(This article first appeared in Real Estate Investor's Monthly.)
This article title is the name of a book by Barry Lepatner that I saw reviewed in The Wall Street Journal.
The book is repetitive and aimed too much at policy makers. But it tells an important cautionary tale for would-be fixer strategy investors. It also suggests that a person who could operate efficiently in rehab or new construction could achieve a valuable competitive advantage.
The book quotes numerous experts, like famous architect Moshe Safdie, who is quoted in the subhead above, as saying the construction industry is a colossal joke.
The fundamental problem is that construction people routinely use change orders to extort money from their clients. Once the contract has been awarded to the winning bidder, and work has begun, it is extremely difficult and expensive for the client to fire or replace the contractor. Contractors know that, so they extort huge amounts of money by demanding expensive changes to the construction contract. In many, maybe most, cases, they deliberately underbid to get the contract, then restore profitability by overcharging for change orders.
Lepatner says the source of the problem is “asymmetric information.” He’s a construction lawyer and he seems fond of professorial sorts of words and phrases. “Asymmetric information” means the construction guys know a lot about construction and the clients of the construction guys know little or nothing about construction. So the construction guys BS the clients and rip them off.
I have previously commented that if I had my real estate investment career to do over, I would have studied certain information-heavy aspects of the business far more. By that I was referring to air-conditioner compressors, condensers, heating boilers, and roofing systems—elevators, too, if I had been involved with such buildings—in other words, large, expensive, complicated building projects.
For example, at one 203-unit apartment complex I managed, we had Weil-McLain boilers the size of locomotives. We also had huge central air-conditioners and underground pipes. We spent a ton on underground pipe leaks caused by lack of sacrificial anodes. Companies like Weil-McLain typically offer free multi-day seminars at their factories. You have to pay your travel expenses. If I had it to do over, I would have taken those seminars.
We bought far too many air-conditioner compressors and other such things when I was a property manager. In my own buildings in later years, I was quick to recognize bad air-conditioner guys, but I still should have known more.
With regard to construction, there are adult education and local college courses you can take on estimating and many other aspects of construction.
If you are going to make your living in new construction or heavy-duty rehab—or even just have large buildings to maintain as I did as a property manager, you need to know enough to tell the good guys from the bad guys in construction and repair businesses.
One way that clients have tried to deal with the information asymmetry is to hire knowledgeable intermediaries like construction managers. But they often have conflicts of interest and may feel allegiance more to the construction industry from whence they came than to their new friends: the clients.
Lepatner is able to point to many interesting culprits in construction. One is the small scale and riskiness of the construction industry. Almost all construction companies are tiny and local. Contrast that with the auto industry where the scale and economies of scale are enormous, brand names are international, and the desire to obtain repeat business huge. There are some big home builders, but even they are only regional, not national and they still stick-build, which is extremely inefficient.
Risk hedging, which often requires large scale because of the details of how financial markets work, is so difficult for construction firms that their almost sole method of controlling risk is to outsource almost everything. But outsourcing injects all sorts of inefficiency into the process.
Manufactured housing is not the answer because it is so expensive to move a manufactured house from the factory to the site.
I read in Fortune or somewhere about a family that builds hotels in the Chicago area to hold for their own account. The local unions went nuts because they did it as a non-union job. But their various machinations had no effect because the workers on the job were all owners of the property as well. According to the story, they were able to build their hotels much cheaper than the competition and thereby made far more profit from them.
A case history I wrote about in this newsletter was about a guy who builds two houses a year almost all by himself. (He only hired out work requiring big equipment he could not afford to own.)
One solution is to avoid investment strategies and situations where you have to rely on construction people. For example, you could just buy properties after the work is done and do a thorough inspection. If you insist on getting involved in construction or extensive rehab, you must become extremely knowledgeable. You probably also need to be in a major metro area where there are many contractors to choose from and much competition among them.
I still shudder at the thought of my apartment building in Corsicana, TX needing a new roof. I told the manager to get three estimates. He said there was only one roofer in the town. He got the job. JTR