Islington -This is why IRR is better for measuring viability (but watch them)

Islington’s recent good paper on stopping dodgy viability assessments

One of the council’s key concerns about the IRR approach is its relative instability as a metric compared to the traditional profit as a proportion of GDV or GDC. Small changes to the timing of scheme costs and revenues can have a large impact on its IRR. As a result, where a development programme and the timing of costs and income are uncertain or likely to change, the approach is likely to be less reliable.

In some viability appraisals that the council has reviewed, it has been found that development costs have been assumed to occur at an unrealistically early stage in the programme (for example land payments being made well in advance of a developer receiving ownership of the land) while income has been received later than would reasonably be expected. Applicants have also sought to rely on assessments that reflect a longer development programme than that which is likely to occur. This has led to a prolonged programme which when the development cashflow is discounted to produce an IRR artificially enhances the impact of costs whilst over-discounting the value of sales revenue. These approaches produce a cash flow which, when deploying the IRR metric, produces an artificially low IRR.

For these reasons, if an applicant believes that the IRR provides useful information for assessing development viability they will be required to fully justify the assumed development programme and the timing of cost and income inputs to the appraisal. The council would reasonably expect the development to be delivered in a manner which is consistent with the development programme assumed in the viability appraisal, and phasing plans for the scheme.

The council has also dealt with schemes where a target IRR has been adopted which is unreasonably high having regard to the timing and risk profile of a scheme. Whether or not an applicant provides information relating to the IRR, the council ill also consider profit as a factor of GDV/ GDC. The council will expect that appropriate levels of profit calculated on this basis would not be exceeded having regard to the specifics of the development.

Some comments

You cant properly measure % profit against GCV or GDC unless the capital advanced the costs and valorisation occur at exactly the same time, it never does, you get two results, its a poor metric, its not used by any accountant simply historically by lazy chartered surveyors because they didn’t do absorption and cash flow models.

% Profit is always measured in economic /accounting terms on the basis of capital advanced over time.  That is what you should be asking for.

IRR is done properly is a robust way of doing this. In no way are old fashioned % GDV/GDC superior.  They are simpler but that doesn’t make them superior.  The assumption in the paper is IRR is dodgy and old style is better – no, what matters is how honest you are.

In any economic model where costs and returns occur over time these are subject to manipulation, the longer the development period and the higher the cost of capital/interest rate the easier they are to manipulate.

It should not be necessary for a developer to justify cash flow assumptions of they are realistic and restrained by typical build out constraints.  What should be necessary to explain is any unusual variation from this.

Target IRR for all firms across markets with the same risks should be the same in a capitalist economy, if not they will see either a flood or starvation of investment.  Particularly strong justification is needed why any IRR varies from development industry norms.

At a time of interest rates close to zero timing should make little difference to viability, unless the developer is using an unrealistic cost of capital.  Big builders should be able to access markets at around 2-2.5%.  You should also check this.  Of course large developers may buy from retained profits and then the issue is opportunity costs.  The most common trick developers pull is delaying starting development until the viability model shows affordable housing to be unviable, and then apply for a variation, even though the development purchase agreement triggers land payments at point of development.  Always check against these.

Much of this problem would be solved if developers had to pay an expensive bond on grant of permission which was released on completion of the last affordable housing unit, market incentives stand a chance of working.  LPS could also borrow against the receipts of these to build affordable housing, one for a future government.


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