Who Should Make the Rehab Budget?

Question

You find a property. The purchase price looks good. The ARV looks even better. It needs work, but that's fine. You've done the numbers.

You figure the rehab at $80,000. Then the real numbers start coming in and $80,000 begins looking suspiciously like $120,000.

The deal may still work. But it's not the deal you thought you were buying. That's essentially the situation in the topic I was given to think about today.

And it got me wondering about something more basic: Who exactly should make the rehab budget?

I can make one. I'm the investor. I've seen properties. I know approximately what roofs, kitchens, bathrooms, flooring and HVAC cost. I can measure square footage, price materials and look at previous projects. But I'm not necessarily the guy who's going to do the work. So I bring in a contractor. That should solve the problem.

Except now we have another problem. The contractor wants the job. If he walks the property and tells me: "This thing is a mess. Don't budget $80,000. You're looking at $120,000, maybe more., he may be giving me excellent advice. He may also have just talked me out of buying the property - and himself out of a $120,000 job.

So what's his play? I'm not accusing contractors of dishonesty. I'm asking about incentives. If three contractors want the job, there's naturally some pressure to give me the best number. And unfortunately, the best number before closing is usually the lowest one.

One guy says $82,000. Another says $95,000. The third says $118,000. Which one do I want to believe? Probably the first guy. Not necessarily because I think he's the best contractor. Because $82,000 makes my deal work.

Then I close. The dumpster arrives. Materials are ordered. Half the place is demolished. His crew and equipment are on site. And that's when the conversation changes.

"Now that we've opened this wall..."

"The electrical is worse than it looked."

"Those pipes should really be replaced while we're here."

"That wasn't included in the original estimate."

"We can leave it, but I wouldn't recommend it."

Some of that is completely legitimate. You cannot see through walls. But my negotiating position is also completely different now. Before closing, contractors were competing to get onto the property. Once the place is torn apart and somebody's crew and equipment are already there, changing contractors costs me money and time. Now he calls the shot a little more than I do.

So perhaps getting three estimates doesn't solve the problem either. If I automatically choose the lowest, I've simply created an auction in which everybody has an incentive to tell me what I want to hear.

And there's another uncomfortable participant in this little conspiracy: me. If I need the rehab to be $80,000 for the deal to make sense, I'm hardly an impartial judge of whether the $80,000 estimate is realistic. The $120,000 contractor might be the expensive idiot. Or he might be the only person in the room telling me the truth. I won't know until later.

So who should make the budget? Should I pay a contractor only to estimate, with the explicit understanding that he's not bidding for the work? Should I hire an independent construction estimator? Should I get three or four bids and ignore the lowest one? Should I rely primarily on costs from my previous rehabs? Should I have my regular contractor estimate projects precisely because he knows he'll get future work and doesn't have to win this particular job? Or should the answer be some combination of all of these?

And maybe we're making another mistake by asking for one number in the first place. Perhaps a rehab budget should have three numbers:

What I genuinely expect it to cost;

What it could reasonably cost if things go wrong, and:

At what number does the deal stop making sense?

That last one interests me most. If this is a fantastic deal with an $80,000 rehab, still a good one at $100,000 and merely less profitable at $120,000, fine. But if $80,000 makes me money and $100,000 wipes out the profit, I don't really have a rehab-estimating problem. I have a deal with almost no room to be wrong.

And construction seems like a particularly bad place to require everybody to be exactly right. So, especially those of you who do a lot of rehabs: Who do you trust to establish your rehab budget before you own the property? And how do you get a realistic number from people who know that the lower their number is today, the more likely there will be a job tomorrow?

Josh Handler · Answer

You described my side of the table accurately, which is rare, so let me answer from inside it.

The thing to understand is that the 82, the 95 and the 118 are usually not three prices for the same job. They are three different jobs. Guy one is patching the panel and painting over the water stain. Guy three is replacing the panel and finding out why there is a water stain. Neither is lying to you. They wrote down different houses. You are comparing prices on scopes you never controlled, and then buying the cheapest house without knowing that is what you did.

So the answer to who should make the budget is this: the scope should be yours and the price should be theirs. Those are two separate documents and you should stop letting one party produce both. The moment a contractor writes the scope, the scope bends toward the number he wants to hand you, and he does not have to be cynical about it. He is just going to solve the problem the way his crew normally solves it.

