Financial modeling is an already obscure art within the property development industry and its accurate application is pivotal to the success of any property development not only in theory but also in practice. To truly understand any discipline, a good grasp of its terminology is necessary knowledge to have equipped and in light of the foregoing, this article will examine the various financial terms found in the property development industry in general and Build to Rent investment in particular.
Even though Build to Rent’s investment is related to residential property development, it would be erroneous to assume that the financial appraisals would be the same. There are key differences between Build to Rent’s financial appraisal and residential “for sale” development financial appraisal.
Key Differences in Build to Rent & Open Market Sales
| Metrics | Build to Rent | Open Market Sales |
| Valuation Methodology | Underwriting Cash Flow Model | Residual Land Value Appraisal |
| Factors of Analysis | Land & Build Cost, Lease Up & Stabilization, Exit of Income Generating Asset | Pursuit & Land Costs Build Costs Cost of Final Units |
| Key Performance Indicators (KPI’s) | Profit Margins Absolute Profit IRR (Internal Rate of Return) Yields Profit from Development Management Fees | Profit Margins (% of profit from costs and % of profit from revenue) Absolute Profit |
| Importance of Timing | Essential as it affects IRR | Less important as there is little impact on profit margins |
Key Terms in a Build to Rent investment Financial Model
Valuation methodology is an approach used to determine the fair market value of a business. The valuation methodology of a Build to Rent is an Underwriting Cash Flow Model as opposed to the Residual Land Value Appraisal of the Open Market Sales.
Underwriting Cash Flow
Generally, underwriting is a method of establishing the risk and probable return of an investment. Moreover, In commercial real estate investment, it is the use of financial modeling to predict potential cash flows and the probability of the potential cash flow being achieved. The process of underwriting a Build to Rent development involves predicting the developments cash flow over a specific period, also, it involves estimating the rents and cash flow for a period of two to three years. The construction period of the development requires an early investment before any income is generated. So, this is why it is important to have accurate budgets and timelines, as cost overruns and delays in construction can hurt returns.
Internal Rate of Return (IRR)
It is commonly used as a measure of investment performance in real estate. The IRR percentage of any development is one of the most central factors when considering the suitability of a prospective development in the Build to Rent industry. Simply put IRR is an estimate of a prospective investment’s rate of capital return. It helps decide on which schemes or investments to take on, as it gives the investor a theoretical sketch of the Build to Rent development, by showing the income cash flows, the timing of the cost of development, and capital structure i.e. source of funding for the development. Note that a high IRR does not always mean it is a secure investment, as it could also mean it’s high risk.
Yield
This can be defined as the total amount of profit realized on an investment over a set period. Yield is a metric for return measure and it is usually represented as a percentage based on the invested sum. So, the yield on a Build to Rent development displays the percentage of capital returned to owners of the schemes annually on their investment. There are also 3 types of yield namely;
Untrended Yield/ Net Initial Yield:
This calculates the supposed yield on a Build to Rent development as if it were completed and fully occupied today. And also factors the operating costs into the equation.
Trended Yield:
This calculates the supposed yield on development in the future after completion, at a stage where it requires asset stabilization. At this stage, the calculation must account for the assumption of inflation of costs such as construction materials, etc.
Net Yield:
This is the calculation of the development yearly rental income after accounting for the operating costs. Net yield provides the actual profit margin rather than the gross yield.
Operational Efficiency
This is the metric for the estimation of the efficiency of the profit generated from the operating cost. The more effective the operational efficiency, the more profitable the investment is. And conversely, less effective operational efficiency leads to the development being a less profitable investment. An enterprise is operationally efficient when it can generate greater revenue or returns for the same or a lesser cost. So, a property investor would be more drawn towards a Build to Rent development that can provide greater operational efficiency. It is because this translates to an increase in return on investment.
Further, one can achieve operational efficiency through the type of management and the implementation of designs that reduce the cost to run a Build to Rent development for an investor annually, thereby increasing the margin they make.
Conclusion of Build to Rent Investment:
To conclude, there are various valuation metrics in a Build to Rent development financial model. Having a key understanding of these metrics is a necessity for any prudent investor. So, armed with the right information about an investment project, they know where to place their scrutiny. For more information regarding Build to rent investment terms, check out out investment guide here.
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