Minimum Bottom Line Profit Should Be > 7%!
After Income Taxes Are Paid!
There are several different construction production styles. The most common is the traditional build and sell style. Here the contractor puts up the capital to build the house and sells the house while under construction. A common term used with this style is ‘Spec’ house. Another style involves shifting ownership of the project to the buyer upfront and the contractor merely runs the project, i.e. ensures it is built properly. This is referred to as a management fee style of construction. The typical contract is between an owner of a lot and a contractor. The owner is willing to fund the project through completion and pay a contractor a flat percentage of the cost of construction as a fee for managing the project. The contractor brings his license, experience and subcontractors to the job to build the home for the owner.
With the management fee style, the question for the contractor is: what is reasonable and fair rate to charge as a percentage of costs to build the home? This article explores how to determine a good rate and the various risk factors that affects this rate. Understanding how to determine the rate is essential to earn a fair and reasonable amount for your services. The reader must first grasp the risk factors involved and customary returns on each respective risk factor between the two most common styles – traditional and management. Once the contractor understands the underlying risk factors, the rate is easier to calculate. Finally, there are some nuances and adjustment factors requiring attention by the contractor in order to determine a good rate. The following sections explain the risk factors involved, proper rate determination and adjustments to determine a good contractor’s management fee.
Risk Factors With Construction
The core element of business is buy low, sell high. The difference is of course profit. Unlike retail or even a restaurant, a contractor must buy a multitude of products/services and address compliance requirements to successfully construct a home. A retailer, buys an item from a wholesaler, marks it up and proceeds to resell it to the end consumer. With a restaurant, it is a little more complex due to mixing of ingredients to sell a meal to a patron. Construction is a whole different world. Here the process is significantly more sophisticated. A contractor must purchase materials and services from many different talents; and time the putting together of these resources to build a custom home. Unlike the restaurateur that must pass simple health inspections, a contractor must ensure that the house complies with architectural standards, meets engineering requirements, passes several local inspections and conform to OSHA safety measures during construction to build a home in accordance with a contract signed buy the end user. There is a lot more at risk here, unlike a $30 meal that if unsatisfactory can be simply thrown away, you can’t just discard a home. It doesn’t work that way.
The risk factors for construction are simply more complex than most other business industries or sectors. Here is a short list of the more common risk factors:
- Market Value Change – Without a doubt, this is the number two profit element in construction (the number one profit element is discussed later in this article). Since construction takes time (in comparison with preparation of food which is figuratively less than a day) to start and finish a home, the market value of the end product can increase or decrease by tens of thousands of dollars during construction. A common time period from breaking ground to receipt of the final inspection with custom home construction is nine months. From the point of signing a contract to finish a home, its closer to a year. A lot can happen in one year, the market value of homes change two to four percent on average per year. Thus, a $900,000 home can decrease or increase $18,000 to $36,000 during construction. With the traditional method, a contractor expecting a 24% profit (approximately $215,000 on a $900,000 contract) could lose $36,000 during this time period. In effect, a contractor could lose almost 17% of anticipated profit.
- Changes in Cost – As stated above, a lot can happen in one year. Shortages of construction materials, skilled labor scarcity or increases in compliance costs can easily drive up the total cost of construction. As an example, when a hurricane hits the United States, the costs for certain materials increase significantly; even the quality of available products change (remember the sheetrock debacle from the early 2000’s?). Other cost drivers include tariffs on certain materials, production delays due to strikes or weather and just simple availability. All of these variables come into play when thinking of the underlying cost to build a home.
- Weather – This is a very common risk element with construction. With home construction, it isn’t as critical as it is with road or bridge construction. It isn’t so much as the delay related to rain, its the volume of rain that customarily causes unexpected damages with new construction.
Other risk factors include cost of capital to build the house, home owner association restrictions, bonding requirements and change orders.
All of these risk factors greatly impact the amount to charge for a management fee. The next section describes the customary profit margin related to the above risk factors between the two styles of ownership.
