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Something to Think About #51 – Uncle Sally’s Nephew, Part 14 – By Klarise Yahya, Commercial Loan Broker, BRE: 00957107 – MLO – 249261

Posted on 01. Dec, 2016 by in all, Magazine Articles

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If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at LuLu.com.

Continued from Part 13:  Hiram asked, “Would you like two bids? One for restoration and another for the remodel into three bedroom units?” Naturally, Emily said, “Yes”.

“Well,” Hiram said, “These are 1,200 square foot units. The original construction plans are no longer available, but I’d be very surprised if they were built as one-bedrooms. I mean, most three bedroom homes of this era were less than 1,000 square feet weren’t they?”

“But the tax assessor has them down as one-bedroom units, so that’s what they have to be”, Emily responded.

“What if we kept the units as one-bedrooms, but moved the partition walls around a bit to give us a bedroom-sized storage room and another bedroom-sized play room? After the work is signed off, we could put in the closets and turn them right into bedrooms? You’d still have to get permits before turning the bonus rooms into bedrooms, of course.”

“Ok,” Emily said, “but what about a second bath?”

“We can make the master bath extra large, with a tub at one end and a separate shower stall on the other end. If you ever want to add a bath, you’d just have to put in a toilet and sink and a small partition wall to make the second bathroom. One bathroom would have a tub, and the other a shower. Most of the plumbing would already be there.”

Remembering that the original bid was for $190,000, Emily asked, “So what do you think all this would cost?”

 

Hiram examined his sketch of the slightly revised floorplan and spent a few moments going over his renovation notes. He drew the moment out to increase Emily’s tension. His face got that succession of expressions designed to show that he was arguing with himself and losing. Finally, he said, “I think we can do it for $240,000”.

Emily could play this game too. Another full minute went by. “All that the bank budgeted was $190,000 you quoted in your earlier bid”.  Emily didn’t tell him about the savings she’d originally expected to invest in this project, but now may not have to. She just kept that secret, in case there were cost over-runs somewhere. There almost always are, and a cautious owner provides for at least a 15% or 20% bump in the final cost.

Missy took Hiram to the adjoining room and had a brief private conversation. They came back, both smiling, and Hiram said, “Ok, we’ll stick by that bid, even though there’s more work.”

“If you throw in garage renovations, including new doors, you got a deal.”

Missy’s lips switched, but she caught her smile in time. She took Hiram’s arm and led him back to the other room. It took a little longer this time, and when they returned only Missy was smiling.

“Ok. Garages included.” They shook hands.

Hiram said he would email the contract to her. Emily agreed, but in her heart she knew she was drifting towards in the deep end of the pool. She knew next to nothing about construction contracts, whereas Hiram would be the expert in the room, and Emily had no illusions:  he would be writing the contract to benefit him.

The thing is, serious remodeling can expose hidden work that was done years ago and is no longer safe. Think of rotted bathroom floors, or serious termites in what used to be pretty substantial roof beams. There are other things, those are just examples.

Also, Emily was worried about some of the horror stories she’d heard. What if Hiram used inferior labor and materials, just to make his profit a bit higher? What about “surprises” during construction, unexpected things that he could demand huge sums to repair?  Or the job crawling along and never really being completed?

Sometimes you get to a point where you just have to look around and see who’s on your side.

Emily’s loan agent is on her side. Her loan agent places more loans in a month than most people do in a lifetime, so when a respected independent loan agent makes requests to the lender, they have a much better chance of being listened to and perhaps honored. Emily called her loan agent and talked it over with her.

The loan agent suggested an appointment with the head of the lender’s Construction Loan Team. Emily agreed and the appointment was made for three days later. While Emily was waiting for the appointed day to arrive, she began a web search. She knew she was perseverating: she just couldn’t get it out of her head. Emily kept thinking that there was certainly going to be a contract and the contractor would write it on one of his forms. Hiram was likable and seemed trustworthy, but Emily wasn’t born yesterday. Any contract presented by one of the parties in a transaction was pretty certain to benefit that party.

She wanted to get an idea of how she might protect herself before meeting the Construction Loan manager. She opened her computer. Google being her friend, her web search turned up 290,000 results in 0.56 seconds. That was probably enough to start with.

Obviously, no contract can be written to cover every eventuality and she knew that. What Emily hoped to find was an overview of some of the major clauses she should include in a typical construction contract.

