New Business Models in Construction
Construction is arguably the world’s fastest-spreading industry — look at the skyline of any major city, and you can see the familiar outline of construction cranes. The construction industry also holds the distinction of being the only major global industry in which productivity has declined over the past 50 years.
At BV, we are excited about the potential for AI, advanced robotics, and sensors to dramatically increase efficiency in aging industries like construction. However, advanced technology is only part of the solution. In the past 5 years, we’ve also seen a rise in new business models for the construction and general contracting industries. Fortunately, new operating models like vertical integration (when a company owns the supply chain it uses) are being utilized. These models have the potential to fundamentally change the relationship between owners, contractors, and suppliers while reducing cost and increasing efficiency. New contractual arrangements such as Integrated Project Delivery (IPD) will better align the interests of all stakeholders involved in construction. When paired with the latest software and hardware, these new ways of building, have the potential to bring construction into the 21st century, keeping pace with other global industries.
The Rise of Vertical Integration
An undeniable shift in the construction industry over the past 50 years has been the rise in complexity. New building materials, better construction equipment, and advanced design software have allowed architects and engineers to design and build large and intricate buildings. Tenants and owners have likewise come to expect a high degree of design across all segments of the commercial construction industry, from skyscrapers to everyday mixed-use buildings.
With increased design requirements come increased supply and labor challenges. Like a manufacturing assembly line, 21st-century construction projects must maintain increasingly complex and costly supply chains with multiple vendors. Often, advanced materials, such as auto-glazing windows ( a process done to improve the security and safety of windows), have just a few global suppliers. General Contractors (GCs) frequently must over-purchase materials to meet minimum quantities or to avoid costly reorders. However, unlike a factory, a construction project cannot easily absorb excess material or reduce output when supply is limited. When a building is complete, excess material is often liquidated, reducing efficiency and wasting money.
Furthermore, with the rise in complexity has come an increase in demand for specialized labor. Subcontractors in more technical fields like electrical and HVAC (heating, ventilation, and air conditioning) are increasingly in-demand and able to command high fees for their work. In the US, trade schools and technical colleges have not kept pace with demand for specialized labor. This results in shortages across all major technological fields. It is these limitations on the modern construction industry that have given rise to the most significant operational change in 50 years: vertical integration.
Vertical integration gives new meaning to the metaphor of a construction site as a factory. In a vertically-integrated construction project, individual components are manufactured by the construction company itself, rather than a 3rd party vendor. Modular components are combined whenever possible to offer owners a high degree of customization without the cost and complexity of custom components. Also, vertically-integrated construction companies opt to develop and maintain their internal labor forces across various specialties, rather than hire outside subcontractors. While no construction company to-date is vertically integrated, one of the furthest along is a startup called Katerra.
A New Kind of Construction Company
Katerra was founded in 2015 as a materials sourcing and supply company using overseas factories to produce standardized construction components. Its founders quickly discovered that they could not get their parts approved in many major construction projects. As a relationship-based business, the construction supply industry was unwelcoming primarily to a new, unknown entrant. Furthermore, few incentives existed for GCs to choose Katerra’s standardized parts over more expensive ‘one of a kind’ components. Katerra’s leadership refocused and decided to open up a design office in Seattle to produce its buildings from ‘soup to nuts.’
Fast forward to 2019, and Katerra has raised over $1.2B from tier 1 and strategic investors, including Softbank’s Vision Fund and Foxconn. The company has focused on the growing niche market of ‘garden style’ small-family apartment buildings and mixed-use developments. These buildings tend to require a lower degree of customization than office buildings and other flagship construction projects. Katerra maintains a network of domestic and overseas factories and closely-held vendor partnerships to mass-produce an array of modular components for its buildings on-demand. Katerra typically offers owners three levels of fit and finish for each element. By mixing and matching these options, owners and designers can select the right level of design and customization for their tenants without needing one of a kind components. By reducing the degree of customization, Katerra avoids the excess materials problem: when a job is done, excess modular components are often reused for another job.
Katerra’s leadership has also spread across other aspects of construction other than materials and supply. The company is increasingly changing how its construction projects are contracted and staffed. Rather than seeking subcontractors for specialized tasks (who leave on completion of the job), Katerra seeks out’ sub-partners.’ Whenever possible, the company recruits and builds permanent, internal labor forces across various specialized disciplines. This process of ‘insourcing’ reduces turnover, ensures that specialized knowledge stays within the company, and helps to smooth out labor shortages during periods of high activity.
