Road Map for Internalizing General Contracting
As discussed in another article, there are several reasons for a Developer not to internalize general contracting within their business. We highly recommend reading that article prior to this one. In this article we will focus on the potential advantages of internalizing general contracting, as well as providing an outline for implementation. It cannot be overstated that, even when done properly, doing so with a strong plan in place with critical milestones and a realistic timeline is paramount. We too often Developers who have made the strategic decision to internalize general contracting but then do so too rapidly and rush too many projects under a new and untested subdivision of the company.
So, after all of our advice to the contrary, why would any developer wish to 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:
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. Let’s assume a Developer wishes to reach 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) across three markets.
When modeled out, this staffing plan requires building eight teams (consisting of a Project Manager, Assistant Project Manager, Project Engineer, Superintendent and two Assistant Superintendents). Following this plan, assuming a three-year rollout, would result in 48 full time project staff by the end of that year. 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 the Developer 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.
Aside from the fixed overhead costs the parent organization may need to absorb over time, additional strategic considerations are discussed below. Executive leadership should consider each and determine whether or not these observations and recommendations align with their vision for an internal general contractor.
Profit Center vs. Cost Center
Generally, it is best practice that each silo within any organization should be independently profitable. Some developers build their internal general contractor as a cost center, believing that stripping out all extraneous fees will create a leaner organization and lower costs. In practice, I have observed that this approach is flawed. First, basic tax and accounting guidelines on transfer pricing are clear and services charged by an internal general contractor should be structured just as they would be for a third-party general contractor. Second, eliminating the profit motive from an internal general contractor leads to a misalignment of incentives. This is further discussed in the following section regarding contract method.
GMP, Hard Bid vs. Negotiated Bid
It is customary amongst most of the internal general contractors of which I am well aware to use a Guaranteed Maximum Price (GMP) contract, despite being an internal entity. While some developers may believe utilizing a Cost-Plus contract would suffice or even be superior as any costs ultimately are paid for by the parent organization, the GMP provides an important backstop to drive performance of the internal general contractor employees to ensure profitability. These incentives typically take the form of bonuses but also accolades in performance of a job well done. These soft incentives should not be dismissed and can only thrive under a contractual environment which highlights successfully delivering a project under budget and ahead of schedule. The GMP structure has a few benefits from the perspective of the Owner:
· The GMP structure places more onus on the general contractor to manage project risk
· The GMP structure reduces the number of change orders submitted to the Owner, streamlining processes, and reducing conflict between teams
· The GMP structure still provides full transparency for Ownership when properly executed
Additionally, the GMP structure is more common in the multifamily industry, for both third party and self-performing developers with internal general contractors. Enhancing internal familiarity, and aligning internal policies, KPIs and training with this structure will better enable the construction business unit to garner and perform third party business.
One critique which is often levied against the GMP structure is that it can result in “sandbagging” in order to guarantee a project deliver under budget and/or ahead of schedule. While this may be a concern initially, over successive projects any continuously improving organization will learn to dial safety factors tighter and tighter to some reasonable minimum. In fact, given the risks associated with managing projects internally for the first time, it is advantageous that more margin for error be incorporated into the first few projects in any case.
As discussed above, there will be a natural tension between an internal general contractor and the incentives of the deal makers, especially when deals struggle to pencil. This will result in a cry to unhandcuff the deal makers and allow them to hard bid to the market. Assuming Alpha Residential is committed to the internal general contractor approach, this option must not be entertained once the internal general contractor is established in a given market. First, doing so will undermine the strategic vision of the organization. Second, doing so will create more enmity between the deal maker and the construction team. Third, deal makers must be made to understand that (outside of a well-established production model), 85%-90% of the construction cost will be hard bid and to the exact same set of subcontractors. Any significant deviation in total costs either represents the third-party general contractor mispricing the project (which will be made up by change orders during construction) or necessary investment by the Developer to create a competitive internal general contractor.
To successfully create an internal general contractor built for production and will achieve lower than market costs over time, relationship with the subcontractor market are critical. This is discussed further below under the Developing Subcontractor Network section, but for the purposes of this section it is important to highlight that while the internal general contractor should hard bid all subcontracts for every project. However, it is just as important that the internal general contractor work overtime to establish a primary (favored) subcontractor in each trade. While hard bidding should be used to keep each primary subcontractor honest, cost reduction is significantly more likely with subcontractors who continue to go from project to project, improving their own efficiency over time. Subcontractors include their own “sand” when bidding for products they have not yet built, or with general contractors with which they have not yet worked. Much as sandbagging is eliminated over time as discussed above at the general contractor level, the greater savings will be achieved by eliminating this sand at the subcontractor level. Additionally, subcontractors exposed to building the same product over and over again will adapt further, finding new areas of cost efficiency (smaller crew size, employing off site preassembly, reduced waste factor, etc.).
Construction During Entitlement
One error that has been observed with developers building an internal general contractor is to limit collaboration with construction, either in terms of frequency of discussion or by restricting discussions only to senior management. It is best practice to conduct weekly meetings with the entire construction team during the preconstruction process and it is recommended that these meetings be attended by the Owner’s Representative, head of Preconstruction/Estimating (or his designee) and the Project Manager slated to take over the project once under construction. Including the superintendent in these meetings leading up to closing is also recommended. This ensures that team members stay abreast of design changes, municipal driven requirements and other issues which come up during the preconstruction process and will reduce surprises to both the budget and the project team once under construction.
Establish a Business Plan
It is recommended that any Developer contemplating internalization of general contracting generate a business plan clearly outlining the goals for organization as if it were a completely independent business. This plan should cover each of the topics listed below, however, the plan may evolve through the development of subsequent steps in this playbook. Therefore, as discussed further in the Outline of Key Steps, the finalization of the business plan need not occur immediately. Establishing this plan will afford the senior managers hired to build the internal general contractor appropriate guidance and accountability.
- Executive Summary
- Company Description
- Products and Services
- Market Analysis
- Strategy and Implementation
- Organization and Management Team
- Financial Plan and Projections
Outline of Key Steps
Finally, below are a series of key steps that should be identified as key milestones in order to establish an internal general contractor. The following is merely a suggested guideline, and can be modified, expanded, expedited as needed. However, each of the following steps are crucial and must be addressed prior to the general contractor starting any actual construction.
Establish Core Cultural Principles
Establish Key Metrics and Reporting
Establish Team Structure, Roles, and Responsibilities
Establish Budgetary Methodology
Establish Schedule Methodology
Identify Key Technologies and Integrations
Finalize Business Plan
Create Legal Document Templates
Develop Subcontractor Network
Document Policies and Procedures
Develop Key Consulting Areas
Develop Training Materials and Program
Each of these steps are further discussed in greater detail in ancillary articles.
