Profit on Cost: a Worked Example

Every development has a margin between what it costs and what it sells for, and that margin is the first thing lost when prices fall or costs rise. Profit on cost measures it against the money going in. Below the margin sits the developer's equity, and below the equity the bank's loan, so the ratio tells a lender how much room there is before the losses reach the second layer, and from there the third.

Names vary. UK appraisals commonly quote profit on cost and profit on gross development value side by side; Australian feasibilities often speak of the margin on cost or development margin. The RICS standard on development valuation defines profit on cost as profit as a percentage of total development costs, and notes that, although an internal rate of return is a truer measure because it allows for time, the capital profit as a percentage of cost or value is what a basic appraisal usually shows.

Both sides need the same basis. Where GST applies to the sales, as it can on new homes in New Zealand and Australia, the sales value is taken net of it, and the costs on a matching basis; mixing the two inflates the margin. Finance belongs in the cost, which means the ratio moves with the interest rate and the length of the programme even when nothing on site changes.

A mixed-use scheme of shops and apartments, constructed for this page like every figure in it, has a feasibility showing land US$5.5m, construction US$15.4m, contingency US$0.8m, fees US$1.6m, finance US$1.9m and sales costs US$0.8m, against sales of US$30.4m net of GST. The bank is asked for US$17.5m; the developer's equity is US$8.5m.

The last line ignores the sales costs that would fall with the prices, and assumes everything has been spent. Now the lender reads the same scheme with its own inputs. Its valuer sets the sales values 4% below the feasibility's, its quantity surveyor adds US$0.6m to construction, and interest at the bank's own rate adds US$0.3m.

Nothing in the scheme changed between the two readings. Three moderate differences of opinion halved the cushion, which is why a lender recomputes the margin rather than accepting it, and why the inputs matter more than the ratio.

Profit on cost is one sum read from the bottom. The same sum read for the land gives the residual land value: fix the profit and solve for what the site is worth. The loan is measured against the same two figures, by loan to cost and by loan to gross development value, which say where the bank sits beneath the margin and the equity.

Time is the measure the ratio leaves out. Two schemes at 16.9% on cost, one built and sold in eighteen months and one in thirty-six, are not equally safe: the longer one carries more interest, more exposure to a turn in the market, and more months in which costs can rise. A discounted cash flow and its internal rate of return show the difference, and a lender reading a long programme gives it weight.

DEFINED IN ONE PARAGRAPH → · RESIDUAL LAND VALUE, WORKED → · DEVELOPMENT FEASIBILITY →

The margin decides how much bad news the file can take, and presales decide where that news can land. A presold unit's price is fixed, so the price cushion is carried by the unsold units alone. On a scheme half presold, their prices can fall about twice the headline percentage before the profit is gone, but only if every presale settles; a buyer who walks away puts a unit back into the market at the new, lower price. Issue 08 reads a townhouse feasibility that way: four of 24 homes presold, about 20% on cost as submitted, and about 12% if the unsold homes fall a further 8%.

There is no correct margin. A lender sets its own minimum for the risk in front of it, and a scheme below it is not refused by arithmetic alone: more equity, more presales or a fixed-price building contract can each make a thinner margin acceptable, and a developer with a record of overruns can make a thick one look thin.

PROPERTY DEVELOPMENT FINANCE → · ISSUE 08 · THE TOWNHOUSE FILE →