The business of construction trade contracting is unique. While it is one of the most closely aligned businesses to macroeconomic conditions, it also features some characteristics that are not just unique, but downright counterintuitive … unless you understand the industry structure in which they operate.

As the graph above illustrates, a broad index of trade contractor margins begins to recover slightly after recessionary periods end and on the very front end of the construction recovery. It is also important to point out that the opposite is even truer: trade margins begin dropping well in advance of recessionary periods.

There are at least two relevant questions for home builders to ask at this point.

The answer to the first question can be found in “Porter’s Five Forces,” first described in 1979 by then Harvard professor Michael Porter in his Harvard Business Review article “How Competitive Forces Shape Strategy.” The five forces that shape strategy include rivals, customers, suppliers, potential entrants, and substitute products.

In the residential building industry, the power of suppliers (in this discussion, trade contractors) is constantly undermined by the exceptionally low barriers to entry for competitors. This problem is more pronounced in some trade categories: plumbing and electrical, for example, require a higher degree of training and in some cases licensing, so therefore are a bit more protected. However, they are also subject to the fact that the main requirements to be in business as a trade contractor are some knowledge of the particular trade and a minimum of tools and equipment.

Therefore, as the market expands and trade contractors become more in demand, they are able to price their services higher, just as classic macroeconomic theories of supply and demand would suggest. However, if the market expansion continues for an extended period of time or the market growth rate is particularly high, new entrants (i.e. new competitors) are attracted to the market. As these participants enter the market, they create downward pressure on pricing because they begin bidding on the same projects that the incumbent firms were targeting. This is the first general factor that exerts downward pressure on contractor margins.

The new competitors come from two general sources: former employees of the incumbent firms and entrants from outside the local geographic area. Because of their lack of experience either in running their own business or with the local construction economy, and their need to develop revenue sources to feed their new venture, these new companies typically bid low. While they don’t win every bid, their low bids begin to drag down pricing in the market.

The second general factor that pulls down margins and overall profitability for trade contractors comes from the cost and productivity side. Because one of the typical sources for new competitors is former employees of the incumbent firm who decide to go out on their own, there is a shortage of intelligent — typically managerial or at least supervisory — labor. Any trade contractor who has been successful will tell you that the most basic unit of capacity for a profitable contractor is either the project manager or superintendent. Lacking enough competent, productive, and trustworthy managers and supervisors, the labor productivity of the incumbent’s business starts to slip, further exacerbating the margin fade.

In addition to the managerial and supervisory gap, an overall skilled and unskilled labor gap will appear in the market during particularly rapid and/or long periods of market expansion. These two talent gaps continue to increase the contractor’s costs. Labor productivity slips as the market wage increases, call-backs increase as quality suffers, and construction defect risk increases. So, at the top of the market (or frequently while the market is still expanding) the established incumbent trade contracting firms begin to experience significant decline in margins and accompanying profit.

At the bottom of the market, “Economic Darwinism” has run its course and the majority of the new market entrants have exited the market in one way or another. The firms who entered from different geographies refocus on their core markets, if they are still solvent, and the local start-up firms go out of business in large numbers and high percentages.

Therefore, even at the bottom of a very bad market contraction, the trade contractors who have the capital base, experience, and management talent to survive will begin to see fewer competitors bidding on the smaller number of available projects. At the same time, the managerial, supervisory, and general labor shortages reverse and the contractor is once again relying on his most experienced and highest quality staff to execute work. In short, the downward pressure on bid prices and the upward pressure on input costs tend to reverse, causing the trade contractor’s margins to brighten instead of fade.

The answer to the second question, “What should I do about it now?” requires each individual builder to examine its core philosophy on how it works with its trades. However, our leadership team’s 50-plus years of combined experience provides some general insights that can be valuable no matter the builder’s preferred sourcing strategy.

The underlying purpose in all of the above activities is to leverage the current environment, where fewer but more stable trade contractors are operating in the market. These contractors will be able to bring expertise to your projects that can help move your performance indicators across all key categories. Builders who identify the right trades to work with and establish the baseline activities described above will see much less inflation in trade costs as the market expands.

In the recovery and next expansionary period of the market, most experts agree that house prices will not appreciate at the same rate as they did during the 2000-2006 expansion. During that time, rapidly rising house prices outpaced significant trade cost increases, obscuring the fact that most high-volume production builders did not have the right relationships, processes, or measures necessary for basic cost management.

The bar chart about illustrates the latest forecast from John Burns Real Estate Consulting, the premier residential real estate market analyst firm, indicates that the recovery and expansionary period is likely to be gradual. A gradual expansion is likely to create less opportunity for new entrants into the trade contracting business, thereby removing one source of top-line inflation control for the builders.

In the next two quarters, builders are likely to see trade contractor pricing bottom out and begin to rise due to the supply factors illustrated above. There is no better time than the present for builders to evaluate and select the best trades to work with going forward and to establish rules of engagement that will promote total cost control, on-schedule performance, high quality, and improved safety. Builders who choose to wait or who choose to do nothing will be subject to higher trade cost-inflation over the next several years and will be at a competitive disadvantage vis-à-vis their competitors who proactively engage in the process described above.

Clark Ellis is a principal and founding partner with Continuum Advisory Group, where he provides consulting services to home builders, real estate developers, manufacturers, and installing contractors. His expertise includes market strategy, planning, market research, training and development, and process improvement. Eliss holds an MBA in marketing and general management from the Babcock Graduate School of Management at Wake Forest University and a bachelor’s degree in political science from the University of North Carolina at Chapel Hill.