Practically, walk it and write the scope yourself, room by room, in plain language. Panel: replace or evaluate. Sewer line: scope it, then decide. Roof: age, decking condition, replace or not. Hand the identical document to all three and require them to state in writing what they are excluding. Now a spread means something. A guy 30 percent under on the same written scope is a real signal instead of noise.

And pay for the estimate. Pay a contractor you trust to walk it and write a real scope on the explicit understanding that he is not bidding the work, and pay him enough that it is worth his morning. A free bid skews low not because of dishonesty but because a free bid is a sales call. A sales call gets fifteen minutes of thought. A paid scope gets two hours and a flashlight in the crawlspace.

Richard is right about age and I would push it harder. Year built is the highest yield input you have, because it tells you which failures are already on the calendar rather than hidden. Pre-1965 means cast iron drains and galvanized supply, which is a repipe conversation whether anyone raises it or not. Late 70s means aluminum branch wiring. Eighties means polybutylene. If a bid on a 1948 house has no plumbing line in it, you did not find a cheaper contractor, you got an incomplete estimate.

On your three-number idea, that is the right frame, and I would add something that sounds backwards: tell the contractor the third number. Say out loud that the deal dies at 105. A good one will tell you before you close whether the honest scope lands under it, because he would rather lose one job than be halfway through a job you cannot fund. The ones who do not want to hear your walk-away number are telling you something.

On the mid-job leverage problem, that is real and contract language does not fix it. What fixes it is moving discovery in front of the commitment. Sewer scope before closing. Pull a plug and look inside a wall if the house is uninhabitable, which you already identified. Get somebody under the floor. Every dollar spent on destructive investigation before you own it comes back several times over, because it converts a change order into a negotiation.

Full disclosure, I run a construction company, so I am one of the people whose incentives you are describing. Everything above is a way to make me easier to check, which I think is the correct thing to want.

Richard F. · Answer

The Best answer is for you to have the technical and practical knowledge to know where to look for signs of those supposedly "hidden" problems so they can be effectively scoped. They rarely are truly hidden, someone just missed the signs. I've said it elsewhere, nobody ever mentions the age in these scenarios. That alone will get you closer to the truth than anything. Recognizing the general quality of the overall construction and materials is part of that knowledge. Also, I have requested permission to actually make a small opening in a wall to investigate further with properties that were already not habitable. You never get something you don't ask for...

Even with three bids, you are getting three disparate scopes, including quality of workmanship and materials, to some extent. Part of that problem has to do with the frequency with which you utilize a given vendor. One job a year, vs. half a dozen gets you different levels of interest. Add to that factor if they know you are choosing between other bids. And honestly, some vendors are too busy and intentionally "cherry pick" via their bids.

You could consider utilizing contractors that you have previously been very happy with, and pay them well for the walk-through and detailed scope they are willing to stand behind, assuming you already have a great working relationship. There are also Construction Consultants that can provide detailed advice and pricing ranges with no direct connection to actual Contractors. Their scopes should be quite solid, and they are helpful with complex contracts. Of course, no one has control over material cost increases for lengthy projects.

You would still want a percentage contingency fund, "just in case", but you should always be able to stay within it.

Drago Stanimirovic · Answer

Your point about age is particularly interesting. At some point, a bit of a historian starts showing in all of us. You learn that in this particular area, buildings from the 1980s were generally built with such-and-such materials, that this particular construction method was common, that these roofs tend to hold up while those plumbing systems don't. The year and the neighborhood start telling you a story before you've opened anything. Maybe a lot of supposedly “hidden” problems aren't really hidden - we simply haven't learned enough of the local history to recognize the clues.

I also hadn't considered asking permission to make a small exploratory opening in an already uninhabitable property. You're right.

Your point about contractors cherry-picking through their bids is another complication. You really don't know when a contractor is pricing the job and when he's politely giving you the cold shoulder. A ridiculous bid may mean “this is what it costs,” or it may mean “I don't particularly want this job, but for this much money I'll take it.”

The obvious solution is a lasting relationship with a contractor, where both sides know what to expect. But that comes with its own set of problems. Familiarity changes incentives too, and sooner or later you may stop checking the market because this is our guy. So I'm not sure there's a completely clean solution there either.