Residential vs. Commercial Construction Profit Margin

Contractor Installing Rebar

There is a significant difference between commercial and residential construction – residential construction is centered on building, selling, or renting out units, while commercial construction revolves around business properties. Profit margin is essentially what remains after overhead, and job costs are subtracted from the income proceeds. Which one, then, is more profitable between the two?

Both residential and commercial construction can be profitable, but several factors should be considered when determining which one profits more. When the residential market is booming, the profits are high. However, commercial construction has more profit margin because of higher demand.

The rest of this article will focus and elaborate more on factors that determine the profit margin of residential and commercial construction, their differences, and ways to increase the profit margin for both.

Differences Between Commercial and Residential Construction

Residential and commercial construction vary in almost every way, from the equipment used, funding, and materials. Residential properties include condominiums, townhouses, detached homes, duplex, and single-family houses.

Commercial buildings include storage warehouses, hospitals, office spaces, assembly plants, and shopping centers. Some of their key differences are:

Building Materials Used

Different materials are required for commercial and residential construction to satisfy the building design. Most residential homes use timber frames for their construction, while commercial buildings require steel frames or concrete for their large, tall, and complex design.

Cost Differences

Regardless of whether a residential and commercial building is of the same size, their cost will vary significantly. Differences arise from compliance, materials used, equipment, overhead, and labor costs.Funding commercial projects is often done by government agencies, corporate banks, and wealthy developers or owners, while residential buildings are mostly funded by homeowners using bank loans.

With commercial projects, labor is secured through bidding, where a capable bidder with the lowest price is selected. Residential construction can accumulate hefty bills for labor and equipment, but because residential properties are small scale, commercial construction projects can ultimately be more expensive.

Project Deadlines

Commercial construction requires builders to complete a project in the shortest time possible as it helps to save on labor costs. They tend to be fast because the workflow is systematized, and construction costs are higher.

Residential owners like to be involved in the decision-making of their home hence slowing down the project. The construction teams often work on several projects simultaneously due to the few numbers of workers. Coupled with the fact that wood frames make the work more tedious, the project takes even longer.

Permits and Codes

Regulations in commercial and residential construction are different, with those of commercial construction being more stringent. Commercial buildings require adherence to these regulations to protect against safety concerns in relation to elevators, parking lots or garages, and handicap accessibility.Specific codes and permits are required from the local municipality where the structure is being erected. These codes and permits require professionals due to their complex nature for compliance to be ensured. Residential construction projects tend to have simpler building standards and easy to comply with regulations compared to commercial construction.

Required Equipment

Specialized equipment is required in commercial construction to complete various projects because of their large-scale nature. Heavy machines such as cranes and earthmovers are required and usually operated by qualified professionals to ensure project quality and job safety.

On the other hand, residential buildings also require professional builders, but heavy equipment is only used in constructing bigger houses. Accidents and mistakes that may occur when constructing residential houses are generally easier to correct than those made in commercial construction.

Factors Determining Residential vs. Commercial Construction Differences

Valuation

Assessing value creates a significant difference between residential and commercial properties. The value of a residential property is predominantly based on demand and supply. It is estimated by a professional who compares the market price of properties that are similar in that location.

In commercial buildings, value is inversely proportional to the level of risk, essential to the property income stream’s stability and continuity. The value of a commercial property, therefore, depends on leases and net income stream despite its cost in building or its attractiveness.

Risk

Because commercial properties attract long-term tenants, they tend to generate more stable cash flow than residential properties. Typically, residential tenants sign shorter leases ranging between six months to one year. What’s more, they can leave the property at a shorter notice compared to commercial properties.

Unlike commercial properties where the owner is responsible for maintenance and repair costs, residential property owners often require the tenant to take responsibility for them. However, the level of responsibility will depend on the lease.

Rental Yields

There are a variety of residential properties for tenants to choose from. If your property is not appealing, either for sale or rent, they can always look at other properties. Landlords, therefore, face a lot of competition amongst themselves. Yields range between 3 to 5 percent in residential construction projects.

