Overhauling the building industry may improve its efficiency and profitability.
For commercial real estate professionals, the past few years have been lucrative indeed. Low inflation, historically low interest rates, and the ready availability of financing have made these the best of times for brokers, developers, consultants, investors, and lenders.
But all good things must come to an end. The credit-market shakeout undoubtedly impacts even the most stable lending institutions. As they become more defensive about their lending practices it will migrate over to the construction-loan side of the ledger. That’s why now is the perfect time for all parties involved in the development process to reassess conventional wisdom relating to how projects are funded and the risks participants take when an owner applies for a construction loan.
In an age of economic uncertainty, when the stakes are higher, it’s time to re- evaluate accepted concepts of how construction projects are carried out. Owners and lenders no longer can accept a status quo in which, as some sources say, 50 percent of all labor costs create no value on a project. They must re-evaluate how projects are managed and cautiously proceed when financing is involved.
A Portrait of Inefficiency
Construction comprises nearly 5 percent of the nation’s gross domestic product, encompassing everything from building and maintaining skyscrapers and bridges to remodeling basements and kitchens. Those projects have employed between 5.8 million and 7.6 million Americans annually since 1998.
However, studies show that between 50 percent and 68 percent of workers’ time is wasted on equipment transportation delays, travel within the job site on hoists and elevators, late starts and early quits, personnel breaks, and workers receiving instructions and waiting for others to complete their work. In fact, only about 32 percent of total time spent at the typical U.S. construction site involves direct work, according to one study.
Additionally, the construction industry is far more fragmented than many in the industry realize. Of today’s 7.6 million U.S. construction workers, 92 percent work for companies with 20 or fewer employees — one of the last mom-and-pop industries in the nation. As a result, the construction field is highly undercapitalized, spends little on research and development to improve productivity, and is the lowest-ranked industry for technology spending. Therefore, the construction industry cannot afford risk and routinely passes all substantial risk back to project owners and lenders.
To avoid bidding too low to win jobs and potentially losing money if real costs turn out to be higher, contractors often limit their geographic reach to areas in which they are familiar with common building types as well as locally available materials and labor costs. Owners and lenders rarely understand this dynamic and then fail to take it into account when seeking funding for a new project.
Furthermore, nearly every construction company is vulnerable to market downturns. After laying out funds to purchase materials and advance labor costs, small companies have little ability to weather a cash flow crisis if a large contract runs into delays that threaten payment. Owners facing financial difficulty often delay payments to contractors who in turn delay payments to subcontractors. Facing payments for materials and labor costs, subcontractors put fewer workers on the projects to minimize cash flow needs. As a result, owners — trying to minimize their own cash flow needs — fall further behind on projects’ completion dates and extend construction loans, which add carrying costs and jeopardize investors’ anticipated profits.
In addition, construction represents considerable risk to financial institutions. Lenders acquiring unfinished facilities must reassemble the project team or pull together a new one that will charge a hefty premium for inheriting responsibility for the previously completed work. Moreover, a default on a facility may result if a problem occurs, such as foundation issues or anticipated unprofitability of the future facility. As a result of these uncertainties, construction lending for unfinished facilities commands a premium interest charge compared to completed facilities.
When the Market Stumbles
In growth markets with active construction, these concerns are minimized. But as an economic cycle nears its end, both owners and contractors add premiums to their construction cost estimates to hedge risk. For large, complex projects, the risk grows progressively as the market conditions degenerate. Unsophisticated owners who try to avoid all risks and pass the construction financing burdens on to the contractor quickly see contract prices increase.
In addition, a contractor’s profits are particularly vulnerable to delays caused by uncontrollable events for which it may not be contractually entitled to recover from the owner. While an owner’s payments may not change during the project, the contractor’s expenses will increase with inflation. For example, steel and other material costs rapidly increased in recent years as construction began to boom in China, India, and the Middle East, increasing competition for these materials. As owners often fail to secure true fixed-price contracts, these rising costs lead to the greater likelihood that contractor defaults will increase during the months and years ahead. Ripple effects include extending final completion dates, delaying the time when facilities under construction can be sold or occupied, and increasing the pressure on undercapitalized owners to find additional funding sources or face the prospect of defaulting on their construction loans.
