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By Altus Group | 9 November, 2020

We’ve all done our fair share of crystal ball gazing this year. While some experts believe costs will rise, others argue costs are likely to fall. Who is right? The answer is both. The question of when is most important.

We all know the effects of the pandemic and subsequent economic lockdowns are impacting the construction industry globally. Initial concerns of supply chain disruptions have turned to worries of cost escalation. According to Altus Group’s latest Global Property Development Trends Report, 73% of development executives nominated project cost escalation as one of the most significant challenges.

 

What’s driving costs?

There are five competing factors contributing to the current climate:

Construction volume

Lower construction volumes are likely to increase competition and reduce margins. At the end of the day, it comes down to supply and demand. The latest RICS Global Construction Monitor report found that nearly 20% of projects in Australia were on hold in the second quarter of 2020. While new housing approvals have risen in the last quarter, ongoing uncertainty continues to temper jobs growth and consumer confidence. Economic contraction, lower inbound migration and the fallout of COVID-19 restrictions in Victoria continue to weigh heavily on the market.

Materials and supply chain

The pandemic had an early impact on cross-border trade, access to materials and scheduling, but workarounds are now appearing. Any current supply chain impediments have been more challenging on tightly scheduled large-scale projects, especially for key components like lifts. Increasing use of local suppliers to shore up supply chains is keeping the cost of materials high.

Trade and labour

We’ve seen downward pressure on tender costs as contractors and sub-contractors reduce margins to rebuild their future pipelines. In the short term, contractor pricing may be much more competitive, which will counteract the escalation rate. But it is wise to proceed with caution. Government stimulus and wage subsidies are propping up companies that would otherwise fail. Identifying the early warning signs that a project or contractor is in distress will be critical as we move into 2021.

Productivity

Social distancing measures are still taking their toll onsite productivity, extending programs and increasing costs. Consider the challenges of limiting the number of people onsite in elevators and hoists alone, as just two workers can use a lift in a 40-storey tower at any one time. That’s an hour per person lost every day, at a minimum.

Market position

With many contractors concerned about the impact of COVID-19 on future projects, we’ve seen a shift in strategy toward more diversified portfolios. Some contractors are trying to defend their positions and adjust to the changing environment, whilst others are reinventing themselves to take advantage of changes in the market. With many retail and residential projects now on hold, the focus has turned to the public sector, specifically health, education and infrastructure.

 

What does that mean for escalation?

Pre-COVID, cost escalation was somewhere around 2.5% to 3.5% per annum, depending on the building or asset type, the scale and location. Large-scale civil and infrastructure projects, which are currently suffering from a lack of availability, are closer to 3.5% to 5% per annum. Margin compression is reducing prices, and cost escalation currently remains flat.

 

Not all sectors and trades are created equal

It’s very common for developers, contractors and consultants to estimate construction cost escalation, for all asset types and trades, based on a single number or range. This can lead to grossly inaccurate development budgets and forecasts, with more time (and money) spent on contingency plans down the road.

When considering construction cost escalation, remember two things:

  1. Each trade cost does not change at the same rate

For example, we have seen the cost of formwork change at a dramatically different pace to the cost of structural steel.

  1. Every building type requires a different set of trades and in different proportions

Consider the significance of the formwork trade in high-rise residential buildings, compared with the small role that same trade plays in a typical warehouse building.

 

Mitigate project risk by better estimating cost escalation

There are, unfortunately, myriad ways that the misapplication of construction cost escalation rates can result in financial or reputational damage. Fortunately, there are some tried-and-tested ways to mitigate cost escalation risk right from the start of any project:

  • Deliver accurate costings upfront. The more accurate the information, the easier it is for investors, developers and lenders to understand the viability of a project. An inaccurate construction cost forecast can result in millions of dollars in variance to budget. The greater the accuracy upfront, the better the feasibility decisions.
  • Adjust your loan conditions to the market conditions. Lenders can tailor their loan conditions to reflect the risks associated with cost escalation. Making conditions more stringent in times of higher cost risk, and more moderate in times of reduced cost risk, helps you ride the market’s rough waves.
  • Plan your procurement decisions carefully. Negotiate contracts early for trades that are rapidly increasing and wait for the completion of construction documents for trades that are expected to remain steady or decrease.
  • Dive deep into the data. Developers with the right data can unpack the trade-by-trade cost escalation to confidently approve or reject claims and avoid protracted legal disputes.

Cost escalation on construction projects is not simply a question of percentage. There’s a host of considerations from the building type and location to the size and scale of the project, the accuracy of cost estimates and market conditions. Not all sectors and trades are created equal either. It’s a delicate balance, which is why savvy developers turn to the experts with the deep experience and the rich trove of data behind them.

Lastly, while competitive tender pricing might seem like cause celebration – it is critical that you proceed with caution. Unrealistically low prices to win work leaves little margin to accommodate unexpected challenges down the line. Any joy will be short-lived, and there could be seriously detrimental financial implications for you and your project partners to recover a distressed project.

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