In-Depth: Construction Industry Consolidation

Focusing mostly on housing construction, it should be noted that in 2003 Russian developers built 36 million square meters of residential space. With 40 million square meters to be built by the end of 2004 the supply will still be three times lower than the demand fueled by the development of mortgage crediting.

At its height the country’s Soviet-era construction industry commissioned some 80 million square meters of residential space annually and still people had to wait in queues for many years before they could move into their new apartments. The reason that housing construction has fallen so drastically in the past few years, failing to meet the demand, lies in the poorly worked out schemes of crediting construction that is for the most part carried out without attracting loan capital.

Most of the major financial institutions regard construction firms as unreliable borrowers. Banks that do venture to extend loans to developers seek to offset the risk by beefing up interest rates, which considerably restricts construction companies’ chances of attracting loans and results in a higher cost for the commissioned residential space. As a result, the market grows even narrower.

Meanwhile, many companies simply fail to get the necessary financing on the market to implement their projects. Banks, for the most part, extend loans to their subsidiaries or to friendly firms.

That is why housing construction in Russia proceeds far more slowly and on a much lower scale than it would if construction companies had readily available credit resources. Instead of securing a line of credit and launching mass housing construction, construction firms, for the most part, are involved in individual projects.

Given the small scale of projects, construction costs are high and real estate prices soar. Moreover, construction firms cannot afford to construct new buildings before the previous project has paid off. In the meantime, demand for residential space in the regions is very high, while the supply is at best modest, due to a scarcity of funds and a lack of loan schemes for construction companies.

The Boom Is Yet To Begin

The situation will be changing in the near future. Development of financial instruments will broaden the opportunities for attracting loans and the market will experience a construction boom. The construction sector covers a multitude of businesses, including housing construction cooperatives, production of construction materials, decorative materials, etc. Growth of the construction industry implies growth of all of its components and related sectors.

Joint Efforts

At the early stages of rapid market development all sorts of companies, regardless of their professionalism, can find their niche. Keen demand makes projects of various levels of quality possible. Yet, as time goes by and the dust settles, with the market becoming more structured, consumers become more careful in their choice, and their requirements increase.

Then the companies that are able to offer higher quality at a reasonable price occupy the leading positions. The road to success lies – just like in other industries producing mass goods – in consolidation of the industry. That process should result in the emergence of vertically-integrated holdings involved in the full cycle of operations needed to offer an end product, i.e. residential or commercial real estate of a high quality.

Proceeding from the present situation on the Russian construction market there are sufficient grounds to believe that within 5-7 years major vertically-integrated holdings will emerge on the market, and the market will be divided between them.

The Process Begins

To a certain extent, that process has already begun. For example, Moscow-based construction companies, such as Inteko, SU-155 and some others have combined the development and construction functions with key construction materials.

Control over the production of construction materials enables them to control and forecast costs more efficiently, thus making their work more predictable and widening the horizons for the strategic planning of future developments. The aforementioned companies have already begun expanding actively in the regions. With competent strategy they have a good chance of claiming the leading positions on the entire Russian construction market for several years ahead.

It would be logical to assume that consolidation of the industry would initially involve companies servicing major cities. Those companies are the largest players in terms of the volume of housing construction and sales. Those firms will then use leading regional companies as a platform for their regional expansion.

New arrivals will either buy into the local construction materials producers or invest in new factories. Development of the construction industry and tougher competition will result in the emergence of new construction techniques, and the development of new construction materials.

Initially developers will invest in construction themselves. Later major Russian financial and industrial groups will join them. Those groups have considerable funds and are always seeking investment opportunities. The investment-starved construction market is attractive for them, but given the lack of transparency it requires close control, which an investor can guarantee by securing property rights.

Incidentally, this phenomenon has already been registered in certain cases. In the future major international companies may enter the market in the capacity of strategic investors, attracted by the dynamic growth and relatively high rates of return.

Economies of Scale

Major companies, in my opinion, will focus mainly on mass housing construction and infrastructure. Shortage of affordable housing is one of the main social problems in the regions. Major companies are able to take full advantage of the “economy of scale” by establishing the production of construction materials, and subsequently to economize on costs, which will help them to bring down the cost of construction and the price of residential space.

While major companies will dominate the mass housing construction sector of the market, top class residential estates will be occupied by boutique-type firms. Small specialized companies will hold the niche for unique individual construction projects of the high price category.

In the deluxe real estate segment of the market developers’ margins considerably exceed the industry average, which is why the “economy of scale” for reducing costs is not a key factor for their commercial success.

A company’s success today is measured first and foremost by such factors as reputation, a portfolio of successfully implemented projects, and so on. Comparing construction with, say, the auto industry, there is the likes of the international giant Toyota, producing millions of cars a year, and then there is Bugatti, that makes several automobiles for the well-off.

Corporate Culture

Corporate culture plays an important role in the formation of major construction holdings. Russia’s present-day construction industry was formed within the framework of the Soviet-era economic culture. The market has brought about changes, but so far the corporate culture has not undergone any drastic transformations.

As a result of the high level of segmentation in the construction market in the regions and the developed monopolization, construction companies have preserved the corporate culture of old.

Consolidation of companies operating in new market conditions is, in many aspects, a process of internal cultural transformations. “Corporate transparency”, “corporate governance”, “team thinking” are clear-cut requirements a large holding must met in order to work efficiently.

Following the modern rules of corporate culture makes a company more attractive for investors, forms its reputation and helps to increase its value.

But all that is only possible if construction companies become more attractive to the financial institutions than they are today. Companies will have to become more transparent in terms of financial flows and risks.

Consolidation of companies, as a rule, can be spurred on by objective factors such as economies of scale, and subjective factors like the personal ambition of executives.

Consolidation of the construction industry will in many aspects resemble the processes in the oil, metallurgical and many other sectors of the Russian economy in the 1990s. As a result, Russia will see the arrival of approximately a dozen major construction firms that will control more than half of the entire construction market.