Whilst there’s been a lot of debate about what constitutes a competitive return to the landowner in viability modelling, there’s been a lot less debate about what constitutes a competitive return to the developer. This is hindered by the fact that developers tend to view development return in different ways. When I asked them what kind of IRR’s developers were seeking recently, one development consultant replied that “IRR is a measure for developers but I normally get asked about the Profit on Cost and Development Yield. Housebuilders quite often use ROCE (Return on Capital Employed).”
In the textbooks and in viability appraisals, profit as a proportion of total development value is probably the most common metric. Whilst they can all be expressed in terms of each other – for example, a target IRR of x% implies a target profit on cost of y% and a ROCE of z% – it is clear that there isn’t a standard metric of return. Developers will tend to emphasise the IRR for long term schemes. Getting a 20% IRR on a 10 year scheme could need a profit margin on development revenues of 60-70%. This could be spinned really negatively for a developer – so it makes sense for developers to focus on IRR in long term schemes. For a two year scheme a 20% IRR and a 20% profit margin on development revenues would probably be roughly equivalent. The difference reflects massive time difference in getting that profit compared to a two year scheme and the risk of a ten year project compared to a two year project.
In terms of estimating an IRR for development projects, academics have not really come up with anything practical. Most proposed approaches to required rate of return for development opportunities need data that typically do not exist or assumptions that are unrealistic. However, this is true for many types of investment – not just real estate development. It’s a typical case where a simple, stable, general answer is demanded where such an answer does not exist. In the context of viability modelling, the game then begins with demand for a simple etc. answer creating its own supply.
Recently, I’ve been in touch with a group of community activists (mainly interested in trying to get more affordable housing delivered through planning obligations) who want to question the emerging convention that a competitive return to developers should be awarded 20%. Part of the issue is – 20% of what? That’s been part of the problem. I have a sneaking suspicion (shared by colleagues) that it might not be fully appreciated within the planning community that a 20% internal rate of return per annum is usually very different from 20% profit margin on the value of the development.
In viability modelling, similar to the benchmark land value I suspect that developers, site promoters and their advisers are attempting to get a standard profit level assumption set at quite a relatively high and fixed level is grounded. One consultant commented to me that “the 20% ‘rule’ (is) becoming accepted through a mix of chutzpah and naivety”. Ultimately, the level of project risk (driven by the project-specific and market-systematic factors) is going to be the main determinant of the risk premium required for undertaking a development project. Market drivers will vary over time driven by the interaction of local and macro-economic performance and the capital markets. Projects will have different risk profiles. With or without planning permission? Phased or single building? Long-term or short-term? Pre-let or speculative? Greenfield or brownfield? So required rates of return (and required profits) should vary over time for the same project and vary between projects at any given point in time.
So, whilst acknowledging that it is a horribly simplistic question given the variability in project risks, what return do developers tend to require (before gearing) in practice at the moment? I asked a few people that I know in the business. The responses were varied and suggested a plethora of return metrics and targets.
1 As a very broad brush response we would look to get 15% plus. However as you say, we would always consider far more than just IRR when looking at any site, not just resi…we would almost always go for something without planning where we can apply our expertise and add value.
2 Externally, we had performance criteria, set by our investors/partners that we had to hit. These were driven partly by the risk of the project, as perceived by the investors… Internally, although we tracked and forecast IRRs, we analysed potential projects on a residual NPV and PoC (Profit on Cost) basis. We used 20% developer’s profit. Our larger projects…the output forecasts were 9% and 14.5% IRR. I know that XXXX, who are tackling XXXXXX among other things, in 2010 used to have a firm 20% IRR hurdle. That was not project related at all – it was simply to entice the banks!
3 It really does depend. The majority of resi developers I have come across remain quite old school – they would look at profit and cost on a ‘today’s’ appraisal – so no inflation of values or costs. They would also cash flow it out but more often to look at peak capital commitment for finance purposes. They would look for 15% – 20% PoC including finance. They would in reality take a view on market cycle hoping to time it right that it would go up in value over course of development but that is ‘upside’.
In terms of IRR – historically the big long term regeneration schemes would look at 12% IRR or more taking a view that the lot size and ability to phase warrants a lower IRR. I think some developers would talk up their target IRR to 20% but I believe when you scratch the surface it would be geared. Therefore gut feel they would probably be looking at c.15% ungeared IRR but may accept something slightly less.
4 The IRR does depend on all the factors you mention. 15-20% is sometimes mentioned as a target IRR but I do not think it is that simplistic.