The implied internal rate of return in conventional residual valuations of development sites

Abstract

Explicit discounted cash flow methods are used in many countries to assess the value of real estate investments or their likely rate of return given a particular price. These are typically supplemented by simpler models for the purpose of estimating market value, leading to debate about different approaches. A parallel situation exists in the case of UK development sites: both cash flow appraisals and simpler residual valuations are used to assess site values. Yet debate here has been limited, even though traditional residual valuations involve steps that depart from project appraisal practices used in mainstream capital budgeting. We explore the relationship between the profit and interest allowances used in traditional residual valuations and the internal rates of return that they appear to imply. Published residual valuations typically allow for profit through use of a simple proportionate relationship between required profit and the cost or final value of a scheme. They also show limited variation in their profit assumptions, but this implies large differences in expected IRRs. Simulated examples then illustrate the implications of applying standard profit-on-cost rates to schemes of different lengths and with different levels of land value. Findings for project duration, in particular, are noteworthy since they indicate that lower IRRs are implied for longer projects, though this relationship is not necessarily rational.

KeyWords:

• Internal rate of return
• development
• valuation
• residual method
• developer’s profit

Notes

1. The study by IPD (2010) is an exception, but this study is not widely available and is no longer updated.

2. McDonald (cited in Graham & Harvey, 2001) suggests that this might particularly hold for projects where cash flows are very uncertain and possess option-like features, as would be the case for many property development schemes.

3. Property Week Student Accommodation supplement ‘Here comes the money’, 27 November 2015, p. 19.

4. These can be estimated by software such as Argus Developer based on the land value result and the revenues and costs used to estimate that value, in a similar manner to the approach discussed in the next section.

5. APP/G1630/A/09/2097181.

6. DVS, or District Valuer Services, are part of the Valuation Office Agency, a government agency, and they provide valuation services to UK public sector organisations.

7. Meanwhile, profit-on-cost (at 19%) lies between the figure from the residual valuation (which assumes 100% debt finance) and the figure from the project cash flow (which does not include debt).