Top 5 Construction Mistakes
Welcome to the Real Estate Espresso Podcast, your morning shot at what’s new in the world of real estate investing. I’m your host, Victor Menasce.
On today’s show, we’re taking a look at the top five mistakes that rookie investors make when it comes to projects that have a construction component. As a general rule, the number one mistake falls into the category of failing to properly forecast the project’s cash flow requirements. In fact, that number one mistake has many different variations. And I’m going to say that it occupies the first three mistakes. So, here we go.
Number one. Many real estate investors who are new to construction tend to negotiate their construction contract separately from the construction loan. The lender will have a process for funding their construction loan in draws. If the payment terms for the construction contract and the payment process from the lender don’t match perfectly, you’re setting yourself up for a cash flow problem.
Let me give you a simple example. Let’s imagine you have a concrete subcontractor that’s doing the foundation work. The lender might assume that the loan will be subject to a 10% hold back on all of the construction draws, and the remaining 10% of the cumulative draws will only get paid out when the project receives its certificate of occupancy. But, if the concrete subcontractor is going to be done early in the process, they don’t want to wait nine or 12 months until the project completes to get paid in full. If your contract with the concrete sub is not in sync with the lender’s draw process, you’re going to have a cash flow problem.
Number two. The second most common rookie builder mistake is in the need to pre-purchase certain materials. Construction draws are part of the way that the lender secures their loan. These are, after all, secured loans secured on the real estate. But, materials sitting on the side walk outside your project are not part of the collateral. It’s only once they’ve been installed in the building that they form part of the collateral.
So, the process requires the borrower or general contractor to complete the contract or the construction in phases. At the completion of each phase, the lender will reimburse the borrower for those expenses once they have been certified and installed in the building. What happens when you have a high value or long lead item? If you’re purchasing kitchens or windows from China, and you need to pay for these months in advance or maybe you’re buying an elevator for your building, the lead time is going to be months in advance and you have to pay for it upfront. If your business plan doesn’t take that into account, you’re going to have a cash flow problem, because the lender is not going to upfront the money for you.
Number three, the third most common mistake is failing to account for bonding over off-site improvements. Let’s imagine your project, this could even be a very small project, has a requirement to upgrade utilities or maybe plant some landscaping. It could be something very simple, maybe you have to cut a trench through a road or repave a road cut. The off-site improvement could be extending an electrical line or a water main or a waste water pipe. It doesn’t matter what the improvement is, chances are the municipality will require you to perform the work, at your cost, as the developer and then donate those improvements to the community.
In some cases, they might offer you a reduction in your development charges and impact fees. Maybe they’ll offer you a tax abatement to refund you those costs over time or they might even give you what’s called a latecomer agreement so if other projects take advantage of these improvements you get partial reimbursement for that improvement. That’s not the problem, the municipality will require you to post a bond for the value of those improvements, usually in the form of a letter of credit with the city until those improvements are complete and signed off by the city. Sometimes the city will only reimburse you of those costs after the warranty period has expired. What that means is you’re going to have to pay for those improvements twice – once to perform the work and the second time to post the bond with the city. If you don’t take that added cost – that double cost – into account it can represent a major cash flow problem for you.
Number four. There’s many different types of construction contracts. These are usually covered by industry-standard forms. In the US these are the AIA, the American Institute of Architects. In Canada, it’s CCDC. They’re fairly similar conceptually. There’s a number of different standard contracts for construction projects. They can be crafted as construction management contracts or pure general contract arrangements. It can be one where it’s a cost-plus contract where the owner is expected to pay for any cost regardless of what happens to the project. There are lump sum contracts where the project is beta to the lump sum with a separate budget for contingencies, and then there’s guaranteed maximum price contracts. There’s only a very limited number of conditions where the price can increase in a guaranteed maximum price contract. They’re still not zero. If you don’t understand the type of contract you’re signing and the conditions under which the general contractor might increase the price, you could be facing a significant problem that you’re not prepared to handle.
And then number five, I often see inexperienced owners facing very expensive construction budgets if they don’t understand the process of value engineering. Architects and engineers often make what seem to be compelling arguments why this particular element of the building is required. And it takes experience to challenge those assertions and eliminate design decisions that could prove to be costly in the long run. We often see a single design decision made early in the process attract a whole cascade of costs that can become difficult to unwind unless you have the stomach to go back and revisit that early design decision. But you got to do it early in the process because the later in the process you revisit that decision the more costly the changes.
So, those are the top five mistakes that we see rookie investors making when it comes to anything involving construction. As you think about that, have an awesome rest of your day. Go make some great things happen. And we’ll talk to you again tomorrow.
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