Real Estate Myth #10: Internal rate of return an appropriate tool for investment decisions by developers

Real Estate Myth #10: Internal rate of return an appropriate tool for investment decisions by developers

Real Estate Myth #10: Internal rate of return an appropriate tool for investment decisions by developers

iscounted cash flow (DCF) method has become the de facto choice by developers for computing the internal rate of return for money invested by them in any real estate project. While DCF is the correct approach for evaluating IRR for investment in real estate projects by banks, non-banking finance companies and private equity funds, it is not necessarily appropriate for investments made by real estate developers.

To understand this difference, one needs to apprise oneself of the pre-conditions for use of IRR as a basis for evaluating project investment. These are:

1. Surplus available from the project should immediately have ample opportunities for re-investment.

2. Once the project starts providing positive cash inflows (annually), then during no year should the projects have a net cash outflow.

The theory says that if these two conditions are not fulfilled, IRR is not advisable as an appropriate decision-making tool.

 Now, when banks or NBFCs earn money from their investment in real estate lending, they are easily able to find opportunities for reinvestment either with other developers or within financial markets to other borrowers.

Similarly, when PE funds earn money from their investments in real estate projects, the funds immediately return the money to their investors. So, they are not obliged to search for investment opportunities when they have surplus. Hence, funds do not remain univested.

In contrast, when developers generate surplus from a project, searching for new investment in land takes a long time, sometimes even up to several years. Moreover, the surplus from sale of inventory comes in small amounts and land markets require investments in larger quantities; the money thus remains idle for long, offering no immediate reinvestment opportunity to developers. The escrow account mechanism has now further increased the idle time of surplus generated by developers.

So the underlying pre-condition of immediate opportunity for reinvestment of surplus is fulfilled for banks, NBFCs, and RE funds, but is not always true for developers.

The second pre-condition for using IRR necessitates that once the project starts generating positive inflows, there should not be any year in which there is a net cash outflow towards the project. This again is generally true for banks, NBFCs and funds since no further disbursement takes place after commencement of repayment. However, for real estate developers there are times where bookings from customer is not sufficient to fund the project and the developer needs to put additional money again into the project.

The finance theory says that a scenario with intermittent cash outflows can result in what is called ‘imaginary roots’ and therefore the IRR given by DCF could give inappropriate solutions in such situations.

So, while IRR is a very accurate tool for banks, NBFCs and funds, for real estate developers it is definitely not the last word. Developers need other financial tools in conjunction with IRR to make investment decisions.

Myth Series: What is its purpose?

While real estate is among the fastest growing businesses in India, it rarely finds respectable space in curriculums of business schools. Also, there are hardly any case studies available to explain the intricacies of the sector.

For these reasons, many facts and theories floating about real estate follow a ‘common sense-ical logic’. Unfortunately, many of these are misconceptions, myths or even downright false.

The purpose of this series, therefore, is to take one real estate myth in each blog and provide insights on the real issues.