Broken Buildings, Busted Budgets

by on September 20, 2007 at 6:00 am in Economics | Permalink

That’s by Barry B. LePatner and the subtitle is How to Fix America’s Trillion-Dollar Construction Industry.

The key problem is that building or new construction owners become completely dependent on information provided by their contractors.  The contractors experience cost overruns and the commissioning owners have to suffer delays, cost increases, and the general feeling of having been screwed over.  Opportunism and recontracting are rampant.  According to the author, no institution successfully helps commissioning owners distinguish between good and bad contractors.  Ex post the construction industry is not competitive, even though it has a large number of firms ex ante.

According to LePatner, the answer is to move to truly fixed-rate contracts.  This means no more passing cost onto owners, real penalties for delays, and much more risk on the construction company itself.  That in turn requires larger and more integrated construction companies instead of today’s small proprietorships.

If this is such a good idea, why doesn’t the market provide such a solution already?  Surely there is enough capital to support large construction companies.  I don’t know, and for that reason I cannot evaluate the author’s central proposal in an informed manner.  Nonetheless this book is argued on a very serious level and I found it definitely a worthwhile and stimulating read.

A must for anyone interested in the economics of construction, and a possible read for others as well.

1 Shefaly September 20, 2007 at 6:56 am

Interesting.

When all details do eventually become public knowledge, the fantastic contract structures and management in constructing Terminal 5 for Heathrow in London would illustrate these principles nicely.

Some prelim information can be found here: http://www.baa.com/portal/site/default/menuitem.1b52c81dd9043acc0fb42410c02865a0/

No vested interest, but as a London resident and LHR user, I am just keen that BA’s lost baggage stats will fall, that the airport will be less crowded and nicer, and LHR will stop getting the awful press that it does!

2 sa September 20, 2007 at 7:32 am

Agree with Mr Kling above. The projects tending to have the most overruns are the ones where clients demand a lot of flexibilty. Suburban homes when built by a developer don’t have as many cost over-run issues.

The smartest developers therefore build the basic flat/house structure and leave the interior decoration to the future occupants.

Another point, why do clients want to make changes as they go along. But if you look around yourself then almost all manufacturing and service delivery systems have some felxibilty built into them. I think therefore that therefore the market therefore sorts itself into two groups- one mass markt builders which can crank out cookie-cutter houses at a super fast pace and small partnerships which specialize in aesthestic desgin and then sub-contract the actual work out to their long-time builders.

3 Bernard Yomtov September 20, 2007 at 8:59 am

According to LePatner, the answer is to move to truly fixed-rate contracts. This means no more passing cost onto owners, real penalties for delays, and much more risk on the construction company itself.

I don’t think this necessarily holds. There are real information problems in construction. Builders have lots of ways to cut corners that are invisible to all but the most obsessive, knowledgeable, and eagle-eyed, customers. So the cost is passed on in the form of shoddy workmanship, or possibly in the need to hire someone to closely inspect the work.

Arnold Kling is correct, also, to suggest that not allowing changes is a poor idea. As a project proceds, whether software or building, new possibilities emerge. Feature creep can be endless, but there are still many worthwhile things that can be done that were not obvious in the planning stage.

4 save_the_rustbelt September 20, 2007 at 9:06 am

Some of us have good experience with contractors. It involves:

1) screening the contractor closely
2) not using the lowest bid as an absolute (asking for trouble)criteria
3) reviewing the building plans in complete detail, down to the last light switch
4) asking lots of questions and anticipating everything (“will that tile floor be easy to maintain?”)
5) using a competent attorney to button down the contract
6) have a very detailed funds draw procedure and a very detailed change-order authorization process
7) include penalties and incentives when advisable
8) have the contractor bonded

I am always amazed when people and companies do one of the biggest transactions they will ever do and do it like buying a used car. Duh.

5 David Hecht September 20, 2007 at 9:53 am

This is similar to the argument in favor of fixed-price R&D contracts in defense procurement. Problem is–as several respondents have already pointed out–it keeps you from making changes while the work is in progress (since the contractor will always find a way to “get well” on them changes), it tends to wind you up with contract-compliant junk, and of course, there’s always the risk that even the biggest firms will go sneakers up in the middle of the project: not on your average four-bedroom suburban house, to be sure, but on a major project such as an office complex or a mall.