Katerra’s unique approach to labor generates significant cost savings over time. While the upfront cost of a permanent labor force is higher than a contracted one, Katerra’s model effectively separates the cost of labor from the cost of materials. In a traditional GC<>Subcontractor relationship, the Subcontractor typically gives a quote on the combination of labor and materials. It is common practice for subs to inflate the materials budget to reduce their risk, and maintain a buffer of operating cash should the project take longer than expected. Under the Katerra model, laborers obtain components internally whenever they need them, reducing the need to ‘pad’ budgets and ultimately saving money for owners.
Despite its enormous potential, the Katerra model is not without its challenges. Vertically integrated construction businesses frequently have high upfront costs, as entire factories must be stood up to produce individual components. Furthermore, labor costs in a vertically-integrated model are often higher than when individual subcontractors can bid competitively on a job. Finally, buildings constructed in this manner are characteristically less ‘unique’ than those made traditionally. Modular designs may be acceptable for a generic suburban low-rise but are unlikely to work well for a large corporate flagship office. It is these challenge areas where advanced technology and new contracting arrangements may be the key to growing the vertically-integrated construction industry.
Aligning Incentives
Improving and stabilizing supply-chain through vertical integration has the potential to reduce materials cost, but how can owners and GCs effectively minimize construction time and labor costs? The answer may lie in changing the contractual arrangements that underlie any large CRE project. Traditionally, construction projects rely on a project delivery method known as ‘Design-bid-build’ or DBB. In a DBB project, the owner contracts an architect (or infrastructure engineer) to design and produce a conceptual design, bid documents, and spec. General Contractors are then invited to ‘bid’ on the project; the winner receives a separate GC contract. The GC is then responsible for recruiting, managing, and compensating all subcontractors required to complete construction through an open bidding process. The main benefits of DBB are that it ensures the design team looks out for the interest of the owners, and it incentivizes the GC to keep costs under control. However, there is also a downside to DBB: often Designs are finalized without any input from the GC who executes the bid. This lack of information leads to costly reworks and delays whenever elements of the design prove difficult or too expensive to integrate.
An alternative approach to DBB is Design-Build or DB. In a DB arrangement, a single individual known as the ‘Design-builder’ is responsible for both designing the building and executing its construction. Typically, a Design-build firm is led by an experienced GC or architect, and maintains a full team of design and contracting professionals. The Design-builder works with the client/owner to design and spec the building, and staff it with appropriate subcontractors. A single contract is executed between the owner and Design-builder, rather than two independent contracts for designer and GC. The DB approach is considered favorable because it provides the owner with a single point of contact and responsibility in the event of delays/problems. DB also increases efficiency by involving contractors in the design process from day one — allowing them to veto or change designs that are likely too complex or expensive to implement. The downside of DB is that the technique has proven most effective in buildings with relatively simplistic designs. Because the interests of the contractor are considered in the design phase of a DB construction, the GCs often advocate for more straightforward, easier to construct designs. Also, critics of DB claim that the process is less competitive than DBB since the design-builder is not required to run an open bidding process for subcontractors.
An emerging contractual framework with the potential to address the shortcomings of DB and DBB frameworks is known as Integrated Project Delivery (IPD). In an IPD arrangement, the GC, architect, and major subcontractors all become a party to a single contract. In an IPD contract, the individual role and compensation for each party is specified, increasing transparency and reducing redundancy. Also, the individual parties in an IPD contract often waive their right to sue each other in the event of delays or problems. IPD contracts specify a limited budget for delays/overruns, putting pressure on all parties to prioritize efficiency. IPD contracts also encourage all parties to collectively engage in multiple ‘design charrettes’ to ensure everyone’s concerns are addressed before constructing the building.
While IPD offers a promising new contractual arrangement that can increase construction efficiency, it is still only used in a small percentage of commercial projects worldwide. One obstacle to widespread adoption is the inherent inactivity found throughout the CRE industry. Many large GCs and subcontractors are multi-generational family businesses, which are slow to adopt new techniques that may introduce risk. Subcontractors are also concerned that an IPD arrangement removes important avenues for legal recourse if a project goes wrong. Finally, IPD encourages open and transparent collaboration between GCs, designers, and subs, which is often tricky with today’s design and project management tools. Under a DB or DBB arrangement, data and diagrams are stored between individual stakeholders. For IPD to succeed, new software tools and technology are needed to allow the individual stakeholders to collaborate efficiently.