The stakes — for the national economy as well as owners’ budgets — are too high to allow the industry to continue to operate as it does today. Higher construction productivity would lead to lower construction costs, increased contractor profitability, and thus more opportunity for investment in further productivity improvements — a virtuous cycle. Improving construction would lead to better, safer buildings and infrastructure, such as bridges, highways, railroads, and tunnels, as well as more actual construction. Similarly, lower construction costs would allow an even higher percentage of Americans to purchase investment property. Higher productivity also would result in further improvements in constructing terrorism-resistant structures and sustainable buildings. Perhaps most enticing of all, lower construction costs would result in lower taxes as municipal and state construction projects remain on budget and on schedule.
Indirectly, lower construction costs would ripple through the economy. “The price of every factory, office building, hotel, or power plant that is built affects the price that must be charged for the goods or services produced in it or by it,” according to a Business Roundtable study of the construction industry’s ills. Lower construction costs would allow for better built, less-expensive buildings that could equal lower operating costs and higher returns for property owners and investors.
Thus, the critical issue facing developers and their lenders today is whether the true risks of construction — and the industry’s recognized faults including the enormous waste and the risk-averse nature of the typically small-scale contractor world — have been fully valued in determining the true risk of construction loans in today’s economic climate.
Prescriptions for Success
Too often, construction executives argue that economies of scale are not possible in the building of today’s office towers, hospitals, schools, or shopping centers. However, a large percentage of costs for similar-type buildings are identical from project to project. Yet few construction managers — even those who have contracts to build two, three, or more of the same building type — purchase raw materials such as concrete, Sheetrock, steel studs, and lumber in bulk. Even fewer dare to discuss the benefits of investing in needed technology to improve worker productivity, even though such investments have been highly successful in most other industries during the past 40 years.
Is the problem the process or the participants? In truth, both are hostages to market failure caused by asymmetric information and poor recognition by owners on how to negotiate better contracts with the construction industry.
Market inefficiencies in construction arise from the existence and persistence of asymmetric information. For example, contractors clearly possess superior knowledge over owners. That, in combination with a lack of effective, construction-savvy intermediaries acting on behalf of owners, allows for the perpetuation of mutable cost contracting, where the negotiated contract price is increased through change orders during the course of construction. It also creates a host of other problems that stem from the resulting lack of effective competition in construction: weak and short-sighted management, inadequate education of industry professionals, and meager investment in research and development.
For a number of reasons peculiar to construction, building owners cannot easily compare building price or quality at the start, during construction, or even after the job is done. In fact, most owners cannot fathom the complex process of transforming drawings into usable structures. In most instances, construction managers, who are paid as a percentage of the final costs, set project budgets by reviewing owners’ programs and preliminary design documents prepared by architects and engineers. Rarely does anyone with equal knowledge of material and labor costs effectively challenge the initial budget set by the construction manager. By the time final bids are received — often based on incomplete architectural and engineering drawings — is it any surprise that the initial budget is almost always exceeded? Most inexperienced owners cannot readily distinguish between reasonable and unreasonable contractor bids. Their only real alternative if the contractor’s price comes in higher than the project budget is to reduce or eliminate desired project features. Rare is the contractor who agrees to reduce its profitability for the owner to maintain the over-budget scope of work.
The only true mechanism for keeping contractors within the bounds of a fixed-price contract is to insist that they develop bids from construction documents prepared by architects and engineers that are 100 percent complete and coordinated in all respects for final bidding. Fast-track delivery and other modalities that call for construction to begin before the drawings are fully complete are invitations for cost overruns. There is no basis to achieve any efficiency when the contractors must provide incomplete bids that they know will be revised during the course of the project. The adviser to an owner who suggests proceeding via a fast track for any but the simplest of projects has opened the floodgates and exposed the owner to costly change orders and delays.
To protect their projects, owners also need intermediaries or consultants as knowledgeable about construction costs as the contractors themselves. Without these advisers providing an independent analysis of the proposed line-item costs submitted by the contractors, owners lack a complete understanding of the information necessary for negotiating fair fixed-price contracts. Architects no longer play this role as they have in the past, but those with years of field experience could be up to the task. Project managers who can fully challenge costs and serve as the owner’s ombudsmen are needed to restore a balance of information and create true symmetry of contract information that often is lacking in the negotiation of owner-contractor agreements.
Developers, lenders, and others investing in construction projects will need to be more circumspect in the future about how they fund and manage projects. The construction industry inefficiencies that have plagued real estate project developments can be reined in through tighter contracts, better project management, and the retention of better-managed contractors. Knowledgeable lenders will begin to require more constraints by owners in the years ahead to better ensure their investments’ security, and owners will need to evidence their commitment to run projects more efficiently.