Insights and Research
Escalation in Development | March2014
Are Price and Cost Escalations Equal?
Overview
Summary
Situation to be
Assessed
Should price and cost escalations be
assumed equal in feasibility
assessments? If not, what should be
the margin?
Common Practice
4% revenue and 3% cost are widely
used by developers as assumptions
for escalations. However, there are
some market participants that
assume revenue and cost escalations
are the same and equal to 3%.
Why escalation
assumptions are
important?
If the value of the project is high i.e.
greater than half a billion dollars or
the life of the project is long, even a
minimum error in escalation
assumptions may result in a
significant financial impact.
Are price and cost
escalations equal?
 Analysis of the data over the past
27 years shows that residential
real estate price escalation is
generally higher than
construction cost escalation.
 The exception is the periods that
the economy of the Australia
suffered from significant
economic downturns.
What is the margin?
Recommendations
On a 27-year average, revenue
escalation has been 90 basis points
higher than cost escalation.
 If 3% is used by developers as a
proxy for the cost escalation, it is
recommended to use 3–3.9% as
the revenue escalation. We tend
to the upper level, if we expect the
economy is growing, and the lower
level if the economy is weakening;
 The main assumption underlying
this recommendation is that the
historical average is a reliable
proxy for the future escalation;
 To have a more informed view on
the impact of the escalation on the
end value of projects, in addition
to the escalation-based
evaluations, evaluating
opportunities on an unescalated
basis is recommended.
Escalation is a critical lever in preparing real estate development
project feasibilities. In Australia, 4% and 3% are very common to
be taken as the revenue and cost escalation, respectively.
However, there are some developers that assume price and cost
escalations are the same and equal to 3%.
This raises two important questions; should cost and revenue
escalations be the same? If not, then what should be the
difference between the two?
“Well, we could escalate our profit forecasts if we had the right
escalation estimate in place. 3% or whatever, price escalation is
higher than our costs.”
Why escalation is important to consider?
In general, escalation assumptions are critical in feasibility when
a project’s life is more than 2–3 years due to the time value of
capital committed to the development.
Particularly, when the value of the project is very high and the
duration is greater than 5 years, then even a minor error in the
escalation assumptions impacts the project’s forecast profits
significantly. As outlined below, 1% incorrect escalation
assumption impacts the value of the big projects significantly.
Project End Value
Value of 1% error in
escalation
$200M
$500M
$1B
$1.5B
$2M
$5M
$10M
$15M
$2B
$20M
Insights and Research
Escalation in Development | March2014
Historical Escalation in Australian Housing Development
(1986 –2013)
25%
20%
15%
GFC and
Euro Zone
Crisis
Deflation after the historical high
inflation periods
10%
5%
0%
-5%
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
Revenue Escalation (% Change in Project Home Prices)
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Cost Escalation ( %Change in Residential Construction Costs)
*: Change in Residential Construction Costs is the change in Price Index of Materials Used in House Building from 1986 to 1999, and weighted average of change in Construction Industry Total Hourly
Rates of Pay and Price Index of Materials Used in House Buildings over the period of 1999–2013. (Source, Australian Bureau of Statistics, March 2014).
Historical Gap in Revenue and Cost Escalations
(1986 – 2013)
10%
Positive Cycle: 3 years average is Circa 3.1%
Positive Cycle: 8 years average is Circa 2.6%
27 years average is Circa 0.9%
8%
6%
Negative Cycle: 10 years average is Circa 0.2%
4%
Negative Cycle: 8 years average is Circa 0%
2%
0%
-2%
-4%
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Escalation Gap (Revenue Escalation - Costs Escalation)
(Source, Australian Bureau of Statistics, March 2014)
Long Term Average
Insights and Research
Escalation in Development | March2014
What we have found?
Recommendation
We have analysed housing property data provided by the
Australian Bureau of Statistics (ABS) over the period of 1986–
2013 to determine whether price and cost escalations are equal.
If the value of the project is significantly high i.e. greater than
half a billion dollars or the life of the project is long, it is critical
to take into account relevant assumptions to use the escalation to
calculate the value of the project.
The findings show that revenue escalation has generally been
higher than the cost escalation over the past 27 years. The
exceptions are for the periods of 1989–1998 during which
Australia experienced high deflation and deep recession due to
the 1987 global stock market crash, and the most recent periods
of 2008–2011 that coincides with the global financial crisis and
the European debt crisis (Figure 1).
Over the past 27 years house
price escalation has averaged
0.9% greater than construction
cost escalation.
During these negative cycles, cost escalation has been higher than
the revenue escalation which is a striking result suggesting that
the assumption that the revenue escalation is equal or greater
than the cost escalation cannot be a general rule. Expected
deep and sustained financial or economic turbulence during
projects life can affect our assumptions for escalations.
Based on our findings, we recommend that
1.
Revenue or price escalation should be taken between 0–
0.9% higher than the cost escalation, depending on
our expectation for the overall economy during the life
of the project. This recommendation is based on the
assumption that historical average is a reliable proxy for
the future escalation;
2.
If 3% is used as the cost escalation, 3–3.9% should
be assumed as the revenue escalation. We tend to the
upper level if we expect the economy is growing, and
we incline to the lower margin if we expect deep and
sustained economic downturns;
3.
All projects should be evaluated based on their market
fundamentals. Some adjustments may be required to
incorporate fundamentals specific to each project;
4.
In addition to escalation-based evaluations,
opportunities should be evaluated on an unescalated
basis, as a conservative approach. This provides a more
informed view on the impact of the escalation on the
end value of projects.
We also looked at the escalation gap (the revenue escalation
minus the cost escalations) to find out how much the revenue
escalation is higher than the cost escalation in lung run (Figure 2).
The long term average of the gap over the past 27 years is circa
0.9%. However, the average margin is different across the cycles:




1.8% over the positive cycle period of 1987–1990;
2.6% over the positive cycle period of 1998–2005;
–0.9% over the negative cycle period of 1990–1998;
0% over the negative cycle period of 2005–2012.
The low margins for the negative cycles coincide with relatively
lower inflation periods or deep recessions, whereas the high
margins occur during economic booms when the level of market
sentiment is high.
Contact
Tim Frogley
Director
[email protected]
+61 431 566 790
Emerge Capital
88 Cumberland Street
Sydney 2000
Tel +61 2 8006 2800
www.emergecap.com
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