When under the pressure of an active rehab project, it’s natural to seek out cost-cutting measures to stay within your budget. It’s always a good idea to seek cost savings. After all, every dollar you save on your rehab is a dollar added to your bottom line. The pressure of sticking to your budget will tempt any investor to find means of reducing costs.
You must tread lightly when seeking creative ways to cut rehab costs. Investors are often tempted to cut corners to save every penny and increase their chances of completing a successful rehab.
Below are three common pitfalls to be aware of when starting any rehab project.
How to Estimate Rehab Costs!
Estimating rehab costs accurately can make or break your real estate business, and it takes years of experience for even the best rehabbers to master the art. However, you can expose yourself to less risk and get more accurate with your projections by learning how the pros think when estimating construction costs.
3 Common Pitfalls to Avoid During Your Rehab Projects
Pitfall #1: Hiring Uninsured Contractors
The fixed cost of a contractor to carry his/her liability insurance will surely add to the cost of the bid. This makes it a tempting to find contractors who are able to offer lower prices because they are not paying for liability insurance. You should make liability insurance a requirement for any contractor who works on your properties; there is no compromising here.
Liability insurance protects your business in the unfortunate event that a contractor gets injured while working on your property. If properly insured, the contractor’s liability insurance will cover the cost of medical expenses and/or time missed from work as a result of the injury. If a contractor does not have this insurance, guess who their lawyer will come after? That’s right, you and your business!
It’s common knowledge that uninsured contractors can get the job done cheaper. This doesn’t mean that it will save you money in the long run. If you have a consistent habit of hiring uninsured workers, you are bound to have something go wrong at some point in your investing career. Starting today, make the commitment to screen all contractors to be absolutely positive they have the proper insurance.
Pitfall #2: Paying Cash
Related to hiring uninsured contractors is the habit of paying workers in cash or “under the table.” This is a pitfall that is way to common for new investors. In the midst of obtaining contractor bids, you encounter a contractor who is willing to do the work at a steep discount. The contractor has only one stipulation: You agree to pay cash! I’m not talking about cash as opposed to a credit card. I’m talking about cold, hard, $10s, $20s and $50s — physical cash!
On the surface, you may think: “Wow! What a great chance to score a discount! I have to pay the guy anyway. What do I care whether it’s cash or check?!” The truth is that it makes a huge difference whether you pay your workers “on” or “off” the books. The major problem with paying in cash is that there is no paper trail to prove what the money was used for. This is precisely why contractors may offer incentives if you pay in cash. If there is no record of where the funds came from, the money is untraceable from a tax perspective. They are able to limit their annual earnings because any later audit would present no way of tracing this missing income.
The reason a contractor would want to be paid in cash is the exact reason why you should not agree to do it! If you pay a contractor in cash, you have no way of accounting for this amount as an expense related to improvements on your property. If you were ever audited, the only thing the IRS would see is a cash withdrawal. What do you think the first suspicion is of the IRS? They will, of course, assume that you withdrew cash to put in your own pocket. Even if this is not the case, you have no paper trail to prove that the money was spent on legitimate expenses related to your rehab. Instead of this amount being treated as a capital improvement, the IRS will require that you treat it as a taxable distribution from your investment business.
Don’t count on the off-chance that you may not get audited. If you are in business long enough, it’s not a question of “if” but a question of “when” you will get audited. When this happens, you want to be able to prove that all your expenses and deductions are legitimate. Failure to do so will lead to additional taxes and interest for the time you “skirted around the IRS.”
Pitfall #3: Skipping Out on Permits
One of the most amateur mistakes newbie investors often make is trying to skip out on required building permits. Permits are required from a wide range of common improvements: framing, structural changes, new plumbing, electrical work, fences, etc.
As you would expect, obtaining permits costs time and money. Your general contractor must communicate with the local building authority to explain the project and obtain the necessary permits. All permits will have an associated cost and require some form of inspection from the local building authority. To many, this seems like a huge hassle that they will try to avoid at all costs.
You will learn very quickly not to ignore the necessity of obtaining permits for your rehab projects. Below are some key reasons why you should always obtain the necessary permits for all your rehab work.
Get on the “Good Side” of the Town Inspector
It pays to be up front with the building inspector as to the scope and complexity of your rehab project. Inspectors are used to homeowners and rehabbers trying to cut corners when it comes to permits. If you are proactive in seeking out your permits and show a commitment to doing a solid job on your rehab, you are bound to fall into the good graces of the building inspector.
Being in the good graces of the building inspector will pay dividends down the road. Not only will the inspector offer whatever leniency possible during his inspections, he will be prepared to help you out on future rehab projects as well.
Be Sure Your Job is Done Right
There is a good chance that your end buyer will perform a home inspection before closing on the property. These home inspections can be extremely rigorous and often bring to the surface many tedious issues. These issues, while potentially minor, can blow up a deal. There is nothing more frustrating than having a sale under contract and having the potential buyer walk away because of an adverse home inspection.
Obtaining the proper permits throughout the project will drastically limit the number of issues that come up during a home inspection. After all, if you have the proper permits, you will have had to pass several inspections from the town building inspector. The eventual home inspector will have a record of all the permits pulled and the resulting inspections. If he sees that the rehab was done in accordance with local building code, the number of potential issues that may come up is limited.
Think of permits and building inspections as checking your work throughout the project. Instead of crossing your fingers and hoping for a positive home inspection from the buyer, you will be confident that the home will pass inspection because the town has checked your work along the way.
Permits Are Not That Expensive
In most municipalities, permits are rarely much more than $100-$200. Budget for these permits and expect to pay them. This low cost pays for the permit, as well as the inspection performed by the town building inspection. Consider this an “insurance cost” to avoid any issues with the eventual home inspection. If you find yourself stressing over a $100 permit for your rehab, you need to reassess whether you can handle the game of rehabbing houses.
Conclusion: Become Legitimate
There will come a time in your investing career where you realize that you a “legitimate” business. That is, you run a reputable business that follows the rules. This is an amazing feeling and one that brings pride and peace of mind. Refuse to cut corners when it comes to your rehab projects. Doing so will put you on the fast past to legitimacy and make you proud of the business you have built.
Investors: What would you add to this list?
Leave your comments below!