Cost Overrun is dangerous for any business. Cost overrun is a vicious cycle and increases in Geometric Progression. A geometric progression is a sequence of no’s in which subsequent no is found by multiplying the previous no with fixed no. This fixed no is called common ratio. Gradually the situation goes out of control if cost increase in GP. This is a universal truth and not a pleasant situation for any business. The definition of cost overrun is an unexpected increase in cost against the budget. In other words, underestimation of the project cost. To be honest, accurate cost estimation is the USP of the big builders. The reason being, experience. They have completed so many projects backed by learning curve to plan better. I must say, the control on cost overrun increase the profitability of builders. During the current economic scenario, the businesses who have controlled their cost are profitable.
The cost overrun directly means project delay until unless the builder is well financed. I shared it in my post, Why under construction projects get delayed. It also impacts his profitability, therefore, he may compromise on the quality or deliverables to the buyer. The cost overrun has a major impact on the buyer as it directly or indirectly increases the cost of the property. The indirect increase is because of interest outflow, additional rent etc. The direct increase is more dangerous and harmful for the buyer. Builders include cost escalation clause in the agreement. Therefore, the financial advantage of early buying is completely wiped off. I will discuss this in detail in my next post. Let’s check some of the most common reasons for the cost overrun.
Cost Overrun – The key Reasons
1. Misjudgement: It is like the budgeting goes wrong at the macro level. A builder initiates a project only if it is profitable. It is based on simple facts like projected cost and estimated revenue. The most common misjudgement is on the projected demand in the area. In most of the cases, the builder buys land at a higher rate in speculation of future growth. The problem of misjudgement is more common with small or new builders. Therefore, experts suggest that buyer should buy from reputed, known and old builder.
2. Unexpected Increase in Material and Labor Cost: Normally 2/3rd cost is material and labor cost. It is one of the major reason for the cost overrun. Some of the common examples are increasing cement price or scarcity of labor. The availability of a labor is a major concern in most of the cities. Most of the times builder fail to judge the labor demand because of new projects. It is not possible to increase the supply of labor at short notice. The cost of raw material also indirectly impact the material cost.
3. Interest Cost: Most of the projects are mortgaged officially or unofficially. Builders don’t prefer official mortgage like lending from the bank. It impacts the marketability of the project. The unofficial mortgage is investment from real estate investors. Builder pays interest to them. In layman terms, if you avail home loan then the bank is an investor. If any calculation goes wrong then interest cost increase like future income, job stability etc. Interest cost is another major reason for the cost overrun. It is not advisable to buy under construction property during the pre-launch or initial phase. The probability of cost overrun is high. Near completion, most of the factors responsible for delay are stabilized. Lastly, you should take care of basic checklist for under construction projects before purchase.
4. Low Demand: Low demand is a key reason for the current state of real estate sector. The huge inventory of 36-48 months is available in key metro cities. It impacts the income/revenue of builder thus increases the cost. The builder is not able to meet the expenses. This is one of the reasons for the slow progress of under construction project as complained by most of the buyers. The work on the project site is not stopped so that existing buyers should not complain regarding the same.
5. Unforeseen delays: The unforeseen delays like bad climate, legal case, disagreement between partners/builders etc cannot be ruled out. One of the properties in Navi Mumbai was delayed by 15 years because of the legal case. The buyers cannot do much in this regard. Builder indemnifies himself against any such delays. The cost overrun is high for both the builder and the buyer. The property is difficult to dispose of in such situations.
6. Approval from Govt Authorities: No. of approvals required from Govt Authorities is humongous. It varies from state to state and project to project. A project near the airport may require additional approvals. A project in green or Ecozone also requires additional approvals. Sometimes the delay is intentional as the builder himself would like to delay the project. It is true when the inventory is unsold near completion.
7. Change in Govt Policies: It is profitable for a builder to launch a project in upcoming areas. These areas are identified based on govt policies. For example, if govt announced some development projects for Area A then appreciation will be high. The builders know in advance and acquire land at dirt cheap rate. For example, before the new airport project was announced for Bangalore, the real estate market near the proposed site was hot. The farmers of that area could not understand why suddenly so much demand for land. Now they regret selling their land for cheap. The same pattern was observed in areas around proposed Navi Mumbai airport.
The problem arises when there is a change in Govt policy. Most of the proposed development plans will never see the light of the day. They remain on paper only. Out of 10 times, the builder may be wrong couple of times in his judgement. Therefore, you may not observe much activity in cities with non-business friendly state government. Development is a must for the business-friendly environment and real estate sector.
Words of Wisdom: The reason to publish this post is to help buyers to find out the exact reason for cost overrun and project delay. Sometimes to control cost, a builder may dispose fixed inventory at a heavy discount. You should be cautious about discounted property. It is important to find out the reason for the heavy discount. Always remember cost overrun at builders end, indirectly eats into your returns from the property. Personally, i prefer resale property as it is free from all these issues but everyone has an own choice. A well-informed decision never backfire.
Copyright © Nitin Bhatia. All Rights Reserved.
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