Right now I am organizing a design build vertical construction retail project, in the middle of a design build civils project (yes they do exist!), and recently was looking at hiring subbies direct versus main contractors on a luxury apartment project. Prior to that I ran a vertically integrated development and construction company doing 200 to 400 mult-unit homes a year. AND over the last five months on behalf of construction company and developer clients have looked at hundreds of CV’s and have interviewed dozens of Project Managers, Site Managers, Commercial Managers, Quantity Surveyors – and all the key roles that comprise ‘construction’ – so have a few different perspectives on this subject.
BUT back in the day the first development company I worked for was a private developer who had started out (as many do) by renovating individual homes and flipping them. Although he was an ex-real estate agent he now acted as main contractor, directly employing subcontractors. As his company grew and he moved into multiple-dwelling new build terrace projects he hired a construction manager, then two of them, to do all the management of the building work. This is about the time I came aboard. The next project was a larger and more complicated apartment project and the decision was made to use an external main contractor. Over the next few years the projects became larger and more complex and there was no longer any work for in-house construction managers as everything was done externally.
This is a common pathway for a private developer — start out building yourself and then pass on construction to external main contractors. This is not the only journey though. Some developers go down the spec (as in speculative) builder route. Buying land or developed sections with a construction team in-house and then selling completed homes, shops, offices (or whatever development product). Others grow into large construction companies and then diversify into development companies, becoming a similar one-stop shop.
Once again, it does depend how you are currently set up. Are you a developer or a developer/builder? To explain the pros and cons of in-housing versus outsourcing construction, let’s take the example where you are a developer who intends to also adopt the main contractor role — i.e. in-housing construction.
Essentially you need to set up a construction business. The most important first step is to hire someone who has experience in running a construction business! The business will require systems and processes. At a minimum you will need to fill the roles of a quantity surveyor/cost estimator and a construction manager. Maybe they can be the same person if it’s a small project. Preferably their experience includes the type/scale/value of project you are taking on. You might need a site foreman (the hands-on site guy or gal) and an assistant or two. That’s the minimum for a small project (like a 10-unit terrace home development). If it’s a large project you can be talking about dozens of directly employed staff. Significant back office financial management resource will also be required. The question becomes do you have the fortitude to go down this track?
To help you answer that you will need to weigh up the reward versus risk dynamics. And by dynamics, I mean the plethora of issues that can easily sink your new construction business and sink your project. You haven’t inherited this project because the previous contractor went broke, have you?
The main reward is obvious. You grab the contractor’s profit margin. This could be anywhere from 4% to 15% of the total construction cost. All the costs to run the construction business, including salaries and office expenses, are typically paid by you anyway. Whether it’s in-house cost as described above or passed on to you in a tender via the Preliminaries and General expense item. There might be a small percentage saving here as well if you in-house, albeit for a single project you will have initial set-up costs to first absorb.
Other benefits are control, flexibility and legal simplicity. I have grouped these together because they all act in unity. Using an external main contractor means a main construction contract. A construction contract creates an adversarial relationship. Changes and mistakes can be painful, expensive and litigious. If you build yourself, you don’t have to endure such a relationship. It’s not like you are going to charge yourself an exorbitant extension of time claim.
On the other hand, the risks of in-housing construction are numerous. Firstly, let’s look at the risks that are a function of company-wide experience (or lack thereof):
- Will the bank let you do it? Your funding line might be contingent on getting a fixed price contract from a reputable contractor, a performance bond and even a tripartite agreement.[1]
- Staff turnover. Project managers, construction managers and site foreman become recruitment target commodities when construction markets are buoyant. If you have created a construction business for a one-off project, then near the end of the project you need to make sure you retain your key staff. Six months out from completion they will be looking for their next gig.