6 Peter September 20, 2007 at 10:15 am

The problem with construction is more a matter that anyone can pick up a hammer and a pick-em-up and go into business with very little licensing/regulation. States where there is a “defective home litigation problem” have a “defective home” problem because unqualified people are building houses. States with low incidences of such lawsuits have licensing requirements for all the site workers. Unfortunately for homeowners, the “cure” being pushed by the administration is to limit the recourse of homeowners to sue and recover damages from incompetant construction companies. And to limit damages, so that if the contractor builds the roof wrong, so that it leaks and damages your sheetrock and carpeting, they’re only liable for the roof and for no other damages incurred by their incompetence. Contractors have squeezed the subcontractors so much that speaking Spanish is now a requirement for most subs, and hiring legal, documented workers will bust the sub’s budgets.

7 kebko September 20, 2007 at 10:44 am

I think there has been an increase in the number of “design-build” projects and “construction manager at risk” projects, at least in the southwest. Usually, on those contracts, there are still mechanisms in place for the owner to negotiate changes after the project is underway.
There are lots of agency problems, also, since you have subcontractors, a contractor, an architect, and an owner in most projects. That many players is bound to lead to problems, and I don’t really know how you’d fix it. Add to that the fact that a lot of medium-sized projects are municipal (schools, water treatment plants, etc.), and each of those players is affected by the fact that the principals for the project are only acting as proxies for the public, so now instead of using intuitive processes to make the project successful, they have to follow sets of rules that prevent fraud.

8 sa September 20, 2007 at 10:50 am

Excellent points by Bernard and ah above regarding the price/quality tradeoffs and one becoming unpegged if you hold the other constant. You could hold both of them constant but that would mean substantial monitroing costs and specialized knowledge – essentially like a credit rating agency for builders. There could be a market in this if the building quality rater amortizes it’s cost of acquiring information about builders over many customers.

So why don’t we see this happen? My guess is that unlike the debt markets where a small no. of institutional players buy a lot of debt repeatedly, most clients(I’m talking big projects here) engage in very sporadic orders to build projects. The role of quality raters has been instead replaced by advertising like in many other industries.

9 David Sucher September 20, 2007 at 11:52 am

Btw, Tyler, I don’t believe that your central premise is correct. You write: “The key problem is that building or new construction owners become completely dependent on information provided by their contractors.”

I don’t think that is so. Sophisticated or even just diligent owners develop their own source of information to triangulate and verify costs. One can hire an estimator or even one’s own “shadow contractor” to assess line-items for plausibility. As well, there is competitive bidding among sub-contractors.

Yes, it can be difficult to tease-out these costs; and the change-order game offers tremendous possibilities for abuse of the owner. But I don’t quite get how by itself a “fixed-price” contract can solve the many problems inherent in any construction process, unless the number of projects going with “estimates” is larger than I think. I guess I will have to try to read this book.

10 Anthony September 20, 2007 at 12:20 pm

One economic reason preventing the emergence of large integrated building contractors is bonding capacity. Many public works projects in California are joint ventures not because the prime contractors bidding can’t manage the project on their own, but because they cannot obtain the bonding required on their own. So they joint-venture, where one partner is primarily providing bonding capacity in exchange for a percentage of the fees, and sometimes a small piece of the work.

11 Ken Hirsh September 20, 2007 at 2:47 pm

In general, construction is a highly regulated, unionized, and corrupt industry. The original post seems to ignore these anti-competitive factors. I sense that Tyler would benefit from learning more about the construction business at the micro- rather than macro-level. I wonder if the book deals with these issues?

12 SamChevre September 20, 2007 at 3:50 pm

Lots of good comments already.

Another reason that true-fixed-price-and-conditions contracts are not common in the smaller markets (houses, small offices) is that they are expensive. The difference in price between a fixed-price and a cost-plus contract will be that on average, buying insurance costs something–the fixed-price contract insures the owner,a nd the contractor has to charge for that.

