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FEATURE ARTICLE, MAY 2008
WE CAN CONTAIN CONSTRUCTION COSTS
Reform in the construction industry will benefit not only contractors but also investors, consumers and taxpayers.
Barry B. LePatner
Under present conditions, both the real estate development community and the construction industry are trapped within a broken system. With chronic cost overruns and delays, the inefficient way we build today is constantly draining the value of real estate investment. By understanding the factors and forces that sustain the dysfunction that pervades America’s construction sector, we can all start focusing attention on specific steps to ameliorate the problem.
For real estate developers, the construction industry’s structural inefficiency carries a hefty price tag, especially in today’s era of economic uncertainty. Based on research collected from an extensive range of sources, projects that perpetually run over budget and behind schedule cost developers and owners more than $120 billion annually — more than 10 percent of the overall volume of construction work performed each year.
It is a big challenge, but America has never shied away from big challenges. Reform is within our reach. We can fix our country’s broken construction sector in a way that will ultimately benefit investors, consumers and taxpayers, as well as the construction industry itself.
Fragmentation, inefficiency and “mom-and-pop shops”
Contrary to popular belief, the construction industry is not composed of large companies, each staffed by hundreds or thousands of workers. In fact, this $1.23 trillion sector, which accounts for nearly 5 percent of the nation’s GDP, is highly fragmented. It is truly the last “mom-and-pop shop” niche in the nation.
Most construction firms are sole proprietorships or small business corporations. In essence, they are mainly individuals serving as subcontractors to take advantage of business tax deductions and limited liability. Tiny shops are the norm. Of the 7.6 million construction workers in the United States, 92 percent today work in firms with 20 or fewer employees.
Consequently, the industry is woefully undercapitalized. The huge majority of construction firms have meager, if any, resources available for research and development to improve productivity. The industry cannot afford risk, so contractors routinely pass all substantial risk back to compliant owners and lenders. Acting as enablers, owners remain persistently willing to accept risks that should be more naturally borne by their construction team.
Financially unable to invest in productivity improvements, the construction sector ranks lowest in technology spending. As a result, construction companies are highly inefficient, coming in dead last among all major industries in productivity. In aggregate, all other U.S. industries have enjoyed increases in productivity per worker of approximately 250 percent since 1964. In construction, over the same period, productivity has dropped approximately 25 percent, according to the U.S. Bureau of Labor Statistics.
Industry fragmentation contributes to poor worksite coordination. One recent study shows that only about 32 percent of total time spent at typical construction sites involves actual direct work. The other 68 percent is devoted to equipment transportation delays, late starts and early quits, personnel breaks, workers receiving instructions, travel within the job site on hoists and elevators, and waiting for others to complete their work. A recent meta-survey indicated that an average of 49.6 percent of labor-related construction time is devoted to wasteful activities.
Fragmentation breeds contractor vulnerability
The construction industry predominantly consists of a complex mélange of small companies with limited funds. Thus nearly every construction firm is vulnerable to market turndowns. This circumstance can create dicey situations for project owners. Smaller firms characteristically lack the financial reserves to weather a cash-flow crisis if a large contract encounters delays that threaten payment. After laying out funds to purchase materials and advance labor costs, small companies have exhausted their available resources.
If it becomes clear that a project will face financial difficulty and the owner or developer delays payments to contractors or construction managers, the trickle-down effects can be costly. Late payments to contractors mean late payments to subcontractors. Cash-flow pressures to make payments for materials and labor costs quickly add up. As a result, subs will frequently start sending fewer personnel to a project to save money in fretful anticipation of the weeks ahead.
Owners, seeking to minimize their own cash-flow challenges, thus find themselves falling further behind on the project schedule. This triggers a need to extend construction loans, while elevating carrying costs. This syndrome jeopardizes projected profit targets.
Developers should set reasonable benchmarks
Over-spending and delays need not continue unchecked. Developers and owners should immediately reevaluate their long-accepted concepts of how construction projects are carried out, educate themselves about the process and become more proactive in cost management to ensure preservation of investment value.
