Why Contingency Funds are Absolutely VITAL in Real Estate

I’ve had the pleasure of working with two incredible partners over the past 5-6 months, and I have to say, real estate is awesome. I mean seriously, it’s a great business. But you already knew that; that’s why you’re here.

Obviously, there is the whole “looking at cool houses” part — and the part where you call your other real estate investor buddy and tell them what kind of crap-hole house you found, or the basement wall that was the “worst you’ve ever seen.” Mine? The worst I ever saw was a linear crack across a 30 foot basement with a crack wide enough in places that I could nearly get my whole hand into it (IF I wanted to do that). Yikes. #someoneelsesproblem

Of course, there is also the part of buying them. Planning the renovations. Demo. Then Construction. Getting her all cleaned and polished up. And then, of course, selling or renting it!

Part of keeping that great relationship with your partner, your spouse, and let’s be honest, your own sanity, is to make sure you have “it” together. I’m talking about anything from insurance, to real estate agents, to having the deal written out on paper and things organized, to your guys on the job knowing what they are doing, to communication with the GC over what is happening. You must have everything in order.

All of these things are vital to the success of your project, no matter how big or small. This post comes from an honest, writing-it-to-myself-kind-of-place. You know why? Because I’ve had to use the contingency funds in each of our deals so far. It’s not because I was a bad planner — my numbers were right on the money for what we COULD see (mostly… more on that in a minute) — but there are nearly always unforeseeable things that come up.

My Contingency Funds

On larger projects I usually have a little larger contingency percentage, depending on how old the house is and the scope of the work. The newer house we are flipping right now didn’t have nearly the number of surprises you find in an old house, so we were a little leaner on that one. But we are in the midst of a large 2200 sq ft renovation that was basically down to the studs, and let me tell you — we weren’t even close on our contingency funds there.

It doesn’t mean we aren’t making money on that deal. Quite the contrary; we bought it right, and we will still do very well on that deal. It still sucks. I hate not having it right down to the penny.

I have another deal going that is a small rental house, one of those “enigma” houses around BiggerPockets –the sub-$30k house that will be worth about double that when it’s done. Straight up, it’s been a nightmare. From expecting a few patches in the gas line and ending up having to put an entire new line in (ouch) to the electrical service panel having to be upgraded (double ouch), along with some other plumbing things we just couldn’t see, it’s not fun writing checks for things you didn’t budget for.

On another deal we have going right now, we ended having to completely change the layout of the kitchen and stairs because of multiple restrictions between code and just physical space. We also ran into problems with the deck we planned to clean up, fix, and paint, which, although both my GC and I thoroughly went over multiple times (clearly not thoroughly enough), we somehow missed the fact that the deck was SITTING ON CIDER BLOCKS behind the lattice side skirt — and wasn’t even attached to the rim joist to the house. Really?

As a side note: Did I also mention that on this very large deck, there was a massive hot tub hanging out there too? Wow. Wish I was there to watch them come up with that engineering and design marvel.

But I was there on the phone anyway, when my GC called me up and describes the scene. Yes. We definitely did not expect to encounter something like that — or the cost associated with making that right.

On that same job, I was meeting with my real estate agent for a walk through after it was all gutted out, and we started talking about a few things we could change with both the front exterior and the new back patio. Guess what? Although our budget went up some, we will be able to not only make it back, but even more because we were so conservative in our ARV price since we looked through multiple comps that would put us $15k or more above where we initially anticipated listing. #thatworks

I’ll take more profit.

Here’s the Point

Don’t try to get away without having your cushion, your contingency funds. Understanding contingencies in real estate is easy once you know how to leverage them. Also, make sure you know if your contractor has X built in for changes, or that you have it, and for us — usually a little of both. Don’t kid yourself and expect there not to be anything. If you don’t have to spend it, awesome! If you have some left, maybe you could put a few more dollars into something that will make you even more money on your investment. Or just keep it, and put it into the next deal.

But don’t get into a project and then be blindsided by something you couldn’t have known was coming: Insects, plumbing, foundation, roof problems, subfloor is rotten, drain issues. Did I mention plumbing? And electrical? Yep… because I’ve been there.

My Rules of Thumb

For small rental houses, I add over 10% depending on the shape it is in. If I am buying a $20k house with a $12k reno budget, I may put another $2,500 in just in case. That plumbing line I am talking about cost me $1,800. Ick. Still makes me mad.

For smaller flip houses — if they are in decent shape — I think if you add a cushion of 5-7% depending on how tight your numbers are, you’ll be in good shape.

For larger renovation projects, I am going to stick with 10%. I’d rather expect it and not need it than not build it in. In the case of a $90k reno, we will be in it for more like $100k.

So, I’ve told you my plumbing story: $1,800 in a unexpected new gas line. What’s your best story of learning the hard way? What’s the one you didn’t plan for that came up unexpectedly? Have you learned your lesson?

Leave me a comment, and let’s talk!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.