Also, it’s worth re-noting that the randomness of government demands makes good prediction much more difficult.

13 Ken Hirsh September 20, 2007 at 4:18 pm

I would argue that where the construction business is highly inefficient, you will find some combination of excessive regulation, unionization, and/or corruption. Certainly, Boston’s “Big Dig”, the example given in the Amazon summary for the book, suffered massively from all of these problems. Home builders might suffer from fewer regulations, unions, and corruption, but it would be odd to accuse them of having productivity problems!

14 Randall Parker September 20, 2007 at 8:54 pm

Tyler, the trend is toward greater consolidation. In many markets the top builder has more than 10% marketshare.

Even back in 2002 it was clear that major national home construction companies exist:

BIG BUILDERS

Three builders were tops in 19 of the 50 markets in 2001: Lennar and Pulte each were No. 1 in seven markets (Lennar in Houston; Minneapolis; Tampa Bay, Fla.; Sacramento, Calif.; Sarasota, Fla.; Miami; and Fort Myers, Fla.; and Pulte in Atlanta; Phoenix; Orlando, Fla.; Raleigh, N.C.; Detroit; West Palm Beach, Fla.; and Cleveland). And NVR (building under the brand names NVHomes and Ryan Homes) led in five markets: Washington; Charlotte, N.C.; Philadelphia; Baltimore; and Richmond, Va.

MARKET DOMINANCE

KB Home and D.R. Horton demonstrated the greatest dominance in a single market. KB recorded a 33 percent market share in San Antonio, with 2,848 sales, while Horton captured a 27.4 percent market share in Austin, Texas, with 1,651 sales.

15 Russell Nelson September 21, 2007 at 2:33 am

There are two ways to build a building:

Fixed cost and variable quality.

Fixed quality and variable cost.

Having built the latter at the same time a friend was building the former, I’d go with the latter.

16 lost September 23, 2007 at 5:40 pm

Glad to see this topic on Marginal Revolution, as this is one that has affected me personally.

I recently completed a huge renovation job where I spent well over half a mil. It was by far the most miserable experience of my life, made even more so by its duration. My GC took over two years and never finished, having walked off the job when I refused to pay a change order that I never signed because he never talked to me about it before doing the work. If I walked into, say, a restaurant and started handing out $100 bills I’d be treated like a king; with my GC, I was handing out $1000 checks (or more) on a regular basis, and I was treated like a donkey. Why is that?

save the rustbelt offers some suggestions. Here is my take on them:
1) screen the contractor – Certainly you should do what you can. But there is a huge disparity in knowledge that an average consumer cannot make up. The GC knows all the tricks, but I was new to the game. In fact, as I started figuring out the game, my GC became progressively more unpleasant and ultimately hostile to me. And while my architect was nominally on my side, he had his own blinders and unwillingness to question things on my behalf – qualities I did not discover until too late. Moreover, obtaining knowledge incurs its own costs – in my case, significant delays in the start of my project and significant time subtracted from my being able to do anything fun.
2) not using lowest bid – Again, sensible, but only marginally helpful. Might help you eliminate the most incompetent out of four bidders, but not to identify which is the best of the remaining three or how best to motivate the winning bidder.
3) reviewing the building plans in complete detail – Again, sensible, but only in moderation. My GC reacted adversely to being micromanaged and thought I was slowing him down. Moreover, I did not have enough time in the day (what with my real job) locking down every detail. But of course these unattended little details often led to disputes. Damned if you do, damned if you don’t.
4) ask lots of questions – This is what ultimately killed the relationship with my GC. He hated having to take time to explain and justify things to me. As I learned, GCs live off of a whole host of kickbacks from favored suppliers. I started asking a lot of questions about sourcing, and when I found out what a racket it was, I started sourcing things myself. My GC hated this and soured on my project completely. I wish I had this knowledge from the start, but I just didn’t know until too late. Should I have asked these questions at the start and, on the basis of his shady answers, not hired him? Maybe, but then I incur further costs to search and for the delays. See #1.
5) using a competent attorney to button down the contract – I am an attorney, but not a construction law attorney. Perhaps some real expertise here could have helped me. But I suspect that bringing in an attorney to put ambiguities under the microscope before I signed would have triggered the same allergic reaction from my GC as described in #4.
6) detailed change order process – Yes, this would have helped marginally. But see above for my GC’s dislike of detailed anything. Anytime I asked for details, my GC thought (a) I was wasting his time and (b) questioning his trustworthiness (which was indeed true).
7) include penalties – I never figured a way to structure incentives and penalties to maximize his incentives to do the job. By the end, the guy just walked away with several thousand dollars on the table, even though he had a big balloon payment coming if he did a few more things.
8) Have the contractor bonded – Certainly. Done in this case. However, this prevents only the worst kind of contractor negligence.