- Pricing mistakes. In a new company one of the biggest risks is incorrectly pricing a job. The person doing the cost estimating is new. Subcontractor and supplier relationships are new — trust is yet to be established. It is more difficult to simply ring someone up and get an indicative price. With all the new business systems being set up, the business focus may not yet be on pricing accuracy. Further, to make it all work you might suffer from optimism bias.[2] This issue hit a construction company specifically set up to work on a development I was involved in by our joint venture finance partner.[3] They were optimistic on their pricing. It went downhill from day one, including miscalculating quantities and appointing site management without the requisite experience. Effectively the development made money, but the contractor went broke, on their first project.
- Subcontractor and supplier management. Beyond all the skills, systems and processes required to manage a construction project an established company has trusted enduring relationships, sometimes through thick and thin market conditions. History shows whose pricing you can trust, or who is variation hungry. You know who will maintain capacity for your job and who can return a quick but reliable subcontractor tender price. When the going gets tough during, you can appreciate who will stick it out, who will absorb price inflation and who will solve problems on their own. Similarly, the subcontractor also has trust in the main contractor, that they will get paid on time and change requests will be dealt with justly. When setting up a construction business from the start, none of this exists. Even if the people you hire say they bring all these subcontractor relationships with them, the very fact it is a new entity will dilute that trust. This can easily mean you will pay more for work and encounter more teething problems. Yet another area where a very experienced person at running a construction company is paramount — don’t promote someone into this role flippantly. Consider an old head on broad shoulders.
- Cashflow management. If you hire a main contractor, then you will have one construction related payment claim to process each month. You will have an estimated cashflow and know approximately what that amount should be. If you run construction management in-house then you take on 20 to 50 new suppliers, each with their own payment claim, complete with variations and mistakes. You must vet each claim when you pay them, and you might have to pay them out of sync with your funding. Software will help, but cashflow management is an important and difficult aspect of running construction.
Then there are the risks that a main contractor takes on that a developer can (try to) contractually opt out of. These present reasons to consider outsourcing construction if you already build in-house:
- Unfixed price. If you are a developer, typically you strive for a fixed price from your contractor. If you are the developer/contractor then you will wear any cost inflation, pricing mistakes, onsite measurement mistakes and the like. You might be able to fix some of the prices with your subcontractors down the line, but that is not always possible.
- Legislation. Building codes change. Changes need to be interpreted and implemented. This can happen mid-job. You may find that a new ruling means inspectors look at details differently. One of our contractors had this example, overnight, even with a building consent stamped, the inspector decided a bracing detail needed to be modified. It required a lot of rework (and dollars) from the main contractor (who did try and blame the engineer’s inspections), but at the end of the day it was the main contractor’s responsibility.
- Cost inflation. This deserves its own bullet point. When the market is busy costs can rise quite rapidly. If you are a developer with a fixed price contract, or a schedule that has fixed rates for each element, then you are contractually protected, for the entire duration of the contract. For the main contractor, suppliers may only hold pricing for a few months. Subcontractors, even if they have fixed the price, may be prepared to just walk away from their commitment and leave nothing worth you legally pursuing. Now, occasionally, it works the other way. For example, a main contractor acquaintance priced a government prison job and agreed to a fixed price. This was just before the global financial crisis. During the three-year project, their input costs from primarily unfixed subcontractors steadily reduced (there wasn’t a lot of other work on). The government price was fixed so the contractor’s margin increased.
- Liability. As the main contractor you are usually the first port of call when something goes wrong. At least when you are the developer only, you can (try to) blame the builder. Contractors have increasingly complex and stringent ‘health and safety’ obligations. There are also practical items to deal with like contract works insurance (in case construction catches on fire), employee safety and site security.
The other main reason why you
might outsource construction is when you lack the experience in the type of
project you are about to embark on. If you are an experienced residential home
builder, but now grab the opportunity to save a commercial office project, the
skill base in your existing team may not suit. Or the project may simply be too
large for your in-house construction team.
[1] A tripartite agreement provides the bank with step-in rights to finish the project if the contractor or developer fails. A good source of failed projects for you to pick up!
[2] You have embarked on setting up a construction business for this project after all, so it must work!
[3] Although the intention was to build other clients’ projects and grow a successful construction business.
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