Vertical integration in RE
Someone asked me this question and I just wanted to check my answer.
Why don't more real estate developers bring construction in house (like JDS).
I said it was probably because they didn't want the liability of being a builder but just wanted to make sure I had the right thinking.
It’s not a very high margin business. In my HCOL city, GCs charge a 2% fee (on cost). To many developers, it’s just not worth the headache and risk plus extra staff you need to do with everything that comes from construction. The low fees are also the reason there is so much corruption in construction and the ‘bad’ bills get placed through the General Conditions line item.
The dev fee is 4% and you can have 1 development manager, (maybe 1 associate tied to the development manager) 1 project manager (maybe a junior person too), and your accountant. If you add a GC in house, you need additional staff, but the fee is less. Also if it’s a large enough project, developers can pass back the cost of their salaries for the employee tied to the project. So that increases the developer’s profits further.
100% with pudding....you're taking on a lot more risk and much more overhead for a slim margin. Most GC's/CM's make more money on the insurance side than the fee these days (general liability, worker's comp, etc)
However it's not unheard of for larger development shops to self-perform. Related Co.'s Boston office has built up its own CM division over the past 5+/- years and they do it all from cradle to grave.
You could ask the same question about other aspects of the business. Real estate development is unusual in that the scale of a firm's operations has very little correlation with the number of employees that it has. There are development companies that have only a tiny number of senior rainmakers in house and outsource everything. Others have in-house GCs, OPMs, leasing, marketing, sales, property management, back office, etc.
One downside to doing things in-house is that, once you build up a big team, you need to keep it together. So you may have to start doing marginal, risky deals just to keep everyone busy in a downturn. There is also just the ongoing headache of managing people- turnover, bad employees, etc.
I've found that the personalities of the company's owners can play a role in some of these decisions. Some people are natural performers who like an audience, and they tend to gravitate to hiring people. Others don't want the headaches and like to keep things lean and mean.
I guess I just ask because I'm seeing small firms having construction arms. Granted these are small firms but even a big Dallas firm like Harwood International has a construction arm.
Some firms feel it’s good for them. Others don’t. It just depends on the firm.
It depends a lot on the scale. For example at the large scale end of the spectrum you have firms that can easily get the attention of the large GCs, while the smaller shops have to compete for access to high quality GCs which drives down their returns as they have to pay more. So to bring that in house they can reduce the GC costs, or at least that is what they tell themselves. I am not so sure it actually boosts returns because on a risk adjusted basis their returns are likely lower than if they just paid more for the GC work.
Can you be a little more specific on “construction arm”? Is it an actual GC, going out managing all aspects of contractor relationship/financial management? Or is this a construction management team who oversees a GC/external contractors? Some firms literally own the GC and can control costs and contractors better, so even if it’s a small margin they recognize the value through better or more transparent contracting/management. When I was at Westfield, they had an entire Construction vertical that was a construction management team, that oversaw all GC related functions, but wasn’t the GC. It was to ensure a fixed price contract across a billion plus dollars of construction and multiple projects. They used their expertise to price, engineer and manage every single aspect of the construction process, but werent physically responsible for hiring every trade and negotiating everything. They were experts in the field and were able to “keep the train on the tracks” and roll that up through the separate entity outside of the REIT structure (big time profits)
Smaller companies tend to build smaller buildings, which are less complicated to build. So it's easier to gather the necessary amount of expertise in-house.
I think location is also a big thing. If you are a big developer you are doing projects all over the country. Are you going to stand up a construction team in every metro? What happens to the team when you are done with the current project, are you always going to have an ongoing project in that city? By outsourcing, you hire the team when you need them and can build wherever you want, not just where you have this pre-existing construction team.
for smaller companies that only focus on a small area, it makes more sense.
Dolorum modi error tempora. Et nisi ut consequatur voluptatem. Placeat aut ut est dolorem eius.
See All Comments - 100% Free
WSO depends on everyone being able to pitch in when they know something. Unlock with your email and get bonus: 6 financial modeling lessons free ($199 value)
or Unlock with your social account...