She found a bunch of important items, some of which follow:

1)  Project: What is the project and who is responsible for what? Who is responsible for payment? How is that person contacted? During what hours / days will the homeowner make the home accessible? What are the contractor’s responsibilities (at the minimum the contractor should probably be responsible to provide the necessary tools, materials, and expertise).This section provides a thorough outline of what is to be done to the existing building and exactly where it is to be done. What will be removed and what will be built. Identifies what items (ie, specific materials, brands, colors, etc) will be used and what fixtures will be emplaced, with their total costs. Requires the contractor to properly dispose of debris. Specifically requires the contractor to initiate the project by getting the required permits and concludes the project by securing the final Certificates of Occupancy (or their equivalent).

2)  Dates: Starting and finishing dates. Can require bond or insurance to guarantee dates. If necessary, penalties can be established for noncompliance.

3)  Terms: After a good faith down payment, additional payments of fixed amounts might be based on milestones. An example might be that the next installment payment would be due when the initial carpentry is finished, or perhaps when the rough plumbing and electricity is installed, etc. Oftentimes the job is paid in several parts, for example a 10% down payment followed by installments of 20% at the completion of each milestone. The final 10% is payable only when the owner has received the Certificate of Occupancy and the owner’s punch list of final project details is completed to her satisfaction.

4)  Changes: Remodeling exposes inadequacies in the existing construction. Even if the earlier work was impeccably performed, time erodes quality. Wood warps and joints separate. Dry rot. Termites. Things are revealed during demolition that were never considered when plans were drawn, expectations formalized, and costs agreed to.

A process to appropriately amend the contract is to everybody’s benefit. The contract should, however, state that no changes to the original plan shall commence until the contractor has provided a clear description of the new work, quoted cost, and stated its effect on the completion schedule, and until the owner has given written approval. All change orders should be in writing. If verbal, they should be memorialized by a follow-up email to the contractor restating the details and your approval and requesting confirming email.

5)  Licenses: Contractor to provide proof of licensure, appropriate insurance, and bonding to protect the owner from liability for property or job related injuries.

6)  Liens: Require contractor to provide a lien waver to protect the owner from liability. This could be done when the contractor attaches a lien waver to each (milestone) payment invoice, or perhaps some other way.

7)  Termination: A termination clause provides a structured way to end the contract before completion. The owner has thoughts of only unicorns and flowers at the beginning of a construction project. The owner believes the contractor will deliver the vision she holds in her mind, and the contractor believes he’ll get paid on the contracted dates and will have a healthy profit when the job is finished. Sometimes this doesn’t happen. The contractor has no way of telling what’s in the owner’s head unless she finds a way to implant the vision in his mind. That is every woman’s major life problem: I know what I want. What’s the matter with him?” On the other hand, sometimes a job just increases to accommodate the owner’s ever-expanding vision. What started out as a contract for a remodeled garage turns into a guest house and pool. That was not budgeted for and the money runs out before the job is finished. If there were no termination clause the contractor could just sue for damages, and then the owner would be in even more difficulty.

 

So a termination clause could be considered a little like a liquidated damages, or maybe like a prenuptial agreement. All three allow the contract to be ended on terms agreed to before the job began, when the unicorns were kissing butterflies.

There are two major types of termination clauses: Termination for Convenience and Termination for Cause.

The Termination for Convenience clause provides for the contract to end without stating a reason, just for the convenience of the owner (or, in some cases, the contractor). When properly served, the contractor must stop work, cancel orders for materials, and take steps to preserve the project. Reasonably, the contractor expects to recover the cost for work already performed, termination costs for subcontracts already in place, and other incidental costs associated with stopping the work. Sometimes, if the contract provides for it, the termination clause even provides for the contractor to recover reasonable overhead and profit on the work not performed.

The Termination for Cause part usually lists the specific events that could activate the clause. On the contractor’s part, they could be things like persistent failure to perform the work in accordance with the contract; failure to pay the subcontractors; ignoring the reasonable demands of the owner or the owner’s representative. If the owner terminates for cause, she usually becomes (at least temporarily) the contractor on the job site. But then she’ll get another contractor to take over the job just as soon as she can.

On the other hand, the contractor could terminate for cause. Perhaps the owner fails to meet milestone payments, or perhaps the project is delayed for a substantial period through no fault of the contractor

The items above are just examples. Some of the clauses may be inappropriate for a home remodeling contract. There could be other provisions that an owner’s attorney might want to include. Emily was, however, a cheap-squat and didn’t want to pay to an attorney the couple of hundred dollars that may protect her from the potential loss of tens of thousands. She did not understand a review by a knowledgeable attorney was a type of insurance: it could limit her loss if something terrible happens. Instead, she placed her reliance on the lender’s Construction Loan Manager and the lender’s legal team. Sometimes that works out. Sometimes it doesn’t.

 

This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing real estate, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email Info@KlariseYahya.com.