Inflation Factor

The estimated annual rate of cost increase applied to replacement costs in a reserve study to project future expenses in inflation-adjusted (future) dollars. Construction and maintenance costs tend to rise over time due to increases in labor rates, material prices, equipment costs, regulatory requirements, and general economic inflation. A common inflation factor used in reserve studies is 3% to 4% per year, though it may be adjusted by component type (for example, elevator modernization costs have historically risen faster than painting costs) and by geographic region (coastal California markets often experience higher construction cost inflation than national averages). The inflation factor works in tandem with the interest rate assumption (the expected rate of return on invested reserve funds) to determine the net present value of future obligations. If the inflation factor is 3.5% and the assumed interest rate is 2.5%, the net cost increase is effectively 1% per year, which means the association's contributions must outpace its investment returns. Underestimating the inflation factor is one of the most common causes of reserve underfunding — a 1% underestimate compounded over 20 years can result in a projected shortfall of 15% to 20%. Reserve study professionals should disclose their inflation assumptions and explain the basis for the rate selected. Boards should compare the assumed inflation factor to recent actual cost increases for major projects in their community and request adjustments if the assumption appears unrealistic.