Should we allow for inflation?

Should you factor inflation in your cash flow forecasts?

Should we worry about inflation? No. It’s not statically significant.

When it comes to predicting maintenance costs and funding, some would have you believe that it’s a finite process right down to predicting the inflation rate to one decimal point over the next few decades. However, in reality it’s far from precise.

Using an example to explain

Say you’ve been advised that the roof will need replacing in year 12.

That’s just someone’s guess. The truth is that you won’t actually know when the roof will need replacing until the job gets much closer. Building elements don’t have expiry or best before dates.

You might even be given advice that you could maintain it forever, or at least extend its life.

In fact you won’t know accurately know how much the replacement - or repair - will cost until you get a quote. But you won’t get a quote from a contractor for a job several years out. That would be a waste of his time and just like everyone else, he would be guessing anyway. The best you will get will be a “wet finger in the air” estimate.

But then, when the job is due and you get several quotes, they won’t all be the same. There will almost certainly be a wide gap between the highest and the lowest quote. More than any amount you might have included for inflation.

So in summary, when you are setting up your plan, you can make informed guesses but the further out each job is forecast to take place, the less accurate your guesses will be.

The reason why it doesn’t work

The reason why it doesn’t work is that you simply can't predict what the inflation rate will be in 10 years time. The world is now a fast moving chaotic place particularly in regard to financial services and commodities. So much so that even the most qualified and experienced economists really don’t know what is going to happen. Of course they will try. But they will only get it close to correct if nothing unplanned happens.

Like an earthquake, or government legislation such as the Health and Safety at Work Act, or a war (or peace?) in the Middle East, or a crazy man becomes President of the US, or a housing boom (or bust), or unexpected net migration, or a Brexit, Frexit, Grexit. Etc etc.

OK. You probably get it by now.

How to provide a buffer for price increases

So you feel the need to allow for price increases to be on the safe side. So do it like this.

Let's say you think the roof replacement job might be $60,000 in 10 years time at today’s currency. Don’t worry about compounding an increase of 2% over 10 years. That’s just a guess compounded by another guess. Just call it $70,000 and update it each year as it gets closer.

Round figures are much better to comprehend and you won’t lose any accuracy.

This might not sound like best practice but it actually is. Because it’s quicker, simpler and much easier for your owners to understand.

And you’re not planning to build a nuclear power station here. Just a humble long-term maintenance plan for a bunch of barely interested unit owners.

It’s the owner’s choice

However, one more over-riding factor. If the majority of owners expect you to factor in something for inflation - in the unlikely event enough are sufficiently interested - well it’s their plan and the majority of owners should always get their way.

It’s a democracy remember.

End

Prepared by: John Bradley. August 2016

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