by Stuart Morley
The use of cash-flow techniques of development appraisal are now commonplace as a supplement to — or sometimes as a replacement for — the traditional residual approach. The reasons are not hard to find — improved education and relatively inexpensive personal computers and off-the-shelf software packages. But while terms like NPV and IRR are commonly used, particularly by bankers and actuaries, how does their practical application relate to more traditional measures of viability such as return on cost? The aim of this article is to examine the advantages of using a DCF approach and to compare the relationship between IRR and return on cost for different types of development.
Traditional measures of viability
Before examining the advantages of a cash-flow approach to development appraisal and how IRR compares to return on cost — and to put the discussion in context — it is useful to summarise the principal ways currently used in the market to assess viability.
- Return on cost (capital profit as a percentage of total development costs)
- Return on cost (capital profit as a percentage of developer’s input)
- Return on cost annualised (the annual equivalent of capital profit)
- Development yield (rental income as a percentage of total development costs)
- Rent Cover (the number of years from the end of the void period before profit is eroded by rent payments, where the developer has guaranteed to pay rent to the funder until letting occurs)
- Interest cover (the number of years from the end of the void period before profit is eroded by interest payments to the bank)
- Break-even rent (the lowest rent needed to ensure that no loss is incurred).
These measures of viability are useful in different situations, depending on the type of developer and the method of funding. For example, a trader developer anticipating a disposal on completion will be more interested in calculating the likely Return on Cost rather than development yield, and vice versa for an institutional developer who will be developing for “long-term” investment. Similarly, if a forward sale with interim finance from an insurance company or pension fund is contemplated, then rent cover will be more applicable than interest cover, which will be an essential calculation for a speculative development financed through a bank. However, all the above approaches to measuring viability are in essence variations on a theme: they are different ways of looking at the same thing, and are fundamentally different from a DCF internal rate of return approach (IRR).
Cash flow and DCF approach
In its simplest form a cash-flow approach, whether a net present value (NPV), net terminal value (NTV) or period-by-period approach(1) is no more than a sophisticated, and potentially more accurate, refinement of the residual approach. A more detailed calculation of a scheme’s total cost is achieved through a more accurate assessment of building (and hence of finance) costs in particular. However, a cash-flow appraisal also has the facility to extend the amount of information provided in appraising a scheme’s viability, thus enabling decisions to be made with a greater degree of accuracy. The anticipated returns from property development can be compared more readily with alternative investments and the cost of borrowing money, by means of their Internal Rates of Return.
In summary, a cash flow or DCF approach has the following advantages:
- It is more explicit, providing a more detailed breakdown of costs and their occurrence.
- It permits a more accurate allowance for inflation and changes in value of key variables.
- It shows when maximum borrowing is required and enables improved calculation of finance charges, consistent with the approach adopted/demanded by other professions (eg accountants, bankers).
- It permits improved monitoring of progress during development.
- It enables the incidence of tax (particularly VAT) and grants (eg city grant) to be allowed for more accurately.
- It provides a potentially more accurate appraisal of large, complex and phased schemes (eg shopping centres, industrial/business parks and residential estates).
- It provides a better comparison with other property and non-property investments. The IRR for a property development could, for example, be compared with the equated yield of a property investment, the redemption yield on gilts or the return from an alternative development.
- It can provide a more accurate picture of profit on a rate of return per annum basis in order to relate to (i) cost of borrowing and (ii) opportunity cost of investment, as stated above. This means that profitability relates to the time taken to realise that profit rather than being purely related to cost, as in the residual approach. Profitability accurately accounts for the time value of money. According to a recent NEDO report(2), it takes nearly twice as long to build a speculative office as a purpose-built shop of the same value. Hence, using a Return on Cost measure of profitability, both projects would show a similar return whereas an IRR approach would show a higher return for the quicker project enabling a more detailed comparison to be made.
It is important to distinguish between modifying a traditional residual valuation by adopting a cash-flow approach and using a true DCF method to calculate the IRR.
In essence, all that a cash-flow approach means is that all development costs, and in particular building costs, are divided into monthly, quarterly, half-yearly or yearly amounts, the net cash flows calculated for each relevant period, and short-term finance allowed for separately in each period. For many small-scale schemes involving a short time-scale of development, a cash-flow approach will give a very similar answer on viability to that achieved by using a traditional residual approach(3). The advantage comes when schemes are complex and involve phasing and a long development period.
