Of great importance and interest to most professional property developers and financiers, when they consider the financial feasibility study of a property development proposal, are the financial metrics, internal rate of return (IRR) and internal rate of return on equity (IRRoE).
Among other things, calculating the IRR and IRRoE metrics involve the discounting of future cashflows in order to take account of the “time value of money”, which is based on the financial analysis principle that a dollar today is worth more than a dollar in a year’s time. This “time value of money” concept is discussed further below.
In most cases, the higher the IRR for a development, the more financially advantageous it is to undertake. IRR enables the comparison and ranking of various types of developments because the same methodology for calculating it is used for each proposal to determine the return. Typically, when comparing development options that have similar attributes, the development with the highest IRR is most likely to be considered the best one.
Before business use of personal computers became nearly ubiquitous in the 1980s in Australia, probably most property developers were almost exclusively concerned about margin on development cost (MDC) metric, which is the developer’s margin as a percentage of development costs, rather than any other financial feasibility metric to gauge a development proposal’s profitability. The most likely reason for this behaviour is that, prior to 1981, more complicated metrics, like IRR, were not widely understood nor readily calculated because calculating IRR practically always involves numerous reiterative calculations and, back then, usually required the use of a small calculator. With the advent of the widespread use of personal computers, this situation changed, such that more property developers could have cashflow and IRR calculations and reports for a development proposal very many times more rapidly, using an electronic spreadsheet or a specific financial feasibility software, rather than transcribing figures from a calculator to hand-drawn boxes on pieces of paper. As a result, development financiers most often require IRR or discounted cashflow information from applicant developers or property valuers to assess the financial feasibility of a development proposal in order to decide on whether they will fund that proposal.
MDC is simply the profit from a development divided by the total cost of the development and is usually expressed as a percentage. Although this is a very useful metric, it is not adjusted for how long the development takes to develop-and-sell, unlike the IRR metric. For example, let’s consider two developments, A and B. A costs half the amount of money to develop-and-sell than B. Both A and B have an MDC of 20% however A will take a year to develop-and-sell, and B will take two years to develop-and-sell. In financial terms, which is the better proposal? IRR can be used to help answer this question. If A has an IRR of 22% and B has an IRR of 15%, then A is most likely the better financial proposal because the time to receive the 20% MDC for A is much less than the time to receive the same MDC percentage for B; and the IRR metric enables us to quantify the returns of the two proposals in “time value of money” terms.
The calculations that our software, Feastudy Professional, uses to deal with IRR and IRRoE for Development proposals are discussed in some detail as follows.
Internal Rate of Return (IRR) is a financial profitability metric for determining the feasibility of a capital development.
The calculation of IRR involves the discounting of the Development's cost and income cashflows. The rate of discounting reflects the average rate of return that is achieved over the period of time between the Development Reference Date (start of cashflow period) and the Development Completion Date (end of the cashflow period) and is achieved when the sum of the discounted monthly net cashflows is zero.
The (overall) IRR is arrived at by a reiterative “trial and error” method, whereby trial discount rates are used to generate monthly Net Present Value Factors (NPV Factors), which are used to discount the relevant monthly net cashflows, with later net cashflows having progressively more heavy discount factors than earlier ones. The NPV Factor for the first month of the cashflow is always set to 1.0000; then the NPV Factors for all subsequent months are obtained by dividing the NPV Factor for the previous month by (1 + i/12), where “i” is the trial (nominally) annual discount rate, which is divided by twelve because 12 is the number of months and “inverse rests” in one year. (NPV discount factors are the inverse of compound interest factors for the same percentage rate.) The IRR, or the required NPV discount rate, is achieved when the sum of the discounted monthly net cashflows is zero.
NPV Factors for the calculated IRR for Development files are shown in the NPV Factor row of their Categorised Cashflow reports respectively. As a default, all monthly NPV Factors are shown in these reports, however when the selection in the Cashflow Interval Selector is for Quarterly or Annual for a file, the NPV Factor for the last month of each time interval is displayed in the relevant cashflow report even though monthly factors are used in all IRR calculations.
In comparison with older financial profitability metrics, such as margin on Development cost (MDC) or pay-back, the main advantage of using IRR as a metric of financial profitability is that it takes account of the time value of money.
The time value of money is illustrated by the following example. If an investor invests $1.00 now for one year at the best interest rate available at the time, say 10% per annum, the investor will receive a total of $1.10 at the end of that year. In other words, the investor's $1.00 now should be worth $1.10 in one year's time because the investor can receive interest of ten cents for the year that the dollar is invested. Similarly, the present value of a dollar in a year's time is $0.91 because 91 cents invested today at an interest rate of 10% per annum will grow to $1.00 in a year’s time.
Deciding on the Target (or minimum required) IRR for a Development project involves at least some subjective judgement(s) but, quite reasonably, the rate should take into account the risk involved in achieving an acceptable return. One approach for deciding what should be the Developer’s minimum required IRR or rate of discounting future dollars is the developer’s cost of capital, i.e., the opportunity cost of the Development or the overall rate of return that the developer would otherwise be able to earn from other business ventures which have the same risk level as the Development that is under contemplation.
The calculation of IRR on Equity (IRRoE) involves the discounting of the Development's equity and profit/loss cashflows. The rate of discounting reflects the average rate of return on equity that is achieved over the period of time between the Development Reference Date (the start of the cashflow period) and the Development Completion Date (end of the cashflow period) and is achieved when the sum of the discounted monthly net equity and profit/loss cashflows is zero.
The IRR on Equity calculation involves the discounting of:
All equity amounts or positive equity percentages entered in the Equity window, for any of the five methods of equity injection available in that window, are regarded by the program as provisional equity injections because the provisional equity amount for certain months may not be actually injected in those months. The reason for the provisional nature of equity entered in this window is that the program disallows an actual equity injection for “the month” if the sum of the Cumulative Net Debt for the previous month (if there is one) and the Net Outlay for the month is a surplus of funds. The principle which is followed here is that equity should not be injected into the cashflow when there is a sufficient cumulative surplus from the previous month to fund all of the Net Outlay (new income minus new costs before interest) for “the month”. In other words, if up to and including the Net Outlay for “the month” the sum of all Development income and all Development equity minus all Development costs is a surplus (i.e., not a debt balance), equity cannot be injected for the month in question because it is not required to fund Development costs in that month – the cumulative surplus is used to do that. Another related principle, which is followed in Feastudy, is that if the sum of the Cumulative Net Debt for the previous month (if there is one) and the Net Outlay for the month is a net debt, then no more than the amount of the net debt can be actually injected as equity for the month.
The "Equity Amount", as reported in the Profit and Loss reports of the program, is the total of all equity actually injected into the cashflow, not what is provisionally injected from entries in the Equity window.
(The detailed discussion of Feastudy’s IRR and IRRoE calculations ends here.)
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Mark Andrews
Managing Director
Devfeas Pty Ltd
26/03/2022