Why do we do this..?
Simple… to make profit through property development. That is surely the primary reason why we all take the risks and go through the blood, sweat and tears to get buildings completed and sold.
If we cannot make property development profit, then there is zero point to doing this. So we can safely say and agree, that making money is important and the KPI for our property development business.
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With that in mind, it is fundamental that there is an emphasis placed on the quality of our property development profit and the overall success of a project by tracking and monitoring the property development profit using industry standard metrics.
By tracking our profit using 3 key metrics, we are better informed on whether a deal works, how it compares to previous projects and whether we are meeting our targets or hurdle rates.
Within this article, I’m going to take you through the following relating to property development profit:
- Profit on Gross Development Value
- Profit on Cost
- Internal Rate of Return
- Why track property development profit
- A ‘guy down the pub’ story…
I’m not going to go into detail about how to calculate each property development profit metric. There are excellent resources online and on youtube which are better at explaining this than I ever will be. I would urge you to explore and research this after you’ve been through this article.
The development appraisals I use for all my projects have this all built into excel, which is incredibly useful.
So lets get started and go through the 3 industry standard metrics:
Profit on Gross Development Value (GDV):
By far the most common and extensively used property development profit metric.
I’d be surprised if you haven’t heard of this yet, and if you haven’t it is the one metric which is most commonly used by property developers, large or small.
Profit on GDV is expressed as a % and basically takes your gross profit figure and divides it by your projects GDV. Your GDV is all the revenue you expect to receive on any given project before any costs.
So… if you develop 2 houses which sell for £1m each, your GDV is £2m.
Lets say you made £400k profit from the project… your profit on GDV would be 20% (£400,000 / £2,000,000)
The industry standard profit target for most property developments is 25% Profit on GDV.
Some companies accept higher or lower returns based on their own business plan, but 25% is a given as the industry standard target property development profit for this metric.
So armed with this metric and information, you know that if a deal you are assessing cannot achieve the required profit, then you should step away.
Profit on Cost:
Very similar to Profit on GDV, but in this case the profitability is assessed against the total development costs.
Profit on cost is expressed as a % figure and takes your gross profit figure and divides it by the total development costs. The same calculation as above but swap GDV with the total development costs.
Profit on cost is preferred by some developers as their target return metric over profit on GDV, however, there is no right or wrong method, provided you have your targets set in your business plan and investment requirements.
This metric is often used by planning authorities when negotiating affordable housing quantum and viability, where typically a 20% profit on cost is accepted by the planners as a suitable profit amount.
Internal Rate of Return (IRR):
My favourite and preferred method of calculating the success of a project and property development profit metric.
Without getting too complicated the IRR can be defined as follows:
A development project’s IRR is the value it generates during the time period in which your project runs or you own it.
Basically, the IRR is expressed as a % and it is the % of interest you earn on each £ pound you have invested in a development project over the entire holding period.
So why do I like it so much… well… because you are including time into the equation and that is why you always hear people say ‘time is money’.
Imagine a scenario where two identical development projects are started at the same time, in the same location and both achieve a 25% profit on GDV. You would say on the face of it, that both are successful.
Lets assume the first project took 1 year to complete, and the second project took 3 years to complete. If we were to only use profit on GDV as a measure of success, you would say both were as successful and profitable as each other, but we know that this cannot be true, because the second project finished 2 years after the first.
With this in mind… you can therefore see the importance of including time into analysing profit.
There is no industry standard hurdle or target rate for IRR and it will be very specific to the investor or developer involved. I’ve worked on projects ranging from 7.5% all the way through to 25% IRR return requirements, albeit the higher end returns are usually reserved for the private equity boys…
Why track property development profit?
Why is this important?
Simple… by tracking your property development profit performance, you are taking more control over your developments and off-setting risk.
You can see your performance over time and assess future development sites more easily.
As I mentioned when writing your business plan, it is important that you have target returns set for your company and developments and it is one of the first thing investors will want to know about a project… how well is it expected to perform?
Personally… I use all the 3 metrics above to measure my projects and my development appraisals have these metrics built into them so when I complete an appraisal, the profit metrics are generated automatically.
This article is only an introduction to what is a very broad topic and you can go much deeper into financial modelling if you want. There are, of course, other metrics used such as return on capital employed or NPV or return on equity, but the 3 above are critical to all property developers.
I’ll finish this article with a story…
A ‘guy down the pub’ story…
This is a true story…
I was down the pub once with a good friend and some of his mates who I’d never met before…
Usual chat, football, girls, politics etc… until one guy mentioned his latest and greatest property development (a full refurb and loft extension of a house) and boasted about how he made £40,000 out of it in 5 months and ‘it was the easiest money’ he’d ever made in his life…
He didn’t know me and my background… but continued to go on about how great he is and how property development is such an easy game… talking about his next projects where he will make loads of money… and he’ll be driving a Ferrari in a years time…
I couldn’t help myself (I love these kind of situations)… and butted in asking what his profit on GDV was..?
Simple question… right..?
He obviously had no clue what I meant, so I pushed on further… ‘What did you sell the house for..?’… £475,000 he came back with…
(you can see where this is going)
‘So you made £40k on a project where you exited for £475,000… so you would have had to invest circa £435,000 to make £40k..?’
Errr… yes… he says…
I then go on to explain what profit on GDV is, the golden target of 25% and why us developers do not accept anything lower given the incredible risks involved, all money up front etc etc… I explained that his 8.4% profit on GDV is terrible..! Nothing you should be boasting about.
He didn’t take this too well and its fair to say the afternoon in the pub was slightly ruined by this conversation.
The best part of the story…?
Two weeks later, the friend text me with a thank you and apology for reacting badly..!! He had gone away and done some homework into development and realised that property development profits of £40k was not great for his project…
He is now a good friend and making real profits in development…
The morale of the storey is this… track your property development profits correctly to minimise risk.
Don’t get into the trap of thinking £40k (or whatever your profit figure) is a lot of money to make on a project, it isn’t when you sell out for £475k.
You are risking too much money for too little reward..!
All the best,