Construction Risk Factor Values
With the traditional ownership style, ‘Spec House’, a contractor customarily earns between 24 and 27% profit margin on the value of the adjusted contract sales price. Those of you reading this are saying to yourself: ‘What does he mean by adjusted contract sales price?’. For everyone to understand, lets think about how it unfolds on closing day. Let’s walk through this, assume the house is sold for $900,00. At closing, there are other parties that come to the table to get their share of sales price. They include the real estate brokerage firm the contractor uses to list and sell the house, the title company with the insurance policy stating a clean title to the land, the closing agency (commonly a law firm), the home warranty company for their assurance to the buyer and of course the local government for their recording and grantor’s tax. Altogether, closing costs run about 11% of the contracted amount. For this example, it comes to $99,000. This means the contractor actually earns $801,000 at the closing table. This $801,000 is commonly known in accounting as the ‘Adjusted Contract Sales Price’. Other terms used include:
- Net Contract Price
- Adjusted Sales Price
- Contractor’s Net
The key is that a reasonable profit margin is oriented on the net closing amount for the house, not the gross sales price or actual contract amount. If you use the actual contract dollar value, then a contractor’s typical gross profit margin under the traditional ownership style is 27 to 31%. For the reader, the author uses the adjusted contract sales price as the actual proceeds from the sale of the home. Why? Let’s think about this, with a management style contract, who absorbs the closing costs at closing? It isn’t the contractor, the homeowner absorbs all of these costs; thus to compare apples to apples, a contractor must compare the net home sales price profit margin earned by the ownership style to the profit margin under the management style.
Take note, under the management style, none of the risk factors above are assumed by the contractor. They are all assumed by the home owner. Walk through each one and think about it for a moment.
- Market Value – the home owner assumes this risk, the management style has no responsibility for this.
- Changes in Cost – exactly the same as market value.
- Weather – again, the home owner absorbs this risk too.
- Costs of Capital – the contractor isn’t borrowing the money.
- HOA – since the land is owned by the homeowner, he/she has voting rights with the HOA and thus has some control over the HOA.
- Bonding – typically your large developments require the owner of property to post a bond to ensure the home is finished within a timely manner so as not to create blight within the community; as with the other risk factors, the bond is paid by the homeowner. This factor can be shifted to the contractor and it is a common risk shifting element and requires the contractor to post a bond to get the work done. But often contractors in a management contract will not do this as they have NO CONTROL over the funds to purchase the materials and pay the subcontractors. As a contractor, pay close attention to this article in your management agreement.
- Change Orders – change orders are merely cost adjustments to a management agreement. Most management agreements charge a premium fee for change orders, i.e. often change orders require a minimum 30% management fee on change order costs to do the work.
Under the ownership style, the 24 to 27% profit margin must absorb or offset the risk factors identified in the above section to equal the final amount under the management style. Thus all management style arrangements have management fees LESS THAN the ownership style of construction. Each of the elements above are a cost customarily absorbed by the contractor with the ownership style. The following chart breaks out the 24 to 27% profit margin to cover indirect costs to build a home, overhead and the above risk factors. It starts out with the anticipated minimum net profit a contractor expects for work they perform.
Breakout of Gross Profit Margin (Contractor’s Ownership Style)
- Net Profit Desired 7.00%
- Income Taxes/Business Franchise Tax 3.75%
- Overhead (office administration) 2.60% (bookkeeping, business compliance, office operations)
- Project Management 5.75% (includes contractor’s salary, field supervision payroll)
- Insurance 1.30%
- Transportation/Logistics .45%
- Tooling .20%
- Market Value Change 2.25%
- Changes in Cost 1.80%
- Weather .15%
- Cost of Capital .15%
- All Other Risk Factors Combined .25%
Total gross profit margin required for a contractor on the adjusted contract price in order to make a reasonable profit is 25.2%. For the reader, let’s look at some math here to appreciate the above formula:
Adjusted Contract Price $801,000
Cost of Construction @ 74.8% (the difference) (599,148)
Gross Profit Margin @25.2% $201,852
Indirect Costs of Construction:
– Project Management (5.75% of adjusted contract price) 46,058
– Insurance 10,413 (Builder’s Risk, Errors & Omissions, Worker’s Comp, General Liability, etc.)
