Successfully flipping a house depends on adding value with construction. Effectively adding that value requires strategic planning and successful management of contractors. Frequent advice on flipping a house begins with, “Get at least three bids, and make the contractor responsible for overages.” This advice assumes contractors know the expected costs and are capable of assuming the risk for estimating incorrectly.
Reality tends to unwind both of these assumptions. First, rehabs are very difficult to predict. Even if a contractor can accurately anticipate the costs of all the known tasks, there are inevitable surprises and scope of work changes in any remodel. Secondly, rehab contractors who are affordable enough to manage a residential flip are probably not in a financial position to assume the risk of a rehab going sideways. Contractors alleviate the risk in two ways: padding the bid and change orders.
Regardless of how well your contracts are written, the contractor has the real leverage once a project is started. Firing a contractor midproject always ends up with a failed flip. More importantly, if the budget runs out, the contractor can’t afford to staff a project. The cold, hard truth is you can’t afford to fire your contractor, but your contractor can fire you. The first step to managing this one-sided marriage is acknowledging the reality of the power imbalance.
It would be wrong to assume contractors are bad people looking to leverage the power imbalance. Most contractors are good, capable people who are set up to fail by flippers who want to minimize risk and maximize profit. Residential contractors typically have very little administrative support and minimal ability to manage cash flow when a client’s budget runs out. Labor must be paid every week, so very few affordable residential contractors can assume the financial risk of miscalculating a bid. As a result, contractors are often forced to spend more time managing cash flow than managing the project.
No matter what the attorneys tell you, the real risk in a flip is on the developer, regardless of how the contracts are written. The best way to minimize risk is to set your contractor up for success. Our last 200 flips have been with the same contractor, and we’ve found a cost-plus relationship provides the best path to success. With a cost-plus contract, the contractor is reimbursed all construction costs plus an agreed-upon percentage for managing the project. The “plus” compensates the contractor for managing the project.
Here are the important advantages flippers gain with cost-plus:
• The contractor can focus on managing the project rather than managing cash flow.
• Minimizes time and emotional energy spent on negotiating change orders.
• Avoids the temptation for the contractor to “hide” issues that would lead to a negotiated change order.
• Allows contractors on the ground to solve problems and avoid the costly delays of approving change orders.
• Increases the possibility of a mutually beneficial long-term relationship with the contractor.
The most valuable partnership you can create is the one between yourself and a quality contractor that lasts for years. We call these sustainable construction ecosystems, and they facilitate win-win relationships. Such a partnership can only exist when the contractor is set up to succeed.
A cost-plus approach allows the contractor to focus on managing a project rather than tracking and negotiating change orders. Yes, there is the risk of a contractor taking advantage of a cost-plus contract. That risk, however, exists in any construction contract. I firmly believe the wrong contractor will be unsuccessful with any contract, but good contractors are able to be the most effective in a cost-plus system.