Power Parity in the Development and Construction World

The Myth of Developer’s Business Superiority

One myth we see often in our industry is that many developers believe themselves superior to general contractors, looking down their nose at an industry which must get its hands dirty and actually manage physical labor. This can take a few different forms, and stems from both societal bias and a complete lack of understanding of the construction industry. We raise this for consideration to ensure our developer clients understand the pitfalls associated with these attitudes, which can result in negative impacts from simple friction between firms and significant monetary loses, and for our construction clients to be wary of their own clients who may harbor such attitudes and consider steering clear. First, to address the societal bias, in our society, white collar work has (unfortunately) garnered a veneer of higher status than that of blue-collar work. This is clearly evident in the ways our schools push kids to attend colleges over trade schools, whether or not this may be well suited for them as individuals, despite the fact that many tradesmen now earn six figure salaries vs. the Starbuck’s barista with a degree in journalism. Also in our society, it is generally considered higher status to be closer to money and power. As developers sit one rung below banks and investors, with whom they deal frequently in order to fund their projects, this places them closer to and in frequent contact with the providers of capital, of whom many developers are envious. General contractors, on the other hand, are often family businesses and are either self-funded, or more frequently in recent years, operate under an ESOP structure. While they may rely upon bank lending for some of their capital needs, such lending is typically limited to needed equipment purchases as there is little other underlying collateral for a bank to provide the kind of massive leverage enjoyed by developers on their projects. This is even more true for the underlying class of subcontractor businesses, which sit below the general contractor in this perceived hierarchy. This can give a developer a false impression of their own importance within that hierarchy, and they may consider that as the client and the benevolent steward who has generously selected the general contractor to whom they direct funds, that the developer is to be afforded greater status, and their will should always prevail. Second, another dangerous bias we have seen with some frequency is that of the superior business intelligence of the developer. Clearly, development being such an incredibly challenging and complex field, involving a sophisticated understanding of capital markets, market rents and/or sale values, land use restrictions, zoning, governmental approvals, etc., surely any developer should easily be able to manage (either directly or indirectly) a construction business. This can lead to yet another significant pitfall which is at a minimum a lack of understanding of the power parity between the developer and the general contractor (and its subcontractors) or worse, the decision by a developer to attempt to build general contracting in house without proper planning or understanding of the industry. The truth of the matter is that these are both hugely flawed arguments based in hubris.

Follow the Money

As states earlier, developers have a tendency to get heady about the size of their deals. It is easy to see why. Development deals nearly always require millions of dollars to execute. They also tend to use the highest possible number when talking about their deals, while sometimes citing total project costs, they may also invoke anticipated profits to project even greater significance. However, the actual amount of revenue a developer is likely to receive for each of their projects is a far smaller number. Typically, a developer may take an acquisition fee of 3% of total project costs and a developer fee of an additional 3%. They might, depending on their size and sophistication, take a fee for construction management (not to be confused with the general contractor’s fee) and for property management (if self-performed). While developers will receive a significant upside in the case that the project exceeds its proforma, they may also suffer considerable losses if the reverse occurs. Therefore, the true amount of revenue a developer receives is likely to be only 6-10% of the total project costs. Their profitability is also a function of how well they manage their internal management of these functions, whether their deals perform better than proforma projections and how many deals must be written off being for being unable to close.

The hard costs under the general contractor are typically around 80% of the total project costs and general contractors score their revenue based on total contracted work. This is an odd way to book revenue for most businesses as typically ~85% of these contracts typically pass thru to the subcontractors (assuming minimal self-performance by the general contractor). Therefore, assuming a 100% passthrough on these on all subcontractor hard costs, these contracts would provide a true top line revenue to their business of only around 15% of hard costs. This 15% is typically made up of general conditions (which may be thought of as project overhead), insurance costs and fee. Many equate the fee with the general contractor’s profit, but this is inaccurate as the fees they receive from all their projects must also support central corporate overhead costs, which can also include pre-construction staff, marketing, accounting, etc.

So what does this mean?

What it means is that the developer more often than not will obtain less revenue on a given project than will the general contractor (15% of 80% is still greater than 6% of 100%). Yes, the developer has greater potential upside, and may make significantly more, but they may also have to absorb losses on other projects which fail to meet proforma expectations.

OK, But We Are The Client!

While we are similarly not advocating being a complete pushover with your general contractor, we believe a better understanding of the industry will help explain where power truly lies within a given relationship. This should also help to explain some of the challenges of internalizing general contracting. Nearly all successful businesses rely upon a steady stream of cash flow. This is a particular challenge in the development world as the deal flow tends to be “lumpy.” While a general contractor assembles a team for each given project, these team members are not just sitting on the sideline waiting for a call. General contractors must keep their employees actively working on projects or be forced to lay them off. The same can be said for subcontractors. Therefore, general contractors must maintain a sufficiently large client base to ensure they have enough work for their employees to be fully utilized. Even for those developers who close on several deals a year and believe that their steady work should result in outsized loyalty by their general contractors, this is true but only to a point. If a developer fails to close on a deal or even temporarily walks away from a given market, the general contractor has no choice but to fill any void with work from other developers to the detriment of any existing relationship.

