The implied internal rate of return in conventional residual valuations of development sites

Abstract

Explicit discounted cash flow methods are used in many countries to assess the value of property investments or their likely rate of return given a particular price. These are typically supplemented by simpler models for the purpose of estimating market value and this has led to debate over the merits of different approaches. A parallel situation exists in the case of UK development sites: both cash flow appraisals and simpler residual valuations are used by the real estate industry to assess site values and development viability. Yet traditional residual valuation methods involve making assumptions that are inconsistent with financial theory and this makes it difficult to compare the required returns for such schemes against those used for other investment opportunities. Hence, in this paper, we explore the relationship between the profit and interest allowances used in traditional residual valuation models and the internal rates of return that they appear to imply. This is done with reference to a number of simulated examples of different schemes and the implications for practice are then assessed.

Performance metrics and required returns for UK real estate development schemes

“…Larger commercial developers, using cash flow appraisals and developing longer schemes, quoted per annum IRR targets of around 10-12%; this reconciles with requiring higher cash returns for longer projects. Crosby et al (2018) found that IRRs and profit-on-cost were similar in magnitude for projects around two years in length, with shorter projects producing higher IRRs and longer projects producing lower IRRs from a static profit-on-cost target. There was comment in the interviews about target returns increasing for longer projects and this would seem logical for cash metrics in order to maintain a constant IRR.…”

“…Figure 8 shows that, for development length, respondents were equally divided between increasing the profit target for longer developments or not adjusting it at all. One explanation for this finding could be that those developers using cash flow techniques keep the target rate static because it allows already for the time effect, while those using conventional residual techniques need to raise their profit target to maintain a similar periodic return rate (see Crosby et al, 2018). However, crosstabulation of the responses showed that this was not the case; there was no significant difference in answers when responses were categorised in this way.…”

“…In contrast, a cash margin would need manual adjustment on the part of the developer to allow for more profit in this instance. Crosby et al (2018) illustrate the impact on profit from using a fixed cash margin regardless of the time frame of a scheme; it results in a declining periodic rate of return as the time frame increases. It is an empirical question as to whether and how much developers adjust cash margin metrics in different situations.…”

“…On the rare occasions that IRR was used, this was either 15% or 20% per annum. Where profit-on-cost was used, this ranged from 15% to 22.5% (see Coleman et al 2013;Southwark LBC, 2014;Crosby and Wyatt, 2016;Crosby et al 2018). These figures are all gross of interest and tax.…”

“…Yet the standard deviation also reduces, which would be consistent with a rational risk-return tradeoff, though it is unclear that longer projects should be less volatile in their outcomes, unless variations are reduced by other factors such as phasing. A lower rate of return would also be the expected outcome if development appraisals and prices paid were based on fixed cash margins rather than periodic rates of return (see Crosby et al 2018). However, an important caveat is that the sample sizes for longer projects are smaller and may be subject to survivor bias; 79% of the projects on which these figures are based being three years or less in duration.…”