Managing the Risks of Cost Escalation | ASAP Finance

Managing the risks of cost escalation

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The Knight Frank Global House Price Index shows that global house prices lifted 7.3 per cent in the year to March 2021, and New Zealand had the second fastest growth globally with a 22.1 per cent increase. Property developers looking to take advantage of the favourable market conditions have ramped up residential building activity with new dwelling consents annually tracking at their highest levels on record.

This is great for the NZ property market where limited supply has been a key issue for first home buyers and investors alike. A new challenge now presents itself as the construction sector struggles to keep up with the substantial growth.

Labour and material shortages are occurring more frequently, and developers are experiencing delays when ordering material. Inflationary pressures are also mounting across the board, as the global economy continues to recover from supply chain disruptions.

Managing the risk of cost escalation is now front of mind as suppliers and builders raise prices to protect their profit margin. Three basic approaches to risk management can be summarised as follows: Control, Transfer, and Avoid. Below, we break down these approaches in more detail and what they may look like in practice.

 

Control

Cost-planning: Careful planning at the start of the project is the best way to manage cost escalation risk. Building a robust budget requires engagement with suppliers, contractors, and consultants before committing to the project. Be sure to include a contingency sum into your project budget to cover unforeseen costs. The contingency sum should be adequate for the duration of the project, including possible time delays. Ask yourself, what is the consequence of a 3-month delay at the end of my project? How does this impact my feasibility?

Procurement: Engage with suppliers to identify potential delays when ordering materials. If material supply shortages are forecast, you may need to order in advance to secure stock. This will likely have an impact your cash flow planning. Leveraging long-term supplier relationships, buying in bulk, or seeking alternate suppliers may also be an option.

Redesign or Substitution: Where certain parts of the project work are subject to constraints (being material or labour) or inflationary risk, you may be able to mitigate the risk by redesigning the plans or substituting materials.

We are increasingly seeing construction contracts and building consent documents that allowed for two cladding options. The first, being the preferred cladding solution for the build, the second, a backup solution should the preferred choice not be available due to supply constraints.

 

Transfer Risk

The Construction Contract: The construction contract is a mechanism for transferring risk. Most infill townhouse projects are done on a fixed price (lump sum) contract. By locking in a fixed price, the developer can transfer cost escalation risk to the contractor. This provides cost certainty for the developer, but often comes at a cost premium.

Be sure to negotiate early with your contractor to eliminate provision sums A provisional sum sets aside money for specific building work when there is not enough detail to provide a fixed price (if an item has not yet been purchased or chosen and the installation cost is unknown). Ask the contractor to confirm whether the quote is appropriate for the quality of goods you are expecting.

The cheapest solution does not always cost you the least! Contractors who are not making their margin may generate claims (variations) to recoup some of their costs. Alternatively, the contractor may prioritise other more profitable jobs ahead of yours, and this can cost you more than if you had negotiated a fair contract from the beginning. In the worst-case scenarios, contractors may end up insolvent, leaving your project in the lurch.

 

Avoid or Defer

If you are unable to mitigate, control or transfer risk to an acceptable level then the best approach may be to avoid the project or defer it until conditions are more suitable.

 

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