ROC…ROE…IRR…
What measurement of development return is better and why?
ROC (Return on Cost)
This is simply the net project profit divided by the total development cost. It is generally the first “go to” measurement that most developers look for. Whilst each project is different and ROC is subject to individual project risks, generally a bankable return would be a minimum of 17.5%. One of the greatest pitfalls of inexperienced developers is not including all development costs in this calculation. I have reviewed many feasibilities over the years that have suggested 25% or more returns…I can assure you this only happens under extraordinary circumstances and is not an industry norm. Quick rule of thumb…if your first run feasibility is 20% ROC or greater, then an alarm bell should ring and you need to check your figures very carefully.
ROE (Return on Equity)
This is the development profit divided by the cash equity in the project. To me this is a more meaningful figure as it’s the return on your own cash that is the creator of wealth. This figure is highly dependent on the finance structure of the project. Increased principal and mezzanine funding of a viable project, will increase the return on equity because the profit is similar but the equity portion is lower. However there is increased risk as debt increases, the more debt the quicker the development needs to be sold through and profit realised. There have been many “creative” ways over the years to increase ROE, which is ok, but you must understand the development as a whole and the financial structure implicitly, otherwise stay within traditional parameters.
IRR (Internal Rate of Return)
This is the measure of a return on a project over time. IRR’s are thrown around willy nilly by many developers just to look smart…I’m serious. But ask many of them how an IRR is calculated or what does it really show, and they come up with the standard textbook response.
In simple terms, the longer the project period the more informative IRR is. I do not believe IRR for a project less than 2 years is a meaningful measure and can often be misleading. Even up to 5 years it has limited value. IRR is valuable for projects longer than 5 years and for large investment properties to be held for minimum 5 year periods, and asset portfolios as a whole.
What you need to understand is that IRR is based on future cash flow, so therefore by its very nature is full of assumptions. Assumptions can of course be manipulated to achieve desired results. Assumptions also change.
So there is nothing wrong with an IRR measurement for a 5 + year project with multiple income and expense streams, however assumptions need to be clearly understood, and these assumptions must be revisited every 12 months as a minimum to identify market movement and ensure the project remains on track.
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