Summing up and speculating: Retail consumers (ie, families doing home renovations) are at a massive informational disadvantage to industry insiders (ie, GCs) that is difficult if not impossible to make up. The building industry is riven by a host of shady practices (eg, hidden markups, violations of fiduciary duty) that the retail consumer finds out about too late, if at all, and has only very limited ability to combat. Once you are in a relationship with a GC, you are stuck with it. The GC will have a very definite idea about how he does business, and woe betide the consumer who aims to alter it.

My theory: home construction is a non-iterative game, as most people do something big only once in their lives. (I am certainly never going to go through this again.) GCs know this so they “defect” – they have little incentive to treat you well (and in some cases try to screw you for all you are worth) because they know they don’t have to deal with you again. Theoretical solution: “eBay feedback” system hosted by state licensing boards or consumer organizations that allow current consumers to benefit from knowledge of past consumers, and GC has to account for reputational signals. But in my locale, I am not aware of any system that is anywhere close to having critical mass to be an effective deterrent to GC defection.

As a side note, I believe the references provided by GCs to be utterly useless, since the GC has cherry-picked only his most favored customers to act as his spokesmen. I doubt my GC will be using me as a reference, although I would be much better at providing potential customers with useful knowledge.

17 Stephen September 24, 2007 at 10:14 pm

Well, first of all, if you do everything a contractor says and don’t double check or do any research for yourself on the cost of your building or the contractor that you hired, you deserve to be screwed. Building a house is not like going out and buying a new pair of jeans. You can’t just go buy a pair and hope that they fit. If you are serious you have to do research for yourself, and that research should tell you that most construction projects under budget by about four percent.

Secondly, having a fix contract is avaliable and if you did your homework then you would know if your contractor that you hired does it or not. Now Why are you trying to destroy the little guys. If every construction project was done through a corporation and there were no proprietorships, the construction industry would have lots of monopolies and prices would go up.

18 David Sucher September 25, 2007 at 11:53 am

The comments on this post are fascinating and thought-provoking. For example, Matt says that “….comparing the software industry to the construction industry are spot on.”

I don’t know the software industry at all but I assume that almost every project requires a great degree of innovation and invention. Of course you start with software building blocks and “sub-routines.” But are these as standardized as building components? There is no reason for dramatic innovation on a building-by-building basis. Yes each structure will be adapted to the specific site but it’s only with ego-architecture (“starchitecture”) that there is a need for extreme innovation with attendant cost unknowns as opposed to systems adaptation. Marvelous cities have been and can be built with very standardized and cost-certain components.

So I would be surprised that constructions requires the degree of novelty as does software development. Of course I don’t know software but construction — aside from underground utility and excavation — can be a rather controllable process if the management is good.

19 Adam Smith September 25, 2007 at 7:38 pm

It’s interesting that no one has yet noted that LePatner received considerable help from two economic historians. They aren’t listed on the cover but they are on the title page and their role is discussed in the acknowledgements. Seems like an odd arrangement. I wonder if there were some agency issues involved between the authors themselves that might be clouding the economic issues addressed in the book somewhat? One of these other authors, Wright, is a very serious and prolific scholar.

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22 ParkerAthanaric December 31, 2010 at 5:49 am

I didn’t read the book, I only this article. I find hard to believe that the solution of all problems are just in front of our eyes and we didn’t see it. Nevertheless, the construction companies should be more responsible. acrylic tub surrounds

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