The bigger profit comes with the developer's own equity and finance; the right comparison is the return on that equity, not the two margins.
A forward commitment pays the developer more profit, but only because the developer finances the build with its own equity and debt. On an illustrative 24,000,000 pre-let scheme, the forward commitment pays 4,151,394 against 2,476,725 under forward funding, and needs 8,556,000 of developer equity to do it. The 1,674,668 of extra profit is a 13.0 per cent annual return on that equity, so a developer whose equity costs more than 13.0 per cent should take the forward funding.
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 →
A developer has a site and a pre-let office building: 1,600,000 a year of rent on completion, 18 months of construction. Two investors bid. One offers a forward commitment: it will buy the completed, let building for a fixed price at a 5.50 per cent yield, and the developer finances the build. The other offers forward funding: it buys the land now, pays the build costs monthly, charges a 6.0 per cent coupon on everything it advances, and pays the developer the balance of a price struck at 5.75 per cent on completion. Prices are taken net of purchaser's costs to keep the comparison clean. All figures are illustrative.
| Item | Value |
|---|---|
| Rent on completion | 1,600,000 |
| Land, paid at month 0 | 6,000,000 |
| Build and fees, 1,000,000 a month for 18 months | 18,000,000 |
| Total cost | 24,000,000 |
| Forward commitment yield | 5.50% |
| Forward funding yield / coupon on advances | 5.75% / 6.0% |
| Developer's bank loan (forward commitment): rate / arrangement fee | 8.0% / 1.0% |
| Developer equity, first in (forward commitment) | 35.0% of cost |
Price = 1,600,000 / 5.75% = 27,826,087
Coupon = funds advanced rolled up at 6.0% a year, monthly, to completion = 1,349,362
Developer's profit = 27,826,087 − 24,000,000 − 1,349,362 = 2,476,725
That is 10.3 per cent on cost, received at completion, with no equity in the scheme. The coupon is not cash the developer pays: it is a deduction from the profit, which is why the developer's profit is so sensitive to time.
The developer puts in 35 per cent of cost first, 6,156,000 at month 0 (land and the loan arrangement fee) and the rest over the next three months, then draws a 15,600,000 loan with interest rolled up.
Price = 1,600,000 / 5.50% = 29,090,909
Finance = 783,515 interest + 156,000 arrangement fee
Developer's profit = 29,090,909 − 24,000,000 − 783,515 − 156,000 = 4,151,394
Equity 8,556,000 in, 12,707,394 back at month 18: 1.49x, a 31.1% IRR
On cost it is 17.3 per cent. The finance line is lower than the forward funder's coupon, despite the higher rate, because the developer's equity goes in first and carries no interest in the appraisal. That is the trap: the equity is not free.
Subtract one cash flow from the other. Under forward commitment the developer pays 8,556,000 out over months 0 to 3 and receives 12,707,394 at month 18. Under forward funding it pays nothing and receives 2,476,725 at month 18. The difference is an investment of 8,556,000 that returns 1,674,668 more, 19.6 per cent over the period.
Incremental IRR = IRR(FC equity flows − FF profit flow) = 13.0% a year
In Excel: =(1+IRR(C2:C20-D2:D20))^12-1 on monthly columns
The 31.1 per cent IRR on the forward commitment is not the return on choosing it. Most of that return the developer would earn anyway, without any capital, under forward funding. What the equity actually buys is 13.0 per cent.
| Case | Forward funding profit | Forward commitment profit | FC equity | Incremental IRR |
|---|---|---|---|---|
| Base | 2,476,725 | 4,151,394 | 8,556,000 | 13.0% |
| Funding yield 5.50% (no gap) | 3,741,548 | 4,151,394 | 8,556,000 | 3.3% |
| Funding yield 6.00% | 1,317,305 | 4,151,394 | 8,556,000 | 21.7% |
| Build overrun 10% | 598,147 | 2,429,952 | 10,356,000 | 12.2% |
| Six-month delay | 1,989,162 | 3,860,534 | 8,556,000 | 10.7% |
| Overrun and delay | 81,765 | 2,167,441 | 10,356,000 | 10.2% |
The yield gap decides almost everything. With no gap the forward commitment's extra profit is only the finance saving, 409,846, a 3.3 per cent return on the equity. At a 50 basis point gap it is 21.7 per cent. The overrun of 1,800,000 comes off both profits, but under forward funding it nearly wipes the profit out, because the developer's margin was thin to start with: risk the developer keeps under forward funding is concentrated on a smaller number.
Developers often compare 17.3 per cent on cost with 10.3 per cent and choose the forward commitment, or compare 31.1 per cent IRR with an infinite one and choose forward funding. Both are wrong. The decision is a financing decision: is 13.0 per cent a year a good return for 8,556,000 of equity tied up for 18 months behind a senior loan, with the overrun and delay risk that goes with it? For a developer with cheap capital, perhaps. For one raising expensive equity from a partner, rarely. The appraisal should show the incremental cash flow, not two summaries side by side. For how time changes a profit on cost, see what IRR a 20 per cent profit on cost gives.
Forward funding agreements often cap the funder's commitment and deduct overruns and the extra coupon from the profit. Read the cost cap and the long-stop date before comparing; they decide how much of the downside you still own.
The book takes a scheme from land to disposal and treats funding structure as part of the appraisal, and the free workbook for this case carries the cash flow that measures finance properly. For the loan arithmetic, see how to calculate interest on a development loan.
In forward funding the investor buys the land and pays the build costs as they are incurred, charging the developer a coupon, and pays the developer's profit on completion. In a forward commitment the investor only agrees to buy the finished, let building at a fixed price; the developer finances construction itself. In the illustrative case the first pays 2,476,725, the second 4,151,394 on 8,556,000 of developer equity.
The funder takes on the construction period: its money is out for 18 months earning only the coupon, and it carries the developer's credit risk in the meantime. It asks for a softer yield in return. Here 5.75 per cent instead of 5.50 per cent takes 1,264,822 off the price, the largest single item between the two profits.
Usually the developer, out of its profit: the funder caps its commitment at the agreed cost and deducts anything above it, plus the coupon on the extra money. A 10 per cent overrun on 18,000,000 of build cuts the forward funding profit from 2,476,725 to 598,147 in the illustrative case.
This article is one calculation from The Real Estate Development Manager. 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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