Vertical integration and reputation: the case of real estate companies

Vertical integration refers to organizing and allocating resources to produce outputs or intermediate outputs within a company by hiring resources in the factor market, instead of directly purchasing those intermediate outputs from an external party in the product market. Examination of the annual reports of listed real estate companies in Hong Kong suggests that these companies have varying degree of involvements in various activities of producing accommodation spaces (real estate assets and associated services), ranging from land acquisition, real estate investment, real estate development, planning and land preparation, architectural services, construction, engineering services, building materials and components manufacturing, interior design and decoration, real estate agency, property maintenance and management. This provides a good opportunity to examine why companies integrate vertically. This research proposes that vertical integration is more likely for companies which have invested in reputation to signal the high quality of their products to solve the information asymmetry problem. In the real estate industry, high-quality products refer to longer lasting real estate assets that requires less maintenance and management, which are usually building with relatively fewer latent defects years after occupation. Latent defects are defects due to poor workmanship or use of substandard materials that are difficult or impossible to discover during the defect liability period (usually after 12 months of occupation the real estate companies are not responsible for any latent defects that occur in the property). However, it is usually expensive for a real estate company to measure the quality of high-quality buildings procured from the market, e.g. selecting an outside construction contractor using the tendering process. Since, by definition, the latent defects cannot be detected easily, the transaction cost of procuring high-quality buildings or its components from the market become prohibitively high. Careful direct supervision of workers and direct purchase of materials are essential to ensure the quality of the buildings required by the developer. Hence vertical integration is likely to supersede the market when the quality of the product produced by the developer is high. Due to information asymmetry problem, a real estate company will not produce high quality products unless it can signal to the potential buyers the quality of its product. This can often be achieved by investing in goodwill or reputation. However not all real estate companies have successfully created a good reputation of delivering high-quality buildings. For those that are successful, the higher quality of their products is reflected in higher transaction prices in the second-hand market. For the empirical tests, this research makes use of second-hand housing transaction data in Hong Kong (predominantly high-rise buildings) to estimate a reputation proxy, which is the mean implicit price (in the second-hand market) of a standardized unit developed by different real estate companies. Based on panel data of listed real estate companies in Hong Kong, this study shows that the estimated reputation proxy is positively correlated with the company’s degree of vertical integration, which is measured by the number of activities in the production of accommodation spaces using the internal resources of the company or its subsidiary companies, holding other factors constant. The empirical result confirms the proposition that a company’s reputation is an important contributor to its degree of vertical integration.