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After a sustained period of global economic stability, a number of market factors today are combining to create economic volatility. While the impact of COVID-19 is diminishing, other factors such as the war in Ukraine are driving up inflation generally, and particularly the cost of fuel and construction materials.
In the pre-construction phase, this makes it difficult for developers to plan their construction or refurbishment projects, and difficult for contractors to price them. For many years, the trend has been toward fixed pricing, with contractors (and subcontractors and suppliers down the supply chain) taking the risk of fluctuations in labor and materials costs.
Every risk allocation, however, carries a cost, and the risk premium of covering new inflationary factors in these uncertain times may be prohibitive for contractors, particularly in hotel projects, which often have long construction periods. Increasingly, developers are considering introducing price fluctuation mechanisms that allow contractors to adjust their prices, with reference to impartial indices (whether the official inflation index of the relevant country or an index that tracks changes in prices of steel or other materials or of local labor). These provide certainty to contractors, but not to developers.
So, how can a developer assess the profitability or even viability of a construction project when the capital expenditure cost is uncertain not only during the planning and design stage, but also during construction? And in an environment where projects are increasingly difficult to finance, will financiers be willing to provide development finance on a project that has limited price certainty?
A hybrid system, either with a sharing of cost overruns or a guaranteed maximum price ceiling, may provide a compromise solution.
- Exposure to fluctuating prices creates new risks for developers.
- Developers must address potential contractor insolvency.
- Effective and proactive claims management is crucial.
- Keep clear and contemporaneous records.