An IRR approach
An IRR approach, however, would involve determining what discount rate would equate total costs (excluding any profit or cost of finance allowance) to capital value. This discount rate or internal rate of return (IRR) would therefore reflect the scheme’s profitability relative to the actual incidence of costs and income and show the true annual rate of return on capital employed in the project. Or, alternatively, IRR could be defined as:
The rate of interest (expressed as a percentage) at which all future cash flows (positive and negative) must be discounted in order that the net present value of those cash flows should be equal to zero. It is found by trial and error by applying present values at different rates of interest in turn to the net cash flow. This rate of interest or return could then be compared with the rate of interest on borrowed money or the return (equated yield) on alternative investments; the minimum acceptable return would be the interest rate on borrowed money plus an acceptable margin for the degree of risk involved.
Comparison between IRR and return on cost
The key questions are what is this acceptable margin; should it vary (and, if so, by how much); and how does IRR relate to the more familiar measure of return on cost? According to our research and a recent survey by South Bank Polytechnic(5), the majority of developers using IRR (a few property companies, but mainly directly owned subsidiaries of life companies where a more actuarial approach is required for decision taking) look for a total return on a “typical project” of approximately 10% above their funding rate, so if a developer was borrowing at, say, 16% it might expect an IRR of about 26%, and this would equate to the more traditional return on cost figure of about 20%.
The following example is a short summary of our research findings and examines this relationship for a variety of different development situations, using two different funding rates. A hypothetical office development was assumed with the following characteristics:
The size of scheme is immaterial and will, in effect, be reflected in the building and development periods assumed (see table below), ie where the development period is assumed to be 18 months, the scheme is obviously smaller than where the development period is 30 months. A 45-month development period is clearly extreme for any scheme, but is used here merely to test how sensitive IRR is to different assumptions. (No assumptions about phasing have been made.) It should be stressed that, although an office scheme has been used to examine the relationship between return on costs and IRR, the results will be applicable to any type of development. It is the relationship between capital value, construction cost and land value that is important rather than absolute values.
The approach adopted was as follows: first, utilise a standard residual valuation programme to calculate site value employing the above principal assumptions and other relevant assumptions regarding fees etc and assuming a required profit margin of 20% on cost. Second, use this site value as a known or fixed cost and calculate the IRR, making some simplifying assumptions about the cash-flow apportionment of costs. The results of this analysis are summarised in the table below.
Analysis of findings
Several key findings emerge from our research:
(1) The first and most obvious result is that there is no straightforward relationship between IRR and Return on Cost. If return on cost is kept constant at 20%, then IRR will increase as the development period decreases and vice versa.
For example, at a finance rate of 15% pa, IRR varies between 24.7% and 37.8%, a margin of between 9.7% and 22.8% above the finance rate.
(2) IRR clearly varies considerably depending on the relevant development period, but not on the breakdown of that development period between pre-build, construction and letting void. IRR will also vary slightly owing to changes in the relationship between rent, yield and building cost (ie the relationship between site value and the scheme’s capital value).
(3) A further conclusion that can be drawn from these results is that if a constant IRR is desired, then the 20% return on cost assumption should vary between developments, depending on the time it will take to develop them. For example, assuming a finance rate of 15% pa and and IRR held constant at 29%, Return on Cost varies between 12.5% (18-month development period) and 29% (45-month development period).
Conclusions
It must be emphasised that the above calculations involve some generalisations and simplifications, but this should not detract from the point of the exercise, which was to provide a simple comparison rather than accurate individual appraisals. This comparison shows that the relationship between IRR and return on cost is not constant when variations in the time-scale of development occur. For development periods of about 30 months, then a 20% return on cost assumption equates to an IRR margin over the cost of finance of 10% to 15%, depending on the finance rate and the type of development.
References
(1) C Darlow (Ed), Valuation and Development Appraisal. Estates Gazette, 2nd Ed, 1988.
(2) NEDO, Faster Building for Commerce. 1988.
(3) S Morley, C Marsh, A McIntosh and H Martinos, Industrial and Business Space Development: Implementation and Urban Renewal. E & F N Spon, 1989.
(4) Glossary of Property Terms, Estates Gazette, 1989 (compiled by Jones Lang Wootton).
(5) P Marshall, Development Valuation Techniques. RICS Sponsored Research, 1990.