– Transportation/Logistics/Tooling 5,207
Accounting Gross Profit $140,174
Overhead (Allocated Share) 20,826
Operational Profit $119,348
Income/Franchise Taxes @ 25.17% of Ops Profit* 30,038 (3.75% of Adjusted Contract Price)
Net Profit with Risks $89,310
*20% Federal Income Tax/4% State Income Tax/1.17% State Franchise/Local Business License Tax
Take note, the net profit is exactly 11.15 percent of the adjusted contract price. Thus a contractor with this ownership style is expecting about 4.15%** in costs to cover all the risk factors identified above. Thus, on a $801,000, the contractor is expecting about $33,242 of additional costs related to the risks of construction. This is a reasonable expectation. Think about cost adjustments for materials and subs throughout the year. What if the bank increases his loan interest rate one quarter of a percent, this will cost the construction company upwards of $1,400 of additional interest during the construction period.
** The difference between the breakout amount of 4.6% for risk factors in the table above and the 4.15% here relates to the basis used with the formula.
With business, risks are absorbed by the net profit. If risks happen, the net profit is reduced. With the ownership style of business, the value of these risks are going to be different each year and with each project the contractor is engaged to build.
With the management style of construction, the indirect costs of construction and overhead continue to exist. If anything, the overhead increases slightly due to additional compliance requirements customarily found in the management style arrangement. However, the risk factors pass to the homeowner and are no longer a component of the contractor’s business model. Thus, the management style fee is about 4.5% less than the desired gross profit margin under the ownership style of construction.
Therefore, a reasonable management fee to build a home is between 19% and 22% on the adjusted contract price.
Adjustment Factors to the Management Fee for a Contractor
This is the point where every reader out there is going to go bonkers. I just said, a reasonable management fee is 19 to 22 percent of the adjusted contract price. However, most contracts are written that the fee is paid on actual costs incurred, NOT ON THE ADJUSTED CONTRACT PRICE!
With the example I am using, the costs of construction are $599,148 and not $801,000. Thus if the management agreement states 20% on costs, the contractor will earn $119,830. From the job profit report above, the contractor wants $201,852 to cover his indirect, office administration, taxes and profit and risk. If you eliminate risks, the contractor needs $168,612 to cover costs, taxes and provide a reasonable 7% profit. Yet, 20% on costs only provides $119,830 of cash, a shortfall of $48,782.
How can this happen?
This is the number one adjustment factor a contractor must take into consideration. The management fee is on costs, not the adjusted contract price. Thus the management fee rate has to be higher to result in the same cash required to cover costs, taxes and profit. In this case, the contractor needs $168,612 of cash to cover all costs, taxes and earn a reasonable profit similar to the ownership style. Therefore, the formula to step up the percentage is as follows:
Costs Needed $168,612 = 1.407
Actual @20% $119,830
The actual management fee must be 28% on costs to mimic the traditional ownership style of construction without risks.
This is the mistake almost every management fee contractor makes when drafting their management fee contract. The most common fee I read is 18% on costs. Every contractor I have worked with using this formula never makes a reasonable profit. Let’s walk through the math to understand why:
Management Fee @18% on costs of $600,000 $108,000
Indirect Costs of Construction:
– Project Management 46,058
– Insurance 10,413 (Builder’s Risk, Errors & Omissions, Worker’s Comp, General Liability, etc.)
