As a Loan Officer who works with many clients and Contractors on financing renovation projects with FHA 203K or HomeStyle loans, I wanted to write about how the Contractors get paid. By this I mean how a Contractor can afford to do a rehab project, pay all expenses and make a profit to stay in business.
This is important for anyone to understand who will be reviewing a Contractors proposal and seeing costs for both materials and labor on a project. But what is usually not defined separately is what has the Contractor added into the cost of the proposal to cover profit and overhead expenses. Or more to the point, how is the Contractor making money on your job ? Most would agree the Contractor does have a need to make money but what is not often clear is exactly how that happens.
In speaking with clients who review various Contractors proposals one question almost always is asked, “Why is this material costing X when I know I can get it on sale or online or at a big box store cheaper?”.
The answer is that the Contractor has placed some part of profit and overhead expense onto the price of the material. Meaning the Contractor must disperse or distribute each dollar of profit and overhead expense across all the materials needed and the labor to install each type of material. This is how the Contractor builds in the necessary profit and overhead expense into each project proposal. It is appropriate and allowed to be done this way for 203K or HomeStyle renovation loans. Even if paying a Contractor cash there would be profit and overhead expense built into the rehab proposal. After all, none of us can afford to work for free, can we ?
This crucial fact is vital to understand or otherwise it may look as if the Contractor is overcharging for materials in a dishonest or illegal way. That might be a natural assumption for a client who had no previous experience working with a Contractor on a renovation plan. I can’t stress enough that a Contractor must build in a profit and overhead expense into your project somehow to remain in business.
In addition, I want to explain that any attempt to reduce the Contractors planned profit by shopping for cheaper materials during construction would be, on a 203K or HomeStyle loan, a violation of the Home Owner Contractor Agreement signed prior to closing. This means that a contract exists with the Contractor who has disclosed certain material prices and costs. Signing the Agreement means you agree to allow the Contractor to make a profit based on costs disclosed to you. Any attempt to change them later can result in voiding the contract and causing the Contractor to walk away from the job. Certainly it is wise to consult more than one Contractor for a proposal to learn how each will charge and what the difference between each will be on the total cost for your job. In that way, you have a clearer picture of the costs and can determine what is appropriate for you.
- A quick example of this process might be a Smoke Detector. I recently saw a Contractor’s proposal with a wired & interconnected Smoke Detector charge at $75.00 for the unit. Most of us have seen Smoke Detectors at a big box store that may be priced less. At first glance, it might appear the Contractor is simply overcharging for the material but consider how a Contractor makes money. A Contractor can distribute the planned profit and overhead costs across all materials. In this example, perhaps the Smoke Detector will cost $35.00 at a Contractors discount. It would appear then there is $40.00 of profit built into this one Smoke Detector, more than double the cost of it. But let’s take this example down another level to see if that assumption is likely to be accurate.
To install a Smoke Detector that must, by most local building codes today, be hard wired into the electrical system of the home, there are other materials needed. That might mean conduit pipe to run the wires through from the electrical panel box; wires to go into the conduit; wire nuts or electrical tape to seal them at the point of installation; a junction box screwed to the studs in a wall or ceiling to hold the Smoke Detector; screws; a drywall piece for patching, paint and so on. Not to mention tools, maybe a caulk gun, a garbage bag for the debris, a vacuum to clean up with, etc. The idea being there are more actual material costs than just what the Contractor priced for the Smoke Detector itself. Of course, the Labor cost would be broken out separately in most Contractors proposals and may have some profit and overhead expense also built in.
The point here is that a Contractor can have a level of profit and overhead built into each Smoke Detector. I have seen clients later tell a Contractor they can go out and buy a certain item much cheaper and think that is a good thing. Normally it would be if it was your own money. But in fact, it is really a component of a contractual agreement signed earlier guaranteeing the Contractor a certain amount of profit and overhead expense needed to complete the job. As above, you may be just hijacking or robbing a Contractor of a legitimate amount of profit woven into each Smoke Detector needed to continue on the job. If an attempt is made to remove these points of profit there may be little reason for a Contractor to continue the job to completion. In other words you may have stripped out much of the profit for the Contractor by trying to buy or source your own materials. Most any Contractor would have to consider whether to continue and make less money or walk away to go to a more profitable project.
- Another quick example I saw on a proposal recently was the cost of 2 French Doors. It is written in at $2500.00 each ($5000 total) with an allowance for the home owner to make 2 door selections that cost $2000.00 each plus $50.00 more for hardware each. Here the Contractor seems to be saying two French doors will be $4100.00 with hardware. The remaining funds out of the $5000.00 cost or $900.00, may be assumed to be part of Contractor profit and overhead. But realize there may be caulk, glue, shims, lock set, weather stripping, etc. needed to fully install the French door at some additional cost. So actual profit can be less than it appears.
The point being this material cost is disclosed up front before the Buyer signs the contract or closes on the loan. If the home owner feels it is not an appropriate cost then that must be resolved early before the contract is signed, not after the fact, it’s too late then. Otherwise the Contractor’s profit and overhead expense would be removed or hijacked. While I understand we all want to save money, this is a dangerous path to go down. It’s dangerous because it will put your project at risk of not being completed in a timely manner.
If a Contractor does walk away and cancels a 203k or HomeStyle rehab contract due to profits being stripped out, the Lender must find another one who will agree to do the project at the same budget. Once the loan is closed the size of the loan cannot be increased. Also, the property was appraised up front with a given set of materials and level of work to arrive at the future, as completed value. If materials are downgraded that may cause the appraised value to drop. Then the Lender can step in and enforce the original contract and cost of materials to keep the original appraised value intact, under which the 203k or HomeStyle loan was approved. That is disclosed in the Home Owner Contractor Agreement signed by the Buyer or home owner. This is an unpleasant situation that should certainly be avoided.
So, it is vital to the success of the project to read through all items in a project proposal and agree to the numbers in advance with the assumption there cannot be changes once the project is started regardless of what sales may be seen later on materials.
The next question might be how much profit and overhead expense do Contractors build into their rehab proposals ? Or how much is appropriate to build in ? That answer will most likely vary with each Contractor and project size. My best advice is to have a couple Contractors write up proposals and review them in detail. Only then can a home owner or Buyer really understand what is appropriate to spend for them. It may be one Contractor is happy at a 10% profit and overhead margin. Or another Contractor may be at 20% or some other number. What you have to determine is what total number is appropriate for you and will allow the project to go forward and the house to have an as completed appraised value that allows a 203k or HomeStyle rehab loan to be approved.
My advice is to always review in great detail the Contractors proposal before you agree to it and before the 203K or HomeStyle loan is closed. Because once these loans are closed the material costs are very difficult to change, they are in effect baked in. But more importantly the costs should not be changed because the Contractor has placed the profit and overhead cost into each material needed to complete the job.
I hope this post has been helpful and encouraging to those that may have thought a Renovation project was too complex or beyond their ability to manage. My intent is always to inform, educate, and generate discussion. Please call me or email me directly or visit my website for more information on renovation loans. I welcome your comments and questions!