Does Internalizing General Contracting Work for your Business?
Many of our developer clients have either debated the need to internalize general contracting or plunged forward with inadequate preparation, only later seeking our advice and insights into where everything went awry. However, when developers approach a certain scale, internalizing construction operations can appear to be a wise strategic play. While many developers have done this successfully, many more have failed, costing them millions due to any variety of setbacks (inadequate controls, poor procedures, inexperienced staff, etc.). It is critical that any developer considering this massive expansion of their business account for all the risks and, if they still decide to move forward, dedicate sufficient resources and time to set their new team up for success.
The many pitfalls of internalizing general contracting
It is the assumption of many developers who elect to internalize general contracting that doing so will enable them to lower costs and more easily get deals to pencil. Unfortunately, this alone is highly unlikely to be the case. The only way to attain truly reduced costs in construction when compared within the broader market is through greater efficiency. Greater efficiency is only achieved through high volume of highly repetitive projects. Conditions for that level of volume and repetition must include:
More than a single project in a given market (or within a reasonable drivable radius for subcontractors)
Timing of projects so that the same project team and subcontractors may be utilized. NOTE: At times you may hear of general contractors trying to obtain volume discounts from subcontractors and suppliers with two jobs at once. This may result in some savings at buyout but can put additional pressures at execution if both projects are concurrent.
A highly consistent design from one project to the next (e.g., prototypical, discussed further below)
Internal discipline to eliminate design decisions which result in change orders during the construction process regardless of potential enhancement of the project.
The establishment of an internal general contractor is likely to result in higher costs on initial projects until the following has been achieved and any developer proceeding down this path should be prepared not only to invest in the direct costs associated with building the general contractor, but also any potential overages which result from associated growing pains.
The internal general contractor has established a good reputation amongst its local subcontractor base for paying on time, ease of administrative burden, rapid responses to subcontractor questions and being fair during the construction process.
The internal personnel have become familiar with their roles, are comfortable leveraging internal processes to expedite work and feel empowered by the organization.
The establishment of a positive communication feedback loop which focuses on systematic correction of issues (fixing problems for the next project) rather than finger pointing.
Aside from the heavy up-front investment to build an internal general contractor, once established, significantly more staff will be added to the organization. This has an impact on the parent organization’s strategy, specifically markets in which the organization can do deals as staff cannot be quickly hired, relocated, or replaced if deals jump from market to market. It is not uncommon for deal makers to feel hindered with market and timing restrictions, as well as adhering to strategic goals to obtain repeat projects in a single market based on a timeframe set by construction. This can result in internal conflicts that deals cannot be done as a result of these restrictions. This discipline is often difficult to establish and maintain, especially when deal makers have been used to getting deals done their way.
Regardless of whether or not a general contractor is internal or external, their direct costs (overhead, insurance and fee) impact only 10-15% of the budget. No matter how well a general contractor operates internally, it is only through effective management of subcontractors who make up the remaining 85% of the budget will any general contractor be successful.
A general breakdown of costs for a commercial multifamily development as a % of total spend.
Some developers believe they can eliminate other seemingly construction related internal costs, such as Owner’s Representation, if the general contractor is internal. While this may be possible after the internal general contractor has become well established and proven, it is not advisable to do so until this occurs, and high-quality standards become second nature. Owner’s Representation is often conflated with Construction, but the two serve very different functions. An Owner’s Representative will approach projects looking out for the interests of the Owner. Construction personnel, even if employed directly by the development company, will most likely come to the organization with a different view on what makes for a successful project; and are often trained to think first of mitigating risk for the construction entity as well as fighting ownership for change orders to protect their own budget and metrics on which their bonuses rely.
Developers may also believe that establishing an internal general contractor will eliminate other internal support costs or enable them to be spread through the organization more effectively. Generally, this is not likely especially at the start. Establishing an internal general contractor should be structured and accounted for as a wholly owned subsidiary. If there are any shared support costs, rates should be established to enable effective internal cost accounting.
Finally, developers, especially those with a successful track record, can fall prey to the belief that they are “smarter than the average bear” and that they can apply their acumen to other parts of the industry to achieve outsized results. Many who have used this approach to justify building an internal general contractor learned painfully that general contracting is its own industry with highly specialized knowledge which is not easily replicated.
Why internalize general contracting?
So why would any developer establish an internal general contractor?