Consider a developer who consistently closes on a single $30M deal per year, but these projects typically require 18 months to complete. Let us also assume that the developer’s CFO has insisted that a general contractor must have performed at least $100M in revenue per year to be “qualified” (generally, this type of requirement is designed to ensure a general contractor is less likely to fail financially during construction and has experience with larger projects of this nature). This means that a general contractor must have 5 similarly sized projects going at any time. Therefore, our developer will contribute only 20% of the general contractor’s revenue for a given year. Certainly, a significant amount, but what if three of the other five projects are from a different single developer? Which client is more likely to receive the general contractor’s full attention? Their high performers? Greater leeway on change orders? What if the general contractor’s revenue is $500M per year or more? A client contributing only a single $30M deal will likely not receive optimal consideration.

This same fragmentary analogy can be expanded to subcontractors and suppliers. Developers often look at their top line numbers and believe they have considerable purchasing power in the marketplace. Frequently this is not the case. For instance, let’s assume our developer closes on ten $30M projects annually, a whopping $300M! Well, except the hard costs for these projects is only $240M, but still, that is a lot of buying power, right? The developer is looking for ways to save money and has decided to cut its own deal for plumbing fixtures and buy direct. The plumbing subcontract is budgeted at 8% of total project costs, so $19.2M. But this number includes the subcontractor’s own overhead and profit. Also, the developer does not believe that they will have any advantage buying commodities like pipe or fittings. Assuming the overhead and profit of the subcontractor is 30% and the commodity materials make up another 30%, the developer should have ~$7.7M to negotiate a deal with their preferred plumbing fixture manufacturer. That should be enough to enable some discounting, for sure. But lets look at it from the subcontractor’s point of view. To remain efficient, a subcontractor must often have even more clients than a general contractor. Also, much in the same way a developer might require a general contractor to have a minimum annual revenue, so might the general contractor require this of a subcontractor to be qualified. Therefore, if the subcontractor performs 10 or more projects per year of similar size, they are likely to have the same purchasing power as a developer. Or another way to look at it is that a plumbing subcontractor whose annual revenue is $20M will likely purchase ~$8M in fixtures per year (the same number as the developer’s outsized buying power). One could assume that client’s specifications on these projects might divide the subcontractor’s purchasing power between a few major manufacturers, which would admittedly dilute their purchasing power. However, let us assume that the subcontractor prefers Moen over Kohler and Delta, and as part of their strategy to win bids, often will bid low and then submit a request to use Moen as an alternative. Let’s assume that was the manufacturer our developer cut their deal with anyways. What if we also assume that the plumber does $40M in revenue and is successful with their alternate strategy 50% of the time. Who is likely to have greater buying power (and loyalty) from Moen?

One final consideration is how the power dynamic can also work the other way. As we have already established, the general contractor controls precious little of the direct hard costs as 85% is actually controlled by the subcontractors. Additionally, the developer has even less control by giving up 80% of the project costs to a single general contractor. While the general contractor theoretically “works for the developer,” the general contractor wields a great deal of power in practice over the developer in whose faith the developer has placed his fortune. Therefore, it follows that given the relatively small margins as a % of the entire contract amount, that a significant cost overrun in just one part of the project can result in wholesale collapse. For example, many may recall the significant and historically unprecedented run ups in lumber costs post pandemic. One of our developer clients was faced with this dilemma on three projects under construction, all with a single general contractor. This was a favored general contractor, who by this time received nearly 60% of its revenue coming from this single developer. On these projects, they were also operating under GMP contracts. The general contractor had, in turn, hired a framing contractor responsible for direct purchase of the lumber. Unfortunately, the framer had opted to gamble on lumber prices going down and failed to lock in pricing at the start of these projects. When it came time to start framing the projects, the subcontractor threatened to walk away, despite the general contractor having a payment and performance bond in place, and if forced to comply with the bond they would file bankruptcy. On paper, it would appear that the developer had mitigated all of their risk, by having a GMP contract and the general contractor having a bond in place. However, executing on a payment and performance bond is an exceedingly slow process. Normally the threat of executing on a bond is sufficient to scare straight a wayward subcontractor, but not if doing so will collapse their business. By the time a new subcontractor would have been found, and the bond could be effective, the projects would be months behind, costing the developer precious time and revenue. Drawing a hard line with the general contractor would not just have negatively impacted these three projects but would have also soured the relationship to such an extent it would have impacted other projects one which the general contractor and developer were working, including those in preconstruction on which the developer relied upon the general contractor who had proven effective on obtaining below market pricing. In this situation, who has the real power? Had the losses been even greater, or the bond not been in place, what would the developer do if the general contractor was also forced to declare bankruptcy. Ultimately, the parties negotiated a settlement in order to keep the projects moving.

Conclusion

What we hope this article has conveyed is that the relationship between a developer and a general contractor is far better seen as a partnership of equals. The skills and risk mitigation of a quality general contractor should not easily be discounted. Developers are also rapid to both hire owner’s representatives to manage their general contractors and just as easily blame them for issues which arise from a strategic misunderstanding of the general contractor’s world and everything, they must manage effectively for a project to just meet expectations. No one enjoys when unforeseen circumstances negatively impact a project’s schedule or budget, but developer’s too often shoot the messenger and fail to look inward at how early decisions they made may have contributed to the outcome. Again, we do not advocate being a pushover for every issue the general contractor might attempt to extend schedule or obtain a change order. However, managing these relationships combatively or dismissing the street smarts a general contractor must employ to ensure their own business’s success should not be underestimated. Developers will be best served by spending considerable time evaluating a general contractor to ensure their values and track record align with the needs of the developer and then brutally honestly (and internally critical) reviewing the root causes for any variances between preconstruction expectations and actual outcomes.