Startups to the Rescue
With economies of scale come efficiencies. As companies like Katerra stand up factories to produce modular components, they can significantly reduce their costs and pass these savings onto owners. While owners appreciate these savings, they often desire a higher degree of customization than what is currently possible with legacy manufacturing processes. Companies like Mighty Buildings are using advanced additive manufacturing technology to 3D-print building components that are unique to each job. Mighty Buildings can produce complex shapes and curves that are not possible with traditional materials. As design software improves, 3D printing robotics becomes faster, and the possibility to print complex building components on a timescale comparable to traditional manufacturing increases. Meaning companies like Katerra can reap the cost and speed benefits of vertical integration, while still producing unique, beautiful buildings.
Technology will, over time, also help to address some of the labor challenges of modern construction. Online course providers like Lambda School have leveraged Income Share Agreements (ISAs) to revolutionize the computer science education market. Unlike loans, ISAs are funded by the school and paid back out of a student’s future earnings. If the student doesn’t find a good job, the school doesn’t get paid. These same models and technologies could be applied to specialized subcontracting disciplines to reduce labor shortages and train the workforce of the future. Students can learn advanced skills in their free time, without the burden of significant debt. Companies can benefit from a larger labor pool and reduced competition. As we’ve seen with Lambda School, large construction companies will eventually recruit directly from these educational institutions, building a tighter feedback loop between the school and the industry. These deep connections between schools and employers also ensure students are taught the skills they need to succeed on the job.
The importance of new collaboration tools increases as owners and industry professionals begin experimenting with new contractual arrangements such as IPD. All major parties involved in construction (GCs, architects, subs, etc.) must have aligned incentives and weigh-in on decisions. For this to work, they must be able to access data in real-time that traditionally is siloed (architectural drawings, plans, specs, financial statements, schedules, etc.). Software solutions like PlanGrid and Procore are becoming increasingly common on the job sites of the future. This software, used as service tools, allows all major parties to access and collaborate on construction documents from a centralized repository using their mobile devices. Like a ‘google docs for construction,’ these tools make it easy for individual parties to weigh in and track changes during the design and build phase. Collaboration tools also allow owners to track and monitor progress in real-time. As more and more buildings are built using collaboration software, the owners of these software tools begin to develop a massive corpus of data around the construction process. When this data is coupled with advanced AI, software providers quickly start to identify issues in a design or build before the individual human stakeholders. AI increasingly automates decision-making during the design phase, streamlining the back and forth process of design reviews and efficiently matching subcontractors to individual tasks/schedules. Insurance and investment firms will also increasingly have a seat at the table, thanks to collaboration software. These entities typically form the financial backbone of any construction project. By tracking and engaging in collaboration, these finance teams can stay better informed and better positioned to react to budgetary changes quickly.
Finally, advanced AI and sensors on the job site itself are helping to eliminate redundancy and increase labor efficiency. Companies like OpenSpace are deploying cameras, lidar, and autonomous robots to scan job sites at regular intervals with high spatial resolution. Advanced AI then ingests this corpus of data and determines whether the building’s progress matches expectations. OpenSpace’s technology allows GCs and owners to identify lapses in productivity with a higher degree of accuracy and speed than what was possible with a standard visual inspection. This allows for labor adjustments to be made quickly, ensuring projects proceed promptly. Pairing these technologies allows an operating model like Katerra’s to ensure that a limited internal labor force is utilized efficiently and effectively across multiple projects.
Increasing Efficiencies
New operating and contractual models in construction show what is possible when the principles of advanced manufacturing, collaborative software, and automation are applied to other industries like construction. When these models and tools are used alongside advanced AI and sensors, the notion of the construction site as a factory becomes all the more real. There is an old joke in the construction industry: I would tell you the punch line, but “I’m still working on it.” Built into this joke is a grain of truth that construction efficiency must increase, particularly as the world faces the possibility of an economic slowdown. New advances, such as vertical integration and IPD, make this future even more likely.