Commercial properties have higher yields, which range between 5 and 8 percent; it can go higher depending on demand and supply, and location of the commercial construction. However, many business owners usually evaluate whether the traffic and location are suitable for them before getting to the property.

Financing

Residential construction, in most cases, requires less funding to start. A deposit of 10 to 25 percent or none is required by lending institutions depending on an owner’s financial capability. Lending institutions also have in place systems and the infrastructure to make access and application of home loans easier for the customer.

Capital required in commercial development is significantly higher, with the application process for loans being longer and more complex. Generally, 60% of the total cost or less loan is evaluated by banks for commercial properties.

Type of Purchasers

Purchasers of residential properties are less complicated compared to commercial property investors. Real estate agents execute the acceptance of residential properties after a standard offer is completed.

Several issues are evaluated when negotiating on commercial properties. These, in turn, delay the settlement hence affecting the contractor’s profit. Purchase contracts are equally complex and would require a solicitor to validate the purchase.

Vacancy Rates

Many people prefer buying or renting near their workplaces, educational institutions, friends, and families. This, therefore, means that regardless of conditions in the economic market, there is always the availability of residential tenants.

Commercial tenants have precise requirements, which make it more difficult to lease. Commercial property owners will compromise on generous terms of leasing to avoid long vacancy periods, hence affecting their profit margin.

Buy-In Land Prices

Land for the development of new residential construction is often available in brownfield and greenfield locations. Land prices can be more affordable, depending on the cycle of property demand at a particular time.

Commercial properties found in good locations such as well-established, inner-suburban areas will have developers pay premiums for them due to their demand. Buy-in-prices are significant when it comes to commercial buildings and are bought by wealthy corporations and groups.

Capital Growth

The demand and supply of residential houses cause the prices to fluctuate. Capital growth can be significant during a booming period where prices are at their peak. This sets the standard for imminent prices.

Commercial building prices are directed by the agreements put in place. An increase in the value of these prices is only relative to the clause of escalation in the agreement. The escalation in a contract is linked to CPI (consumer price index), which has been quite low for the last ten years.

Where commercial leases are longer, say more than five years, a review of the rent clause can be added to adjust the rent according to market value.

Rental Growth

Depending on the country or agreement, tenants pay their rent either weekly or monthly. Similar houses in a particular area determine the market rates. Rental growth for residential properties can differ depending on the location; however, commercial properties offer better rental growth opportunities.

The rental growth of commercial properties is attributed to the Consumer Price Index (CPI). This is because they can negotiate a specified rate yearly. Landlords of commercial properties can also review the rent paid by tenants to suit the market value and economic growth of that location.

Market Research

With residential properties, the price is based on that of similar homes in the same area. Market research is, therefore, more localized and conducted within the suburb and adjacent suburbs. However, market research for commercial properties is broader and carried out at regional and macro levels.

Construction Profit Margin

The profitability of construction, whether commercial or residential, is a fundamental key to its success. The profit margin is the amount of money that remains after you have subtracted all your expenses from the net income. Profit allows you to make investments and grow your business. Expenses include equipment, supplies, bonding, materials, and other costs incurred in the project.

Markup and overhead are factors that can help in determining the profit margin of a construction. Additionally, markup is the additional amount of money charged to a client on top of the cost of a service or a product to ensure profitability.

On the other hand, overhead is the cost of other fixed, indirect expenses that accumulate yearly in the construction. These include legal costs, insurance, debt payment, support staff, owner’s salaries, tools, and bookkeeping. This mostly applies to commercial properties, which are large-scale and require maintenance. They are more expensive compared to those of residential properties.

To understand your construction profit margin:

  1. Subtract payroll, overhead, materials used, and other costs from your proceeds.
  2. Divide the total by your proceeds.
  3. Multiply the decimal by 100 to get the percentage.

