How to Deal With Contractors

Contractors. Hate 'em. Can't live without 'em.

Well, most of them. I can count on one hand the number of contractors that I've ever liked to do business with. But they're the life blood of any renovation project, so you're gonna have to learn how to deal with them - sooner or later.

You may have a background in construction or have super-amazing God-given Do-It-Yourself talents. You might be able to do framing, masonry, drywall and roofing with equal skill and ease.

You're still going to have to deal with contractors from time to time, for four inescapable reasons:

1. You don't possess all the skills needed to do every task in a renovation job
2. Some tasks require licenses, permits and inspections
3. Some tasks require specialized knowledge and equipment
4. You don't have enough time in the day to do every task all by yourself

Even a light renovation can include flooring, paint, cabinetry, and upgrades to mechanical systems. Heavy "full-gut" renovations require the skills of every type of contractor involved in new home construction - and perhaps even more.

Contractors will make or break your project. Dealing with a good contractor can make your project a joy. A walk in the park. Like going through a revolving door on someone else's push.

A bad contractor will have you fantasizing about scenes from Criminal Minds.

Part of the problem is that novice investors just don't know how to find, hire, and work with contractors. They hire the wrong people, don't provide specific requirements, don't manage the work properly, and then wring their hands when the project schedule and budget fall to pieces.

The next several  posts are going to show you how to find, qualify, hire and manage contractors. We'll also talk about finances and contracts.

Remember, you can post comments and ask questions below. If there's something you really want to know, post a comment and I'll either answer it, or cover it in a future post.

Potholes #6 & #7 - Business Expenses & Taxes

The last two categories of expenses can suck a big chunk of your rehabbing profits. But they can be difficult to plan for and control, because they're not tied to any specific project. Rather, they're both governed by your annual profits and expenses.

When you're rehabbing, all your profits are considered by the I.R.S. to be ordinary income, just the same as a paycheck that you receive from a regular job.  There are two big differences when you get a paycheck though:

1. Somebody else (the company accountant) is responsible for figuring out their income, expenses, profits, and filing all the appropriate paperwork.
2. The company has already taken taxes out of your check for you - the only thing you have to do is file your personal income tax return each year.

But now, you have money coming in and going out through your rehabbing "business". Like it or not, that means you're now a company and have to do the bookkeeping and deal with the I.R.S.

To start with, your profits from rehabbing are considered ordinary income. How much tax you end up paying depends on your business organization structure and your allowable expenses.

There are three basic business structures for tax purposes. You need to have a long, quality discussion with a qualified tax accountant about the pros and cons of each. You can also Google a lot of info for free, but remember that some things are worth what you pay for them.

The three business structures are:

• Sole Proprietor - this means that you're just a regular Joe (or Jane) and everything is taxed at your regular income tax rate, just like the paycheck from your day job.
• "C" Corporation - this is the form used by big companies, who get all the cool tax breaks and end up paying less in taxes.  This probably isn't you, unless you're renovating dozens of properties and employing lots of people.
• "S" Corporation - this is a combination structure that has less accounting and some better treatment of expenses, but still ends up taxing things at your normal tax rate.  That's why you need an accountant to help you figure things out.

In any event, you need to keep track of every dollar that you spend. Is that Starbucks latte you bought this morning a valid business expense? Depends on several things. But, you can't use it as an expense if you don't have a record of it. Even if it's not a deduction, you need to keep track of your cash flow.

A good accountant can give you a list of dozens, or even hundreds, of items that might be usable as tax deductions - based on your own situation. Use that list and keep track of everything that you spend.

Remember, if you're in the 30% tax bracket, every dollar of deductible expenses that you keep track of is thirty cents you don't pay to Uncle Sam.

Speaking of Uncle Sam, here are a couple of inescapable land mines that will blow you up, if you're caught unaware.

