floors. (You’d be astounded at how often these sequences are compromised due to indifferent coordination of the trades involved in a poorly run real estate rehab.)

It is that kind of inept or inattentive timing that, left to an unrelated or incompetent contractor or project manager, may drag out the completion of your project.

To run the job yourself, scheduling each of your trades to come in at a specific time, gives you the control to determine just how long that project is going to take to complete.

Hour glassRemember: Only YOU care that the job gets done

Regardless of who tells you what they think, a typical real estate rehab should probably take no more than three to five weeks to complete. Elsewhere I make the case for completing a typical single family rehab in 21 days or less.

Do not be surprised if you ask a tradesman or a general contractor for their “time to complete”, that they give you an estimate that is much longer.

In this real estate “rehab industry” you’ll find that there is a strong inclination among contractors to “drag out the job”. Quite frankly, this gives unscrupulous or inept contractors opportunity to manipulate budgets and increase costs.

The investor/rehabber is the only actor in this process who cares about timely completion and staying within a reasonable budget. These important objectives are best served by the owner running his/her own job.

Why you should consider being your own Project Manager

The role of project manager is easily satisfied by "letting" (entering into) major contracts, such as the roof, siding, windows, heating and ventilating, and plumbing, yourself. For example, with very little investigation and preparation, one does not need a general contractor to identify and hire a roofing contractor.

Such major (readily defined) trade categories can be handled as individual contracts, directly administered by the project manager or the owner. The benefit here is that it puts the you the owner, the investor, in control of the schedule.

There are other benefits to the owner as well. Leading the list is:  directly employing multiple contractors limits the investor’s exposure to job shutdowns. To have a falling-out over price or quality with a roofing contractor should be by definition an isolated problem within your project: the project goes forward while that problem is worked out.

To have the same problem or serious disagreement occur with a general contractor can result in virtually all the work stopping on the project until such time as the issues are resolved. Obviously the dynamics of that occurrence put a great deal of control in the hands of the contractor rather than the investor.

A skilled contractor can make it very difficult for you to simply fire him, send him off the job and hire somebody else.

Changing contractors will increase costs

In my experience any replacement tradesman in any category, certainly including the general contractor, will substantially increase costs of the typical real estate rehab over and above the original budget.

There is a tendency on the part of a new contractor to denigrate (criticize)  the quality of his predecessor’s work and insist that, if you want the job “done right,” all of the first contractor’s work will have to be redone. And that’s part of the deal, it is asserted, or the replacement contractor simply has no interest in “cleaning up somebody else’s mess”.

Regardless of whether the contractor’s criticisms are true, the consequence for the investor is the same: it’s going to cost more. I’ve never had a contractor come in and say, for the balance of the contract (the remainder of what was not paid the first guy) that they would happily finish the project. It always costs more.

Handling your own payments enhances your control

Another benefit of assuming the role of project manager is that payments to contractors (“payouts”) will be much easier to control.

Your goal as an investor or a project manager, and certainly the objective of the bank, is to pay for the work as it is completed.

This is accomplished by having very clearly defined thresholds or benchmarks of completion.

To diversify or intentionally separate the trades working your job brings the obvious benefit of not putting virtually all the activities within the hands of a single contractor, regardless of their representations that they can “do it all.”

Once again, letting one overall contract is essentially a trap.

The client, the customer–in this case you, the investor–loses control of the schedule. Unless you are very skilled, you lose control of payouts and you become vulnerable to serious cost overruns.

Get it In Writing!

Central to that, of course, is usint “industry standard” documentation. Chief among these is the Contractor’s Sworn Statement. This document is simply a spreadsheet that documents progress payments over time during the completion of the project. This statement summarizes the budget for the construction phase of the real estate rehab and is agreed to by both owner and contractor prior to commencing work. (We will discuss this further below.)

It is commonplace for the contractor and the customer, the investor, to agree on certain changes to be made during the course of the job, and such changes are often verbal. If such changes are not documented by written change orders, this can easily lead to disputes in the end over the actual cost or value of those changes, as well as disputes over final compensation.

Such issues will be readily resolved by insisting on written change orders, and that no changes are authorized absent a written change order signed by both parties.

Avoid paying by the hour or “time and materials”

You will be approached, especially on the smaller jobs, by tradesmen or by so-called handymen, who will be perfectly happy to undertake the work and be paid by the hour. This might appear to be attractive, because the tradesman indicates he will do the work for $10, or $15 or $20 an hour.

The problem arises when the work is not clearly defined the customer has no control over exactly how long it will take to complete the work (and therefore how much it will cost).

