Knowing capital needs on a construction project is critical to ensure proper cash reserves and interest reserves. Rabbet users can forecast what funding sources are going to be drawn during which months on the project then ensure sufficient interest reserves remain available.
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. Nowadays, it is a requirement on practically all construction loans. On public construction projects, retainage is prescribed 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. But, before we get ahead of ourselves, let’s first define what we’re talking about.
How Does Retainage Work?
Most commonly, the retainage percentage is taken out of every progress payment in the construction process. Taken out of individual installments, retainage does not represent a great burden on the ongoing construction costs, but over time it builds 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. (10% is the standard on public projects.) They can also be scalably 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 – usually after the final release of 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, pay suppliers and subcontractors to complete the work, etc.
A Case Against Retainage
Owners and contractors tend to partially blame retainage for cash flow problems and delays in payment. It is argued that retainage can be abused and can cause disputes and delays in payment when the contractor and the owner have differing views on the project’s completion. This can result in financial burdens for the subcontractors involved in the project.
Since it represents only a small percentage (up to 10%) of individual draws, it is safe to say that any such problems are more likely the result of poor budgeting, planning and process implementation. This problem can be remedied at the very start, through a clear contractual definition of substantial completion and a well-defined timeline for the completion and the release of retainage. Additionally, construction loan software can be helpful with the process implementation and retainage tracking piece.
The Final Verdict
Despite it being commonly considered a “necessary evil”, the fact that retainage has remained to be a type of leverage vehicle 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.
Retainage has time and time again proven to be the best assurance of a job’s completion. Ultimately, any negative effects (wrongly or not) associated with retainage can be prevented with a realistic budget assessment, well defined contractual terms, and effective implementation of processes.