1. Self-Employment Taxes - In a normal paycheck, you'll find deductions for unemployment insurance and social security. That's only half of what gets paid, though. Your employer pays the other half. When you're self-employed, you get to pay both halves. To be fair, though, the government used to want people to be self-reliant, and they gave you a break - the self-employment ends up being somewhat less than twice the deduction on your paycheck.
2. Quarterly Estimated Taxes - An individual files their tax return once a year, paying or getting back the difference between what they owe and what was deducted throughout the year.  But, the company actually has to file a form and pay taxes they withheld from your paycheck four times each year. If they don't, the I.R.S. will hit them with huge fines, seize their bank accounts, and even shut down the business. When you're self-employed, you are the business.

Welcome to the big leagues, Slugger.

So there you have it - a whole boatload of reasons to be worried if you're still bound and determined to jump into renovating distressed properties for fun and profit.  Education and due diligence are required if you intend to end up with anything other than an expense education.

I think we'll jump into dealing with contractors next. I could go on about contractors for weeks and months - they're one of those groups I love to hate.

Right now, I'm dealing with a failed water well at my own residence. I'm a week into trying to get a licensed plumber out here to deal with it, and getting tired of hauling in potable water.

Damned plumbers.

But that's a topic for another day.

Potholes #4 & # 5 - Holding & Selling the Property

Please pay attention, dear reader. This is critically important. These expenses can suck all the profit right out of your project, and if you're a beginner you'll never see it coming.

Sometimes, the real problem isn't in the getting, it's in the having.

In other words, you can do a bang-up job renovating your project property.  But, if you don't sell it quickly, those holding costs will eat up all your profit.

Let's say, for the sake of argument, that you bought your property for $100,000 and put $60,000 into it with the expectation that it would sell for $200,000.  You'll probably have to put about $50,000 of your own money into the deal by the time it's ready to sell.

You're thinking $40k / $50k = 80% return on investment (ROI), right?  Uh...nope.  Not even close.

You're probably going to pay somewhere between 8%-10% of the selling price for closing costs, sales commissions, etc.  So half of your profit disappears at the closing table.

So that means $20k / $50k = 40% ROI, right? Nah, sorry.

Every month that you don't sell it, you're going to pay another month's interest, plus other holding costs like insurance and utilities.

A typical renovation loan will run 4%-6% over Prime, interest only, with a 12-month balloon.  If you've used hard money instead, you may be paying 12% or more.  At 6%, a month's interest on $170,000 = $850.  At 12%, a month's interest is $1,700.

And don't forget those other pesky holding costs. We'll budget $500/month for those - making $1,350/month at 6% interest, and $2,200/month at 12%.

It takes a while to find a buyer and get to the closing table.  It'll take 2 months, if you're lucky. Maybe as much as 6 months if you're not. So, your holding costs might be as little as $2,700 or as much as $10,200.  That means your profit would be...

$17,300 / $50,000 = 34.6% ROI

- or -

$9,800 / $50,000 = 19.6% ROI

Now, don't get me wrong - 19.6% ROI is a pretty darn good rate of return in today's world. It beats the heck out of the 1% certificates of deposit being offered by banks.

But, think about the big picture. What if your project ran into unexpected problems, and you had to spend an additional $10,000?  Suddenly, your numbers change DRASTICALLY.

$7.300 / $60,000 = $12.2% ROI, if you have a 6% loan and close in 2 months.

Or, you lose $200 if you have a 12% loan and close in 6 months.

Okay, class - here's your pop quiz.  What lessons can we take from this?

1) ALWAYS know and take into account ALL your deal costs
2) Be really conservative because things will probably go wrong somewhere
3) Be fast because every month chews up your profit due to your holding costs

That's it for today's blog posting.  Stay tuned for Pothole #7 - Taxes.

You didn't forget about your uncle, did you...?

Pothole #3 - Fixing the Property

Now we're getting to the good stuff.  Fixing the property is what rehabbing is all about. And it's the part that we understand the best.  Drywall, paint, carpet - easy, peasy, right?