Compensation by the hour is almost always to be avoided. Why? The most obvious reason is the longer it takes, the more that tradesman gets paid.

Another way some tradesmen describe what they will do for the customer is that they will work on a “time and materials” basis. Well, materials are okay; generally speaking, such costs can be supported by receipts from the lumberyard, from the plumbing supply house and so forth.

Once again it is the time element that should be of concern to the customer. An open-ended time and material agreement, even in writing and signed by both parties, without stipulation as to the specific number of hours (or days) which will be required, is yet another potential quagmire for the customer.

Legal issues arise when paying by the hour

An additional risk of these “pay by the hour” or “time and materials” situations is that such arrangements can expose the customer (our investor) to the allegation that they hired this worker as an employee.

In fact both the courts and the IRS may likely concur that, once you agree to pay somebody by the hour, and perhaps be there at 8:00 in the morning to unlock the door and again at 5:00 to lock up, you are behaving as an employer. To actively dictate, and agreeing on work to be done for the day, you will be seen as in fact having an employee.

While such activities might be satisfying to one’s ego, the downside to having a de facto employee puts you under payroll deduction requirements by the IRS and the state, and perhaps certain insurance requirements.

Most importantly, in states that have workers’ compensation laws–which most states do–to have an injured worker who can successfully claim that he was your employee makes you vulnerable to a workerscompensation claim, which can be very costly.

So, your best protection against being deemed an employer is to have virtually everybody on that job working subject to a written contract or work order that identifies the tradesman as an independent contractor. Such agreements explicitly do not index by the number of hours taken to complete the task.

There can be deadlines, that the work be completed on or before a given date. And that payment will be made upon completion. But, as you can see, that is different than saying it is going to take the worker twenty-three hours on the job at $12 an hour. To cite an hourly rate may be interpreted as an employment agreement, rather than a contractual agreement with an independent contractor.

Finally, in terms of overall project management and timing, I hope I have made the case that there are important benefits to managing your project yourself, as an investor, as a rehabber. (For more on this go to: [click here].

That said, there may be constraints on your ability to undertake the role of de facto project manager. Depending on local regulatory issues, you may or may not be obliged to secure a general contractor’s license. In most communities that is not required of owners improving their own property.

Interestingly enough, according to Chicago regulations, if you are an investor and not residing in that home, then you are required to secure a general contractor’s license and function according to the regulations governing general contractors. So one should take care to investigate local protocols with regard to being a contractor.

Managing your own real estate rehab project, is simply a matter of being the primary conduit of payments between the bank and the tradesmen. Using appropriate documentation for identifying the work to be done, in the form of work orders, contracts for completion, and perhaps the so-called contractor’s sworn statement will add to control of costs.

As mentioned above, the contractor’s sworn statement is simply a spreadsheet that documents the progress payments over time during the course of completing of the project. In some cases the project manager is the owner and is preparing that document in order to receive the progress payments from the bank as the work is completed.

There are complexities to the documents involved (the sworn statement, lien waivers and affidavits), but the documents are few, the forms standardized and, once learned, highly repetitive. While it may require extra effort on the first couple of projects as the investor or rehabber gains experience, these procedures become much more efficient, much more perfunctory.

If anything, the primary benefit becomes more and more the control of costs during the course of the project and control of the work flow or the timing.

A final thought on project management and timing.

Given the nature of what we do, if I intend to keep the property for investment purposes, I will begin the application process for my refinance or “end loan” almost immediately upon getting work underway on the real estate rehab project. If the project is running on time and on schedule and an active marketing or rental program is underway, I will make every effort to be well underway to securing a new loan as well.

The application process for your refinance takes time. Since the preliminary part of that application process tends to be credit-related, get all of that underway so that it is being completed as the project itself is being completed. With the work done, final payout on the construction loan will be ready for the interim lender’s approval and funding. If your application for new financing is largely complete, you will have minimized the length of time for your entire real estate rehab project cycle.

To recap– Your “best-case” scenario

Once again, if you plan to keep the property your refinance process should begin the day you close on the purchase on the property. A skilled rehabber will have work underway within days, not weeks, of having acquired the property!

It should be possible to complete your project from acquisition through having the property occupied by a paying tenant in a matter of weeks, not months. The end loan will be in place within the shortest possible time, thus freeing up working capital which was committed to that project. That working capital is now freed up to go forward with yet another deal.

Congratulations!

You have completed “the perfect rehab”

Leo DeCaprio gives toast


- Philip Elmes, Author & Presenter

The Urban Rehabber Program