Myth #10 : IRR is the most appropriate parameter for investment decision
Real Estate Myth #10 :
Internal
Rate of Return (IRR) using DCF method is the most appropriate parameter for investment
decision by developers
(Category : Finance)
Also published in CNBCTV18
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Myth #10 :
Internal
Rate of Return (IRR) using DCF method is the most appropriate parameter for investment
decision by developers
(Category : Finance)
Discounted 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/NBFCs/Private
Equity funds but not necessarily for investments made by real estate
developers. (NBFC : Non Banking Finance
Companies)
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 :
a)
Surplus available from the project should immediately have
ample opportunities for re-investment.
b)
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/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 upto 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/ RE funds etc, 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/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 “imaginery roots” and therefore the IRR
given by DCF could give inappropriate solutions in such situations.
So, while IRR is a very
accurate tool for bank/NBFCs/funds etc. but for real estate developer it is
definitely not the last word. Developers needs other financial tools in
conjunction with IRR to make investment decisions.
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