Not really.

This is the heart and soul of any rehabbing project.  It's often where you're going to spend the most money.  And mistakes here will absolutely decimate your profit on the project.

You start spending money right off the bat, with buying insurance.

Insurance?

Yep.  Most lenders aren't going to loan you the money to buy and fix a property unless it's insured. That insurance is only to pay the lender off if the property is destroyed. You'll also need to insure the improvements you're making, and you'll need liability insurance in case someone gets hurt on the property.

Before you can start doing much of anything - you or your contractor(s) have to pull the needed permits.  You'll have to pay when the permits are issued.

Next comes cleanout and demolition. You'll pay to have trash removed and anything torn out that you're not keeping. This will probably involve renting dumpsters and paying for hauling and dump fees.

Don't be surprised if you run into nasty surprises during demolition and cleanout. Asbestos, mold, and lead paint can be realbudget-busters if you're not expecting them.

Now you can start to fix stuff, beginning with the structure - foundation, framing and roof. When you get these in pretty good shape, everything may come to a halt until you pass your rough-in inspection.

After you fix the things the inspector pointed out, you can get the mechanicals done - heating and air conditioning (HVAC), plumbing, electrical.  Then, you'll get your mechanical inspections, which will probably require multiple inspectors.

After you pass the inspections, it's time for the finish work - drywall, cabinets, doors, counters, paint, flooring, etc. Don't forget the outside - landscaping, deck, gutters, paving, etc.

Assuming you pass your final inspection, the renovation work is complete and you can enter the next pothole, er, phase of your project.  That's a matter for the next blog entry - so stay tuned.

Or better yet, sign up to receive future blog updates via email.

Next entry - Potholes #4 and #5 - Holding and Selling the Property

Potholes #1 & #2 - Finding & Buying the Property

Before you can renovate a property, you have to buy it. And before you buy it, you have to find it. Finding the right property can be frustrating. Get used to it. Just about every part of this business can drive you crazy -- if you let it. It's the nature of the beast.

The basic game goes like this:

1. Find a property that has potential
2. Figure out the numbers to find your maximum offer price
3. Make the offer - if the seller doesn't accept, go back to #1
4. Buy the property

Most of your expenses involved with finding the property will be deductible. That means they reduce the amount of taxes that you'll have to pay. If you're in the 25% tax bracket, every buck you spend on these expenses will save you a quarter at tax time.

So, yeah, it's worth keeping track of them. And this is really, really important. You can't just guess at expenses when you're doing your tax return. You need proof.

Keep an Expenses Journal. Write all your expenses down in the journal, and you'll know exactly what you spent at the end of the year. Then, when your Uncle Sam and the Infernal Revenue Service demand that you prove your deductions - you can.

The first part of this dance is to find a property that has potential. We'll get into property hunting in future posts. Right now, we're only worried about expenses.

The most obvious expense is mileage while you're driving around looking at properties. But, stop and think about all the other things you pay for. If you use them for real estate, some portion of those items may be deductible.

Phone, utilities, insurance, advertising, computer, Internet service.

Get the idea?

Just make sure you write everything down and run the expenses past your accountant at tax time. What? You don't have an accountant?  Don't worry - you will.

Before you can make an offer, you have to know your numbers. These will include ALL of your project costs (Potholes #3, #4 and #5) and your selling price (probably based on an after-repaired appraisal).  Remember the basic business formula:

Resale (Income) - Expenses = Profit

Be sure to understand that your offer price is an expense.  To refresh your memory, these are the seven major categories of expenses:

1. Finding the Property
2. Buying the Property
3. Fixing the Property
4. Holding the Property
5. Selling the Property
6. Business Costs
7. Taxes

The expenses related to a specific project include categories #2, #3, #4 and #5.  The other three categories - #1, #6 and #7 are general expenses, not usually tied to any specific project.

