Profit on cost measures margin with no clock attached. Lay the appraisal out as a quarterly cash flow and the same hurdle gives very different returns.
A profit on cost has no time in it, so the IRR it implies depends on the programme and on how the money is drawn. On an illustrative 30-month scheme with a quarterly cash flow, a 20.0 per cent profit on cost, after finance at 7.0 per cent, is an unlevered IRR of 20.5 per cent; the same 20 per cent earned over 60 months is 13.0 per cent. Annualising 20 per cent over 2.5 years (7.6 per cent) understates it, and reading it as an annual return overstates the longer scheme.
Worked in full in The Real Estate Development Manager by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
Profit on cost is the development industry's hurdle because it fits on one line of an appraisal: GDV less total cost, over total cost. It tells you how much margin protects the scheme against cost and value moves. It cannot tell you how long the money is at risk, and two schemes showing the same 20 per cent can be very different investments. The IRR answers that, once the appraisal is laid out as a cash flow.
| Input | Value |
|---|---|
| Land, including acquisition costs, paid at start | 5,000,000 |
| Construction and fees, drawn over eight quarters | 17,800,000 |
| S-curve, share of cost by quarter | 6, 10, 14, 17, 17, 15, 12, 9% |
| Gross development value, received in quarters 9 and 10 | 30,800,000 |
| Sale costs | 2% |
| Finance on all costs, compounded quarterly | 7.0% |
Profit on cost = (net GDV − land − build − interest) ÷ (land + build + interest)
Interest is rolled up quarter by quarter on the running balance of land and build, as a lender would charge it, until the sales repay it. Here it comes to 2,354,280, so total cost is 25,154,280 against net sales of 30,184,000: a profit of 5,029,720, which is 20.0 per cent on cost and 16.3 per cent on GDV.
| Quarter | Cash flow |
|---|---|
| 0, land | −5,000,000 |
| 1 | −1,068,000 |
| 2 | −1,780,000 |
| 3 | −2,492,000 |
| 4 and 5, each | −3,026,000 |
| 6 | −2,670,000 |
| 7 | −2,136,000 |
| 8 | −1,602,000 |
| 9 and 10, each, sales net of costs | 15,092,000 |
| IRR, quarterly 4.78%, annualised | 20.5% |
Annual IRR = (1 + quarterly IRR)4 − 1
In Excel, with quarters 0 to 10 in B2:L2: =(1+IRR(B2:L2))^4-1. The project IRR is measured before finance, because finance is how the return is split, not how it is made. That is why it sits above the 7.0 per cent rate already charged inside the profit.
Two things lift the IRR far above the 7.6 per cent you get by spreading 20 per cent over 2.5 years. First, the profit is struck after 7.0 per cent of finance on every pound of cost, and the IRR is not. Second, most of the money is not out for 2.5 years: land is, but the build is drawn along the S-curve, and weighted by amount the capital is outstanding for 1.42 years on average.
| Case | Months | Interest | Profit | Profit on cost | IRR |
|---|---|---|---|---|---|
| Base | 30 | 2,354,280 | 5,029,720 | 20.0% | 20.5% |
| Build six months longer | 36 | 2,883,722 | 4,500,278 | 17.5% | 16.8% |
| Build twelve months longer, sales three months later | 45 | 3,877,391 | 3,506,609 | 13.1% | 12.6% |
A 15-month slip takes 30 per cent off the profit, all of it in extra interest, and 7.9 points off the IRR. The profit on cost still reads 13.1 per cent, which looks like a thin but acceptable margin. As an annual return on capital at risk it is 12.6 per cent for a development risk profile.
| Programme, months | GDV needed | Interest | Years capital out, weighted | IRR |
|---|---|---|---|---|
| 30 | 30,801,148 | 2,354,271 | 1.42 | 20.5% |
| 36 | 31,442,876 | 2,878,349 | 1.72 | 18.1% |
| 45 | 32,647,286 | 3,861,951 | 2.26 | 15.4% |
| 60 | 34,617,102 | 5,470,634 | 3.09 | 13.0% |
The same headline hurdle produces IRRs from 20.5 down to 13.0 per cent. A phased scheme or a large site with a five-year build that clears "20 per cent on cost" is earning about two-thirds of the annual return of a 30-month scheme with the same label, and is exposed to the market for twice as long.
The common mistake runs in both directions. Treating 20 per cent on cost as if it were an annual return flatters long schemes: at 60 months it is 13.0 per cent. Dividing it by the programme length, 8.0 per cent a year on a simple basis, condemns short ones, because it ignores both the finance already deducted and the fact that build cost is drawn gradually. Report both measures, from the same quarterly cash flow, and set the hurdle for each separately.
Profit on cost measures margin; IRR measures margin per unit of time. On this scheme 20.0 per cent on cost is 20.5 per cent a year over 30 months, and the same profit on cost over 60 months is 13.0 per cent. The quarterly cash flow under the summary appraisal, with the cost of a delay, is in the free workbook for this case; how to calculate interest on a development loan builds the interest line used here, and yield on cost covers schemes held after completion.
Hurdles of 15 to 20 per cent on cost are commonly quoted for speculative schemes, but the figure only means something with a programme attached. Illustratively, 20 per cent on cost after finance is a 20.5 per cent IRR over 30 months and 13.0 per cent over 60 months, so a long scheme needs a higher margin to earn the same annual return.
Because the profit is struck after finance, which the project IRR excludes, and because build cost is drawn gradually. In the example finance at 7.0 per cent is charged inside the 20.0 per cent profit, and the capital is outstanding for 1.42 years on average over a 2.5-year programme, so the IRR is 20.5 per cent rather than about 8.
More, in points, than it costs the profit on cost. In the illustration, extending the build by twelve months and sales by three adds 1,523,111 of interest, takes profit on cost from 20.0 to 13.1 per cent and the IRR from 20.5 to 12.6 per cent.
Chapter 3 of The Real Estate Development Manager sets out the residual appraisal and where it misleads; the free companion workbook adds the quarterly cash flow and what a delay costs. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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