Purchasing commercial real estate… The price of inaccurate cost estimates
POSTED 11 February 2020
Property Week recently reported that the commercial real estate sector in London is set to receive significant increased investment in 2020. Knight Frank research suggested that investment in the commercial sector could reach £48bn. With the value of buildings currently for sale reported at a value of approximately £2.3bn, coupled with an under supply of office space, this could well result in higher than expected bids to secure assets. This in turn could put a squeeze on the capital costs associated with improving acquired assets to levels which are attractive to relevant occupiers.
Chris Greening, Head of Cost Management at Paragon BC, looks at some common mistakes in the early assessment of construction costs and how some of these pitfalls can be mitigated.
So, how can investors ensure that early appraisal of the capital costs required for improving commercial real estate assets accurately reflect the desired outcomes, especially when the scope may be undefined or indeed be non-existent, based on a glossy sales brochure that tells little of the building fabric and underlying infrastructure?
When considering the capital cost of any construction project, particularly at the early feasibility stage, accurate cost estimates are key when authorising an investment decision. The effects of inaccurate estimating, whether too low or too high, can be significant.
So, what are the common mistakes when estimating and how can they be mitigated?
Through the delivery of cost planning and bank monitoring services, experience has shown that a number of mistakes commonly occur when undertaking early capital cost appraisals of potential schemes: Such as:
- The full scope is undefined, leading to scope omission from the estimate.
- Insufficient time is allocated to the initial feasibility estimate, potentially leading to key project criteria being missed.
- A review of the project’s risk profile is not carried out, leading to omission or low contingency allocation.
- Over optimistic assessment of the market, both in terms of component/element rates and delivery performance.
Many projects, even when well programmed and executed, can experience an escalation of costs against the original cost estimate. A number of reasons are commonly associated with cost over-runs, including:
- Material price changes that were not reflected in the estimate, both pre-construction and contractor costs. This may well become more acute given the UK’s withdrawal from the EU given the volume of construction materials sourced from EU countries.
- The availability of appropriately skilled labour; recent industry reports have highlighted a skills shortfall throughout the industry.
- As a result of the skills shortage, wage increases for key trades.
- Lower productively than provided for in the initial programme, resulting in delays and associated delay costs. This could also have a knock-on effect of delays in future tenants occupying leased space, resulting in damages under lease agreements.
- The procurement and contract approach not reflecting the project characteristics and risk profile. In many instances, procurement workshops are not undertaken. Instead clients simply resort to a form of procurement and contract previously adopted. Whilst the benefit may be familiarisation with commonly used contracts; poor project definition and mis-alignment of the procurement route and contract form can impact on the project’s overall delivery. It may also fail to provide an appropriate risk assessment, leading to increased costs due to delays and lower than required contingency allocation.
- Material availability and lead-in times not as planned, impacting programme performance.
- The completed work’s scope not in line with the original or improved estimate.
- Owner/Investor pressure to reduce costs to support the initial investment decision. As cited above, the forces of under supply of commercial space and over supply of investment funds, may result in capital costs of development being driven down to make the deal stack up. Whilst the initial development appraisal figures may work for the owner / investor; in reality the actual cost of the works required to bring the asset to a lettable standard for targeted occupiers are far higher.
- Project stakeholders who have invested considerable time and cost in the early appraisal of a project and have a vested interest in seeing it go forward. Despite the presence of some of the issues referred to above, many continue to plough on. Whilst rarely a palatable option, withdrawal from a potential development, despite incurred costs could prove to be the wiser option.
Experience has shown that the common mistakes in the compilation of estimates, particularly in the very early feasibility stages and / or where there is very little, or sometimes no information, can be mitigated through the application of the following:
- A visit to the property/site to gain an understanding of the building, it’s form of construction, suitability of layout considering potential future usage, surrounding infrastructure, capacity of current utilities and site constraints. Assumptions made on costs associated with such aspects of a building can be hugely inaccurate without an understanding of the site conditions and constraints. Many of these will not be articulated within a sales brochure.
- Selection of experienced cost planners who can interpret high level information and an understanding of the costs associated with client aspirations for the completed project.
- Obtaining information regarding the structural make up of an existing building. Requirements for structural alterations can greatly impact costs, particularly if re-location of structural cores are required to facilitate improved structural grid for optimal office configuration.
- A realistic and constructive review to drive a clear definition of the scope of works.
- Early identification of the key cost drivers and those which will have the biggest impact on the project outcome.
- Use of benchmark data to test the acceptable cost limits within which the project is realistically expected to be delivered. Current market data is key when assessing the potential costs of some of the project drivers discussed above. This can support early investment decisions, both in terms of potential building usage based on required investment returns, and also support early investment decisions to avoid unnecessary expenditure in reviewing option appraisals.
- Robust assessment of project risk to provide appropriate risk/contingency provision.
Conversely, although overestimating the cost of a project may not have an impact on the specific project or its stakeholders, there is the opportunity cost to consider. This is especially relevant if the excess capital safeguarded for one project could have been allocated to secure an investment on another project.
Whilst not necessarily impacting the asset owner/client, overestimating can also hide underperformance under the protection of an over inflated budget.
However, the impact of a project which has been underestimated can have far wider consequences, including reputational damage, loss of prospective tenants and insufficient funds for project completion. This may result in a dilution of the final product due to scope reduction. Experience has also shown that the project team often becomes very defensive and spend many hours explaining cost overruns, rather than focusing on achieving project completion.
Whilst there may be pressure in the early stages of a project to keep costs low to aid investment decisions, it is important to recognise the longer-term impact of underestimating project costs.
Should you wish to discuss any of the issues mentioned above our would just like some impartial commercial advice based on Paragon’s extensive experience, then please get in touch on 020 7125 0112 or drop me a line on firstname.lastname@example.org
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