– Transportation/Logistics/Tooling 5,207
Accounting Gross Profit $46,322
Operational Profit $25,496
Income/Franchise Taxes @ 25.17% of Ops Profit* 6,417
Net Profit without Risks $19,079
Everyone reading this will scream out, hey Dave, $19,079 is a 17.66% profit on earnings. I agree, HOWEVER, go back above to the profit under the ownership style of construction above. Once you subtract out costs of risk, the bottom line profit for the contractor is $56,070 (7% of $801,000).
Look at the two styles adjusted for risks:
. Management Fee Ownership
. 18% on Costs 20.00% on Adjusted Contract Sales Price
Earnings $108,000 $160,200
Project Management 46,058 46,058
Insurance 10,413 10,413
Transportation/Logistics/Tooling 5,207 5,207
Overhead 20,826 20,826
Operational Profit 25,496 77,696
Taxes @25.17% 6,417 19,556
Net Profit $19,079 $58,413
Net Profit % 17.66% 7.30% (as a percentage of Adjusted Contract)
Both styles are exactly the same. How so?
- No risk in either style, remember we adjusted out risk under the ownership style;
- It takes the exact same amount of time to build the home;
- The contractor must invest the same number of man hours to ensure the house is constructed in accordance with the plans;
- Negotiation w/the homeowner for the contract takes the same amount of time:
- All logistics, insurance and on-site supervision costs are the same.
Take notice, the ownership style puts $39,000 more in the pocket of the contractor. In order to be equal, the net profit for the contractor must equal $58,413. This means, at the operational profit point, there must be another $52,200 of earnings on the top line (taxes adjust the net profit increase to $39,000). Thus, the management fee on costs must be $160,200. For this to be true when costs are estimated at $599,150, the management fee must equal 26.7%.
This is the true management fee a contractor must charge under the management style in order to match the ownership style.
Why is there such a huge difference between the return on investment between the two styles if the management fee is 18% on costs?
Definition of Investment (The Primary Element of Value Between the Two Styles)
The key is that under the ownership style, there is more to this than just the time investment. Under the ownership style, the contractor invests his own money, often $50,000 to $100,00 and borrows the balance from the bank to pay the $600,000 of costs. Thus, there must be a return on the capital investment and the relationship investment the contractor creates with the bank. This means the contractor under the ownership style is desiring and additional $52,200 to compensate for the risk of capital. Is $52,200 a reasonable return on a capital investment of $100,000 and the borrowing of $500,000 from a bank?
That is up to you. I would emphatically state that $40,000 is a minimum reasonable expectation, anything less than that may be too risky given the duration of the project (remember the longer the project turnover the more risk one assumes) of nine months. Once this value exceeds $70,00 then it is getting to be excessive. Thus $52,200 is reasonable.
Key in on two important points:
- The ownership style requires investment of capital and the ability to borrow money whereas the management style does not.
- Both styles are equal with regard to time investment, have differing risks and similar conditions.
Therefore, any contractor involved in the management style of construction must have a floor for their fee and adjust the fee higher depending on the risks associated with construction. The floor rate must never be less than 18%, I would argue 20%; however, based on my experience in contract negotiations, only elite builders (ones with really highly skilled subs etc.) can charge more than 21%. The best I’ve seen is 24% but this was driven by a shorter window of time to complete construction. In effect, the contract gave him seven months to get the house finished or penalties accrued.
Let’s look at some nuances involved and what kind of adjustments you need to make to the floor in order to compensate you appropriately.
Nuances and Adjustment Rates
There are seven core nuances involved with the management fee and each has their own adjustment rate. All of the nuances stated can only increase the management fee rate. Thus, when drafting your management agreement, consider all seven and how much to adjust the fee rate higher.
- Time of Completion – The shorter the window, the greater the fee adjustment. My experience is adjust the fee higher .25% for every week reduced beyond a reasonable construction period. Thus, if the contract is 8 weeks less than a normal time period, then your management fee must be adjusted 2% higher.