A developer’s view of the construction process can be shrouded in mystery when it comes to timelines, material costs, and bottom-line dollars and cents. Developers cannot easily compare price or quality before, during or even after construction. But owners and developers can protect their interests by setting a series of reasonable and attainable benchmarks, with the assistance of experienced construction experts.
Improved accountability will translate into myriad positives for developers: lower construction costs, higher productivity and more opportunity for the kind of investment that delivers a more profitable outcome. Building tenants would benefit from better and safer buildings — and taxpayers would enjoy a better and safer infrastructure.
Use intermediaries and fixed-price contracts
To maximize the value of their investment, developers must embrace the principle of “knowledge is power” as a guiding imperative. But most developers and owners cannot read drawings or distinguish between reasonable and outrageous contractor bids. A gaping asymmetry of knowledge separates developer and contractor.
Contractors know tremendously more than owners about construction. Bluntly, many developers would not recognize construction inefficiency if they saw it right before their eyes. To balance this chronic asymmetry of information — and protect their projects — owners need intermediaries who know as much about construction costs as contractors and who will serve as on-site watchdogs of the developer’s interests.
Also, developers must resist the temptation to cut corners by defaulting to “standard form” contracts. They should demand fixed-price contracts that are agreed upon only after completion of full and coordinated architectural drawings.
Lacking construction-savvy intermediaries and hamstrung by standardized, one-size-fits-all contracts, the development community stands to be victimized by highly mutable costs. Owners are buffeted by persistent and costly change orders. Regrettably, contractors frequently use such devices — unconsciously or otherwise — to make up for revenues sacrificed after winning a contract with an excessively low bid.
Yet even with fixed-price contracts, developers need advisors who can independently analyze proposed line-item costs submitted by contractors. Otherwise, if the contractor’s price comes in over budget, an owner’s sole alternative is to curtail desired features of the project. This diminishes marketability and investment value.
The typical absence of construction-wise intermediaries representing the owner helps to perpetuate mutable cost contracting, which essentially destroys competition. Mutable costs also help give way to weak and short-sighted management, inadequate education of industry professionals, meager investment in research and development, and other industry shortcomings.
Cost control delivers broader benefits
By educating themselves — by using fixed-price contracts — and by having qualified and experienced representatives on site, developers will save time and money, making projects more attractive to investors and tenants.
Higher construction productivity would give our society more terrorism-resistant structures and more sustainable buildings. As public-sector construction projects remain on budget and on schedule, lower construction costs would spell lower taxes. For potential homebuyers, less expensive housing would allow a higher percentage of Americans to purchase a home and deepen their commitment to their communities.
Benefits of a newly efficient construction industry would permeate through innumerable aspects of the economy. Lower construction costs would decrease rents. Some of the savings would be passed onto consumers and some would help boost corporate profits. In a country where most people own corporate securities, either directly or through such intermediaries as banks, higher profitably tends to enrich the population as a whole.
We can fix this
Sadly, America’s construction sector has evolved into a unique market segment that seemingly thrives on wasteful overruns. This huge component of the economy is monopolized by managers and contractors who typically control all project-related information, accept little risk and operate unchecked by a healthy fear of being easily replaced.
Developers have the power to take greater control. They can propel long-overdue reform of the construction sector via the recommendations set out above. They can be the catalysts who transform a fragmented and outmoded industry that competes to bid lowest for a contract into one that engages in real competition over the right to build an actual project properly on time and on budget.
The development community can help put an end to the unproductive and splintered nature of this last remaining “mom-and-pop” industry. By demanding that contractors become truly competitive, developers will help drive the kind of consolidation that will open the door to improved productivity.
A competitive construction sector would become smarter, more efficient and more profitable. Through this new approach to building, both real estate developers and the construction industry will come out winners — along with the rest of America.
Barry B. LePatner, a construction attorney and founder of LePatner & Associates in New York City, is the author of “Broken Buildings, Busted Budgets: How to Fix America’s Trillion-Dollar Construction Industry” (University of Chicago Press, 2007).
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