Investing Responsibly in Real Estate Projects
People who choose to invest in real estate projects should consider a series of profitability indicators that will help them select the best investment alternative. An important decision will be to define the investment strategy and its time horizon: whether it will be for rapid realization (build and sell) or whether it will be carried out under an equity scheme (build and operate over time).
Build and Sell
In a real estate project whose strategy is to generate profitability through the construction and sale of units, achieving the return on capital invested in the shortest possible time with the highest rate of return becomes the goal. This is achieved by managing value parameters, such as the margins obtained on the cost and revenues of the project, without neglecting the rapid realization of sales according to optimal levels of absorption. Mentioning the capital structure of the project, and in countries such as ours where this advantage is presented, selling units during the planning and construction stage greatly help the investor’s profitability, as it uses lower levels of capital and debt and therefore decreases the investment risk.
The higher the risk of executing a real estate project in terms of debt levels, development duration, macroeconomic scenario, security, among others, the higher the level of return required by the partners. Similarly, the time required to carry out the management of the investment during its development cycle cannot be neglected, and believe me: there will be very important challenges to solve.
All real estate investment concentrates its profitability on the cash flow of the project, on time, and on the profit that will be achieved once all the costs and expenses inherent to it have been paid.
The following metrics are the most commonly used in real estate to evaluate if the proposed projects represent a good investment:
- Cash-on-cash: a simple way to measure the return on the capital employed by the partners. This is achieved by dividing the flow obtained on the investment capital.
- Return on Capital (ROC): represents the resulting net profit expressed as a percentage of invested capital. It is also common to see this indicator expressed as a ratio or multiplier; that is, the number resulting from dividing the total capital resulting from the partner over its original capital.
- Internal Rate of Return (IRR): is the indicator of the profitability of the project or of the investors’ capital. It takes into account the cash flows in time, discounting them to the present; the time factor in the flows greatly influences the results of this indicator.
- Net Present Value (NPV): represents the present value of the net flows of a project. When discounting cash flows to present value, the discount rate is used, which is equivalent to the rate of return required by investors.
In the case of equity investments, in which projects are planned under a long-term operating scheme, the profitability factors become others. Value drivers such as income levels, the rate of increase in annual revenues, occupancy rates, and operating expenses, become very relevant factors during the operating period of a property.
The metrics to evaluate an equity investment have to do with a long-term projection of the flows that are obtained periodically, plus a calculation in the residual or exit value of the asset. It’s for this reason that the assumptions made at a pre-planning stage should be as close to reality as possible, and appropriate sensitivity scenarios should be established.
It is very common that the internal rate of return (IRR) and the net present value (NPV) are used in the evaluation of equity projects. IRR will help us to understand the return on capital invested during the life cycle of the investment, assuming that the flows obtained are reinvested at the same rate. The NPV will be the test that we will apply to the investment, since when a positive result is obtained, it will indicate that we are above the required rate of return, and we will be able to continue with the project. Generally, projections are calculated over five and ten years, and a residual value is estimated at the end of each analysis based on a value that considers a rate of capitalization of future flows (multiple output).
In order to achieve good performance in the project, the market fundamentals in terms of leasing values and absorption rates should be carefully studied, always seeking to maintain positive flows in the operating period that offer good profitability.
In most cases, an investment in real estate projects in Mexico turns out to be very profitable in time, and generally this has to do with the fact that the growth in the value of the asset (patrimony) tends to be superior in comparison to alternative investments; this added to the fact that the increase in the value of the land in the country is very encouraging, and the increases that happen in the costs of construction tend to a considerable rise in time.
It will always be important to make the smartest decisions on property development and investment. Investing only in the best projects requires discipline, hard work, and research.
If you want to know more about the subject, the author shares his development method in the first eBook of Real Estate Development in the country. You can buy it in the Apple iBooks store and at: www.editorialdigitaltec.com