- Unusual Construction/Architectural Issues – Any odd or abnormal construction issue is going to demand more of your time. For example, instead of asphalt shingles, suppose the roof requires a slate roof. This automatically triggers additional engineering work, additional roofing structure to accommodate the additional weight and the engagement of an unknown vendor. I would add a .5% increase to the fee rate for every unusual issue that obviously exceeds $10,000 in value. In one case, the contractor had to build a retaining wall to hold back an additional 5′ of earth heading backwards at least 35′. This was definitely something abnormal and thus the contractor increased his fee rate .75% to address thus uncommon construction issue.
- Change Orders/Upgrades – Most management agreements exclude change orders and upgrades and they are priced separately. Better arrangements allow for up to $25,000 in changes without a fee adjustment. Any aggregated value change added 10% to the fee structure for those costs associated with change orders and upgrades (thus a 18% management fee plus 10% on costs for the change order). The simple reality is that change orders do take time, some are easy but most require a lot of time input by the contractor to get it right.
- Use of Contractor’s Capital – Many management arrangements require the home owner to place in trust a minimum balance of $50,000 allowing the contractor to pay subs and materials without using the contractor’s money. If the contractor is fronting any monies, the fee structure must be adjusted to provide a return on the fronted capital and of course a return on the investment. The better additional clauses in the contract related to using contractor’s money stipulate a separate 15% fee for any monies fronted by the contractor no matter the time period to get reimbursed.
- Lien Release Documentation – Many home owners want every sub to document and sign lien waivers upon payment. This includes suppliers. If the contractor is responsible to track and get the appropriate signatures, there is going to be additional administrative costs. Adjustments with the fee rate is between .25% and .5% for this aspect depending on the anticipated number of waivers to build the home.
- Assumption of any Construction Risk Factors – In the first section above, I covered the typical risk factors home contractors face. If the home owner desires to pass any of those risk factors to the management agreement, the fee rate must be adjusted accordingly based on the values I determined above. Since those adjustments were based on the adjusted contract sales price and not costs, I would multiply the risk amount by a factor of 1.5 and add this to the fee rate. As an example, suppose the homeowner wants to pass the bond requirement onto the contractor, naturally there will be more costs for the homeowner to bear, but in addition, the risk is now assumed by the builder. This risk amount is about .075% on the adjusted sales price. Thus, the management fee rate must be bumped up .1% to compensate the contractor for this additional risk.
- Home Owner Personality – This one is the scariest of all the nuances. I’ve seen contractors work with some really good folks and in a few cases, home owners that were notoriously litigious. Listen to how the potential client communicates, hear their past experiences and how they dealt with the circumstances. Most importantly, understand the relationship between the two spouses, does he dominate or does she dominate or do they have an agreeable back and forth discussion when dealing with the particulars over the plans. Does one listen and the other appears bored by the discussions? Any outward signs of disagreement between them or the lack of interest to listen to your points related to construction issues is a key indicator of a rate adjustment. In one situation, after three meetings, the contractor politely excused himself from being considered because he knew it wouldn’t work. He actually said to me, ‘I want my competition to take on this couple as he’ll never make a nickel, it might even put him out of business’. This is one way to eliminate your competitors.
All of the above require an increase in the management fee. In my mind and based on my experience a reasonable management fee is 19 to 20%. Of course 20% is the most common economic decision point by most home owners. They think they are getting ripped off at that rate. Therefore, it is important to bring up good examples of how your subs are not only skilled in what they bring to the table but how they work with home owners to ensure a good quality product at the end of the day. Sell the quality of your subs and you will sell yourself. They will justify the 20% fee rate or more. Remind the homeowner that for $120,000 in fees (20% on $600,000), you are investing along with your site supervision close to 750 hours of time. Furthermore, you are providing insurance, equipment, administration and knowledge/resources to the project.
Good luck and please let me know how about your experiences and issues you faced using the management fee style for construction. Send me an e-mail firstname.lastname@example.org. ACT ON KNOWLEDGE.