Increased Control:
No matter how much an external general contractor may prioritize its favored client, their business practices will always deviate to some extent. While cultural alignment between two companies, some amount of process inefficiency and data loss is inevitable. In addition, leveraging external general contractors introduces two primary risks. If the client cannot provide sufficient workflow, they will be deprioritized and not obtain the best pricing, team members, etc. If the client provides too much workflow, the general contractor can become overwhelmed but more importantly the client may be harmed in the eventuality of a management turnover or bankruptcy. Internalizing general contractor operations reduces this risk and affords the developer greater insight into the business and industry.
Potential Cost Reduction:
As stated above, it is possible to achieve significant cost reductions when compared with the broader market if volume and repetition can be achieved. This is not easy to prove empirically, and organizations with internal general contractors will constantly debate whether or not they are getting the best price. Why is this so hard to establish empirically? Because it is not sufficient to merely compare hard bid numbers on a single project. First, hard bidding projects is an extremely poor way to establish the true cost. Only after a project has been completed does one ever know the true cost. Second, hard bidding incentivizes general contractors to cut corners in the bidding process and then later identify scope gaps or other opportunities to achieve a true market price.
If hard bidding projects, and comparing the low bid to the others does not indicate the broader market price, how can it be proven that a strategy of repetition and volume can yield savings? The best evidence for this would be experience from a prior development firm with a true production model, that utilized third party general contractors. As of late 2021, one of these general contractors had built twelve projects (representing approximately 3,100 units) over the course of six years, growing from a single project to five per year. These projects ranged from Minneapolis to Madison to Chicago but were highly prototypical. At one point, we established that our business supplied upwards of 75% of their revenue. For obvious reasons, it was a significant risk factor to have so much volume with a single general contractor and we worked diligently to find any other general contractor who could match their pricing. After three years we remained unsuccessful despite having more than ten general contractors attempt to price.
What creates the conditions for one general contractor to provide pricing so much more competitive than the rest of the broader market? First, we were their largest client by far (though not their only one), so they not only gave our projects top priority but had also optimized their business to conform with ours. Second, we conducted our projects as negotiated bids, ensuring not only that the general contractor would work with us to get the project across the finish line, but that their subcontractors would as well (while they would hard bid their subcontractors to keep them honest, the subcontractor base from project to project remained approximately 75% consistent). While this system was not true vertical integration, it was as close as possible given the dynamics of diversified, independent contractors yet tool advantage of free market efficiencies. The first project this general contractor undertook was plagued with the same kinds of challenges one often sees with the average construction project. However, over time and with each subsequent project, consistency amongst on-site team members provided ever increasing efficiencies. As stated above, cost “reduction” (given an ever- increasing cost environment) was invariably challenging to “prove” empirically in a vacuum. However, the schedule reduction was easily observed. Outside of municipal driven challenges, more recent projects delivered three to four months ahead of schedule (and compared with the standard schedule for similar projects built in other markets by other contractors) while still coming in under budget.
It is possible to create an efficient organization with a fully integrated internal general contractor. However, doing so exposes the organization to risks which, if not effectively mitigated will result in significantly higher costs in the short term and may become systematic and nearly impossible to dislodge.
Strategic Business Considerations
As stated above, executive leadership must make sure that the development of an internal general contractor makes strategic sense for the organization. While the following guidance may need further refinement with additional input on Alpha Residential’s current position and long-term goals, the following recommendations have been based on reaching a stable 2,000 units per year (assuming average project size of 250 units per project and an 18-month schedule from groundbreaking to final certificate of occupancy). Also, the following is based on a project team being fully staffed with a Project Manager, Superintendent, Assistant Project Manager, Project Engineer, and two Assistant Superintendents.
To illustrate what a potential staffing plan might look like to reach a stabilized 2,000 units in four years, please refer to Exhibit 1 attached to this document. This staffing plan assumes building eight teams (consisting of a Project Manager, Assistant Project Manager, Project Engineer, Superintendent and two Assistant Superintendents) in three markets. Following this plan would result in 48 full time project staff by the end of year three. This does not include additional required support staff such as project administrators, accountants, estimators, and senior managers. Assuming an average salary of $90,000, and a benefits to salary ratio of 30%, the project staff alone would constitute an expense of $5.6M annually (again not including support staff) some portion of which may need to be supported in years where insufficient deal flow does not materialize in a given market.
In addition, assuming Alpha Residential reaches 2,000 units before the internal general contractor can be staffed and will necessarily grow using a hybrid model outsourcing some projects to third party general contractors, this can run the risk of straining relations with those general contractor partners as they will be unsure of the viable future of a long-term partnership.