How to Increase Profit Margin

The profitability of construction, whether residential or commercial, depends on various factors. The primary reason for developing these construction projects is to attain wealth and success. Below are a few ways you can increase your construction business profit margin:

Create Actionable Plans and Business Goals

Setting a goal makes it easy for your profit margin to increase because estimators can work around your expectations. Your management is also able to create necessary contingency plans and steps to achieve your goals. Unexpected costs are avoided, resulting in a higher profit margin.

Adding a percentage to your overhead and profit doesn’t lead to increased profits. Therefore, it is important to meet yearly and discuss business trends, overhead costs, and profits to set goals and strategies on how to achieve them.

Have Open Communication

Communication in different company levels and across departments is crucial to have a higher profit margin. This is because all staff members stay on the same page through constant communication with managers, key figures involved in the construction, and clients. Delayed communication and miscommunication can be avoided through field notes and daily reports.

Offer Training

Training your workforce, as much as it is undervalued, can result in increased profit margins. Your team becomes better equipped with skills for the job and prepares them for any mishaps that may occur. Training solidifies good practices hence reducing the amount of time taken during construction by avoiding the numerous common mistakes.

Employees also feel important, needed, and part of the journey to make your construction business more successful. Training employees on faster methods to complete a project increases the construction profit margin and betters your business performance.

Carry Out an Estimation Process

This process involves the estimation of the total cost of the project. An accurate estimation process can increase construction profit margin in both residential and commercial construction by preventing unforeseen costs or excesses.

Some estimators are overly accurate due to the methods they use and experience. However, using construction estimation software to track old bids and ensure more accuracy is a great option. Old data can, therefore, be used in crafting your current bid.

Including the risk to your estimation is also important. This creates insulation around your construction bid, hence expanding your profit margin. Risk refers to possible problems that may occur and their costs. Without risk insulation, any unforeseen expenses are taken out of the overhead and profits resulting in lower profit margins.

Use Data Analysis

Data analysis is an integral part of any business, including construction. Data analysis can be used to establish where your losses are and why your goals regarding profit margins are not being realized. Field notes and daily reports can be used during construction to determine work progress compared to the program.When estimates go wrong, payroll information and purchase orders can be analyzed to avoid future mistakes. Data analysis is, therefore, key to improving performance during construction and increasing profit margin.

Give Performance Rewards

This is a good way to motivate your workforce and, in turn, increase your profit margin in construction. Whether residential or commercial, if you come under budget, that money can be used to give employees bonuses. Employees also become motivated to deliver on time without overspending.

However, it is important to make sure that construction maintains quality even when coming in under budget. Employees are made aware that if construction does not pass inspection, then there would be no bonuses. Quality work ensures that your profit margin increases as it is the first choice for many clients.

Things to Note

  • Automating various construction processes in commercial construction can reduce errors, improve work quality, and increase your profit margin. Some of these include: automating bid processes, using cloud-based digital estimating construction software, making use of digital takeoffs, and establishing automated workflows.
  • There are nine important construction numbers to keep in mind which are: overhead numbers, equity, sales, job cost, contract, receivable, liability, cash, and, most importantly, your construction profit margin numbers.
  • It is important to know when and how to increase prices for your construction so as to give tenants ample time to prepare and adjust. In residential and commercial properties, giving warning beforehand keeps clients informed, and in other cases, they can decide early if it’s something they want or not.
  • Ensure you understand the market and identify your area of specialty before getting into construction. Residential construction could work better for you as opposed to commercial construction or vice versa.

Bottom Line

With commercial construction, you have to understand how property will fit into the market. This is because commercial construction is challenging, large-scale, and requires a hefty investment. Location is also a key factor in this construction. However, commercial construction has proven to yield tremendous profits.

Residential and commercial construction differ in many ways. For example, residential properties are easier to finance compared to commercial ones, and residential properties have a shorter leasing period. Factors such as rental growth, capital growth, valuation, financing rental yields, buy-in land prices, and the type of purchasers determine the differences between residential and commercial construction.

Profit margin determines the success of a construction project once overhead and other costs are subtracted from income revenue. Having open communication, and estimating process, offering training to the workforce, giving rewards based on performance, and setting goals can help prevent unexpected extra costs and ultimately increase your profit margin.

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