The basic formula for finding your offer price is:

Offer = Resale - (Expenses + Profit + Contingency)

Your project's expenses will include all the costs of Buying, Fixing, Holding and Selling the property.  For this formula ONLY, Buying Expense won't include your offer price - just your closing costs.

Profit is pretty self-explanatory.  You need enough profit to pay your Finding Expenses, Business Expenses and Taxes.  Anything left over is NET PROFIT. Finally, something you can spend.

But what is Contingency?

No matter how good and detail-oriented you are, you're going to miss something or get surprised. That's Contingency. I always budgeted an extra 10% of all my Fixing and Holding costs, as a Contingency Fund.  By the way, bankers loved it.

I need to direct your attention to the Buying Expenses category.  Your offer price will have two pieces - the Earnest Money Deposit that you give to the seller when you make an offer, and the balance which is payable at closing.

In addition to the purchase price, there will be several costs that get added at closing time.  I usually budget about 2% of the purchase price to cover these additional expenses.

When you're buying distressed properties, you'll discover that sellers sometimes don't have the ability or willingness to pay their part of the closing costs.  The seller's closing costs can run from 3% to 10% of the purchase price - or more.

You might have to agree to pay the seller's closing costs in order to get the property. If so, don't forget to add them to the Buying Expenses.

That's enough for today's posting - but there's a lot to think about here. 

Feel free to ask me questions or suggest topics for future posts. You can post comments or send me email below. If you want blog postings delivered to you automatically, enter your email in the box to the right.

For more in-depth conversations and questions, check out our LinkedIn discussion group by clicking on the DISCUSSIONS tab at the top of this blog. Also check out the RESOURCES tab.

And stay tuned for the next posting when we'll dig into expense related to Fixing the Property.

7 Potholes In Your Road to Rehabbing Success

For which of you, intending to build a tower, sitteth not down first,

and counteth the cost, whether he have sufficient to finish it?

- Luke 14:28 (KJV)

Rehabbing is another name for renovating older residential properties.  It's the way that most of us get started in real estate investing.  This kind of deal sounds pretty simple, at least at first.

Well, I hate to bust your bubble, but it's not simple.  Rehab deals are complicated, and there are a LOT of moving parts.  Mistakes will cost you money, reducing your profit.  And most novice investors under-estimate the costs, thereby over-estimating the profit they'll make.

There are seven (7) major categories of expense in any rehab project.  Remember our business formula from earlier posts?

INCOME - EXPENSES = PROFIT

These seven categories added together make up your Expenses.  If you under-estimate any of the costs in these seven categories, you won't make as much profit as you had planned.

You might want to think of these seven categories as potholes in your road to success.  You're going to hit all seven, so you might as well plan the best you can.  But if any pothole is bigger than you planned, it'l knock the front-end (profit) right out from under your project.

These seven categories of expenses are:

1. Finding the property
2. Buying the property
3. Fixing the property
4. Holding the property
5. Selling the property
6. General business costs
7. Taxes

I'll be drilling down into each of these categories in the next seven blog posts. 

As an investor (and businessperson whose goal is to actually make a profit), you must, MUST, MUST understand and carefully calculate each and every one of the costs in each category.

Here's an example of the impact unexpected expenses will cause.  Let's say you bought a property for $120,000, plan to sell it for $200,000, and expect to make a profit of $15,000.

$15,000 is an 8.1% Return On Investment (ROI), based on the total investment of $185,000.

Assuming that you put 25% of your own money into the deal and financed the rest, your actual ROI would be 32.43%.  That beats just about any other type of investment - savings accounts, certificates of deposit, the stock market, etc.

So, in the back of your mind, you're anticipating this 32% return on your money and feeling pretty darn good about life in general.  Unfortunately, the project doesn't go as well as planned.  The costs run over for roofing and drywall.  Some unexpected problems in the basement have to be dealt with.  In the end, you don't make $15,000 profit.  You make $5,000.

