The Basics of Retainage
What is Retainage?
Retainage is the withholding of a portion of the funds that are due to a contractor or subcontractor until the construction project is finished. It is meant to serve as a financial incentive and an assurance that the contractor will complete the project in a satisfactory manner.
Retainage has been a standard practice in construction projects in the U.S. for a full century. These days, it's a requirement for practically all construction loans. On public construction projects, retainage is required by state laws with fixed percentages and release conditions, while on private projects it is regulated by the terms of the contract.
In the realm of construction loans, retainage is a bit of a controversial term. It is often painted as a burden placed on the owners and contractors by the lending institution, even though it primarily serves to provide added assurance that the construction project will be completed. Let's define retainage and why it's an important part of real estate development.
How Does Retainage Work?
Retainage is typically withheld from every progress payment in the construction process. It's taken out of individual installments to lessen the burden on overall construction costs, but over time, it adds up to provide a strong incentive for contractors to complete their work.
The percentage of retainage withheld is sometimes fixed and sometimes a matter of agreement, but is most commonly set between 5% and 10% of the total approved funds. They can also be defined by the contract with varying percentages withheld for different construction stages.
Retainage is released and the funds are paid out to contractors and subcontractors once the construction project is completed. This usually happens after the final release of a lien has been signed, along with any relevant completion certificates.
Why is Retainage Important?
Retainage remains the most effective insurance policy for the successful completion of construction projects. This is particularly important in the final stages of the project when the contractor could determine that it is financially more viable to simply move on to the next project since there are no retainage funds to collect upon completion of the current project.
Retainage also represents readily available funds in the case of a contractor default. If a contractor is unable to complete the work or meet his financial obligations due to various factors (like frozen assets, fraud, or a lawsuit), these funds can then be used to remedy the default and pay subcontractors to complete the work.
Owners and contractors tend to partially blame retainage for cash flow problems and delays in payment. It is argued that retainage can cause disputes and delays in payment when the contractor and the project owner have differing views on the project’s completion. This can result in financial burdens for the subcontractors involved in the project.
However, retainage represents only a small percentage of individual draws. Often, cash flow problems are the result of the challenges inherent in the real estate development industry. Retainage resistance can be remedied through a clear contractual definition of substantial completion and a well-defined timeline for the completion and release of retainage. Using software like Rabbet Construction Finance can be helpful with process implementation and tracking retainage.
The Final Verdict
The fact that retainage has stuck around for a full century is a credit to its effectiveness. Over the years it has been questioned and modified a number of times, and even today there are various other solutions presented as alternatives. However, most of these alternate solutions look to remedy the perceived disruption of cash flow from the withheld resources and effectively eliminate the financial incentive for project completion.
Many project owners view retainage as the best assurance of a job’s completion. Ultimately, any negative effects associated with retainage can be prevented with a realistic budget assessment, well-defined contractual terms, and effective implementation of processes.
