Profit or Return on Investment?
Updated: Jan 30, 2020
By Daryl Norkett
Profit or Return?
For those of us at LendWell, we’ve spent our careers obsessing about property finance – not only how to lend money safely but also how to create value for borrowers through innovation. Thinking about how finance impacts upon a property project comes as second nature to us, in the same way that building out a site comes as second nature to an experienced developer. It’s that partnership between property and finance that adds real value.
Most of us involved in the industry will spend a lot of time focused on profit – on cost and on GDV. But what about return on investment? The way you fund your development has a material impact on all three of these numbers.
Development finance, and for that matter refurbishment finance too, is a broad market with a wide range of options available for different types of projects. Whilst interest rates and fees vary as widely as those options, and keeping costs down is important, I would argue that an understanding of your cash on cash returns on a deal is even more important.
In a typical scheme, we often see targets of 20-25% profit on GDV and a little higher if looked at as profit on cost. However, you only achieve the profit on any scheme through a combination of hard work, expertise and cash. Cash tends to be the scarcest commodity for us all and so deploying this effectively will play a large role in determining the options to scale a business.
Let’s consider some example numbers on a scheme with a £1,000,000 land cost, £1,400,000 build cost and a £3,100,000 GDV. At a headline level, before finance costs, this achieves a profit on cost of 30% and a profit on GDV of 23%.
A typical challenger bank may offer the lower of 80% loan to cost or 60% of GDV – in this instance, a potential loan of £1,860,000. From that advance, an amount will be deducted to allow for interest roll up and fees to be paid. Over an 18-month term that would reduce the cash to the developers bank account to around £1,635,000. This leaves a £765,000 cash requirement from the developer – 109% return on cash over the project. In other words, you can double your money if the builds costs don’t over-run and sales achieve the GDV numbers.
Bank finance can work well for plenty of deals but it’s not the only way. A private lender, able to spend the time to get to know the developer and the scheme may be comfortable to stretch the loan amount rather than being constrained by Bank policy which doesn’t allow for a bespoke approach to every transaction.
One example would be a facility structured at 85% loan to cost or 65% of GDV but where interest is then rolled up above these limits rather than within them. From the lender’s perspective this has merits –on a scheme of this size the developer still has considerable cash in the deal and the loan size still allows some margin for build costs to over-run and sales proceeds to fall a bit short without heading underwater.
In this example, £2,040,000 could be funded through the loan, deductions for fees reducing cash to around £1,980,000 leaving a shortfall of £420,000 for the developer to fund. Profitability is reduced to £600,000 through a combination of a larger loan and increased finance costs but return on cash increases to 143%.
The lower cash requirement can help to facilitate developers to undertake more schemes or larger schemes than would otherwise be possible. If the development business has the opportunities, this style of finance can increase profits as well as returns. With the same cash, the developer could fund another similar sized scheme – spreading risk over two sites and earning a second profit.
The Cost of Equity
A further consideration is the cost of the developers cash itself - commonly referred to as equity. Some of this is intangible – what opportunity cost is missed through not having funds to deploy into an unexpected opportunity? How much time is needed to manage what could be tight cashflow during the build? Could another site be run at the same time?
There are also tangible costs of equity. It is common for developers to partner with investors in return for a 50% profit share. In the example above, this would cost £350,000 in return for £765,000 of equity. In other words, an interest rate of 46% over the project. If that same investor was only asked for £420,000, would it be possible to negotiate the profit share agreement? Would a reduced amount of cash required increase the pool of available investors or enable them to invest in to multiple schemes with the developer instead?
There is no right or wrong way in which to fund a development project, or indeed any property deal, but there are a wide variety of options available. Each of these will impact upon both the profitability of a scheme and the cash required in order to undertake it. With a bit of planning, investment can be maximised over not only a single scheme but over a series of deals with cash requirements planned out. The only real mistake a developer can make is not to engage with expert finance advice to assess the options for their business.