That takes your ROI down to 10.3% ($5,000 / $48,750).  If you end up paying 30% in taxes, it actually means your after-tax ROI is about 7.2%.  And you will have spent every waking minute for months and months working and sweating over the deal.

Suddenly it doesn't seem like such a cake walk, does it?

A $10,000 mistake doesn't sound that big on a $200,000 deal.  But it knocked your profits down from $15,000 (32.43%) to $5,000 (10.3%). 

It's a numbers game.  You have to count the cost, and then manage EVERYTHING to make sure that the project doesn't spin out of control.

So stay tuned, and we'll take a deeper look into each of the seven expense categories in the next few blog posts.

In the meantime, feel free to post comments or send me suggestions for future blogs.

If you know anyone who's interested in real estate investing, be sure to tell them about this blog.

And, I'm going to set up an open discussion group on LinkedIn.com where folks can post and discuss real estate questions and issues.

Be sure to keep watching for the next update of this blog (or subscribe with the box on the right if you'd like to receive updates via email).

How YOU Can Turn $1000 into A Million Dollars

Real estate investing has been around since before Columbus convinced Queen Isabella to hock the crown jewels to fund his first voyage.  But it never really struck the fancy of John Q. Public until 1959, when William E. Nickerson published his seminal book on real estate investing, How I Turned $1,000 Into a Million in Real Estate -- in My Spare Time.

Actually, in today's dollars, the title should probably be How I Turned $50,000 into Fifty Million in Real Estate -- in My Spare Time.  A grand just doesn't go as far as it used to -- inflation and all.

It's a good read, and it's been updated a few times over the years.  You should get a copy from Amazon. It's a great place to start because it's based on plain old common sense, not some self-annointed guru's "magic secrets" to "untold real estate fortunes".

In this book, Nickerson lays out a simple, step-by-step plan that should inevitably lead the investor to success, ending up with a really respectable nest egg.  It only requires:

• Money -- you'd need about $50,000 to get started in today's dollars
• Credit -- you would need leverage (bank financing) to purchase properties
• Time -- this plan takes years to accomplish, but you get to retire rich

Let's face facts.  In today's world, most people don't have the initial investment and they're not willing to work diligently for decades in order to realize their dreams.  That's why shady ne'er-do-wells make millions of dollars hawking courses on how to Buy Properties With No Money Down or Make Your Fortune Flipping Properties.

Everyone wants something for nothing and they want it yesterday.  There are just too many people looking for a free ride.  Our generation is cursed by a general feeling of "entitlement".

Reality check -- nobody "owes" you anything.  If you're not willing to earn it for yourself, get used to going without.  Fortune favors the prepared and the hard working, not the whining wannabe.

Nickerson's plan is pure simplicity.  Here is the gist of it:

1. Find a house that needs some work but is basically livable.
2. Put 25% down on the property and get a bank loan for the rest.
3. Fix up the property while you're living in it
4. After a few years, sell the property, realizing a profit
5. Repeat

I knew a woman who used this formula.  When she and her husband finally retired, they owned ten rental properties free-and-clear.  They had no mortgage payments, just ten rental checks coming in every month.

Talk about a comfortable retirement...

After her husband died, she got tired of managing rentals and sold them all.  I bought one of them.  She took all the cash and bought herself a very, very comfortable home to live in - and paid cash for it.

That'a what discipline and time will do for you.  And it's within the grasp of anyone who's willing to do the work and give it the required time.

There are a lot of related topics that I'll get into in future blogs - leverage, banks, inflation, equity, rehabbing, home improvement, gurus, etc.

For now, try to find a copy of Nickerson's book (HINT -- they still have these big buildings where you can borrow books FOR FREE -- I think they call them "Libraries").

And here's a freebie.  If you like Nickerson's book, try to get copy of The Millionaire Next Door.  It's not the most exciting book in the world but I consider it to be mandatory reading.  It's another book that will probably open your eyes to new possibilities,