Welcome to the final instalment to our two-part blog series focusing on the famed ‘Back of the Envelope’ (BOE) analysis commonly used by seasoned real estate investors.
In this post, Trident Real Estate Capital switches to the revenue side of the BOE analysis to determine how much a developer can achieve by selling the residential product. As you may recall, our analysis centred on a site located on Mitchell Road in Alexandria, providing 2,000 square meters of saleable residential space. If we use an average selling price per square meter for the area, we can obtain an estimate of value that is derivable from the development. Taking AUD$8,500 as an average price per sqm for apartments in Alexandria, total revenue from sales (assuming 100% take-up) is AUD$17m. Balancing this, our pre-tax profit will therefore be AUD$4.33m, providing a 34.1% return.
These figures make for poor reading as they do not take into account, among other things, GST, holding costs, selling, legal and stamp duty fees. If we assume that this project will take 2 years to develop, a 34.1% return (or 15.8% per annum return) is nothing to jump around about when one takes into account the risk. With the ability to achieve a saving rate of 4.5% per annum at a high street bank, an investor could achieve a 9.2% risk-free-return on a bank deposit over the same two year period. Factoring in the risk ‘premium’ demanded by investing in such a development, the return would need to be closer to the 56% mark over a two year horizon to become attractive or an internal rate of return of 25%.
There is, however, a major factor that we have so far overlooked: financial leverage. In order to finance the development, a developer would need to take out a loan and accordingly account for the interest payments on the loan during the development period. Let’s assume that 75% of our total development costs are financed by debt. If we only pay interest, and the principal is left untouched, we can determine the total cost of interest payments.
|Total interest payments||
What effect does this have on our bottom line?
|Total Project Costs||
|Return on Equity||
So, when leverage is added, return increases significantly. This is a result of the fact that an investor’s return is calculated as a percentage of the actual equity invested, rather than the total development cost. Thus, debt provides you with a greater opportunity to leverage the development’s appreciation into a greater equity appreciation.
Investors must be mindful that leveraging equity returns is no ‘free lunch’. If, for some reason, property prices decrease and the revenue stumbles, the more debt you have taken on, the worse your equity appreciation returns. As Peter Linnemann notes, ‘the key insight about leverage and equity appreciation returns is that in good times, debt juices your equity returns, while during downturns, your losses are magnified.’
It is critical to note that an investor’s financing decision is separate from the decision to commit to the development project!
We hope this blog series has provided a suitable outline of the manner in which a BOE analysis works. It should not be forgotten that the BOE analysis is only the first step in the due diligence process. As we learnt upon further investigation in connection with Mitchell Road, an organised and active resident action group had successfully challenged the owner’s DA submission on the site. The action group would, undoubtedly, be a thorn in any developer’s side and most probably result in lengthy delays and cost overruns. Unfortunately, a BOE analysis ignores these sorts of problems, revealing that while it may be an excellent tool for getting one’s head around the numbers, there are many other potential considerations that a real estate investor must take into account before committing any hard earned equity!