Mammoth has long held an interest in the broad social, economic, and logistical systems which provide the context within which any infrastructure, landscape, or building is designed and constructed. One particularly important contextual component is the nature of a project’s financing. This is true for the Panama Canal Expansion, it is true for the Fresh Kills Landfill transformation, and it was true for building the Seattle Public Library. It is true for every new Starbucks, and the suburban freeway extensions which instigate their construction. The environment you are sitting in right now, reading this post, was almost certainly facilitated in part by someone with a background in finance.
Unfortunately, in my experience, finance (and money generally) has been a particularly inscrutable topic for designers. At best, it’s just not something we’ve taken the time to learn with any sort of rigor; at worst, an explicit focus on money, profitability, and financial value is considered to be taboo in the design professions.
Lacking basic financial literacy is harmful to the design professions, especially now, when profit margins are slim and the value designers bring is being called into question. How can we defend the value of our profession when we’re barely able to define ‘value’ in the first place? We’re bringing renderings to a gun fight. Beyond self-justification, understanding the financial constraints and opportunities for each specific project will help improve the chances for outstanding architecture by allowing architects to better leverage our position at the nexus of the project team.
I’m sure, by now, you’ve heard all these arguments before. After all, SHoP built the Porter House, one of the first projects to wear a design-develop model of architectural practice on its sleeve, nearly a decade ago. The past few years of Great Recession have seen calls for increased architectural agency (the most common buzzword for intervening more explicitly in politics, finance, technological development, community outreach, etc.) accelerate even more. And firms like Alloy are creating highly successful projects while breaking new ground by vertically integrating design, development, and construction practices within a studio environment.
So let’s say you buy it. It’s time to learn more about finance. Well, what does that mean?
Most of the time, it’s discussed in vague principles about accepting increased risk — financial, liability, or both — in return for increased reward and opportunity to influence a project. It’s time to add some specificity to this dialogue. Something I’d like to talk about in the near to mid term future (a timeline you should absolutely disregard, given that this is my first solo post in about 14 years) are proposals for alternate ways architects can structure their fees, form nimble partnerships and team organizations on a per-project basis, appropriate and share risk, minimize overhead expenses, and find recurring revenue streams beyond design fees. But to have these discussions, it’s important to establish a set of baseline metrics and principles which can be used to compare different options among the topics above. How are things done now? How does an investor know whether a project has been successful? How do they determine how much they can spend?
To answer these questions, we first need to learn a little math.
I’d like to run through a few basic financial definitions and principles used in the real estate industry. This won’t turn you into an investor, but hopefully it sheds light on some of the key metrics which drive the real estate industry, and shifts a few unknown unknowns into known unknowns.
There are a handful of key metrics I want to describe – Internal Rate of Return (IRR), Net Present Value (NPV), Discount Rates, Net Operating Income (NOI), Cap Rates, and Loan to Value (LtV) – and how we derive those metrics from estimates (hopefully based off of sound market research) about expenses and revenues associated with the property. This post, long though it is, will only discuss IRR, and hint at discount rates and NPV. I may get around to writing about the others in another few years.
The first thing you need to know about investing is that you do it to make money. The second thing you need to know about investing is that having money today is worth more than having money tomorrow (not just because of inflation, but also due to risk – money you’re waiting to receive is hypothetical until it’s actually in-hand). So when evaluating an investment, you need to figure out how much it’s expected to make you over a specified period of time (called the ‘Future Value’ or FV), then revert those numbers back into today’s dollars to get an apples-to-apples comparison with the other potential investments you’re evaluating (called the ‘Present Value’ or PV).
The most common metric used to determine future value is called ‘Internal Rate of Return’, or IRR. This is a fancy way of saying, if you put this money in the bank, what is the compound interest it would have to earn to give you the same amount of money at end of an identical number of time periods? IRR translates between PV and FV according to the following formula: FV = (1+IRR)^n * PV (where n = the number of periods over which the rate is compounded). IRR is one way of determining the bang for your buck for an investment.
Why is that the formula?
Imagine you have $100, and you will earn 10% per year by making a certain investment. At the end of the first year, how much will you have? it’s pretty simple – 100 * .1 equals $10, which what you earned. Add the original $100 you started with, and you’re at $110. In the second year, that $110 becomes the figure earning 10% – so we take 110 * .1 and get 11 in earned interest, then add that to the 110 we started year two with, and we’re at 121. Shown in a single equation, we’re doing this:
$100 * (1.10) * (1.10) =
100 * 1.21 =
$100 * (1 + .1)^2 = $121
$100 * (1.1)^2 = $121
You take the rate and add it to one (the one accounts for the starting value, instead of adding it back in like we did above), raise it to whatever power equals the number of periods over which the interest will be compounded (this could be monthly, yearly, whatever – for real estate investing and mortgages, it’s almost always described in yearly values [but compounded monthly, which is a twist we'll ignore here]), then multiply it by the starting value – and, voila, you have your future value.
FV = (1+IRR)^n * PV.
Now, where this formula starts to get really useful is when you use a little algebra to take a known present value, future value, and number of periods to figure out your IRR. Imagine I’m presenting you with two buildings. One costs $125, and will make you $12/year for the next 5 years. The second costs $113 and will make you $12/yr for the first 2 years, but only $11/yr for the last 3. Which one has a higher rate of return? (You’ll need a scientific calculator that can take the nth root of a number – the 5th root, in this instance – to solve for the unknown IRR)
FV1 = 125 + 12*5 = $185
FV2 = 113 + 12*2 + 11*3 = $170
IRR1: $185 = (1+IRR)^5 * 125; IRR = 8.2%
IRR2: $170 = (1+IRR)^5 * 113; IRR = 8.5%
When we run the numbers, we see that building two has the higher IRR, despite having lower total FV, because your going-in cost was lower as well. In our simplified scenario, we would therefore consider building two to be the better investment, because our money is working harder for us — those dollars are earning just a bit more each year.
Right about now you’re thinking – surely this is too easy, there must be more to it. And you’re right, of course. There is no one magical metric in real estate finance that can be relied upon to guarantee a good project. There are two main shortcomings with an IRR-only analysis. First, it doesn’t tell you anything about cashflow. And second, it doesn’t tell you anything about risk.
Cashflow is exactly what it sounds like – flows of cash into and out of a project, business, investment, whatever. Cashflow is particularly important in real estate because of something called debt service. Debt service is the payments you make on your mortgage, construction loan, acquisition loan – they are the dollars that you owe your lender, as opposed to your investors. Buildings and land are, for the most part, really expensive, so it’s rare to pay for acquisition and construction costs without debt financing. However, It’s not just a lack of purchasing power that makes debt such an important component of real estate financing. Even if you could afford to buy the building, you’ll typically still want to borrow money for it because it increases your return on equity higher than the return on the overall returns achieved by the investment.
This is called leverage, because it allows a multiplication of the initial force — the equity you put into the investment — into much higher returns. Here’s an extreme example to show how that works: imagine you have a project which costs $100 and achieves a 15% IRR. You pay $100 out of pocket, and you have $115 at the end of the year. Nice and tidy. But what if you only needed to pay $1 for that same investment, and borrowed the rest at 5% interest? The cost of borrowing would be just under $5 for the year, but you’d still have the rights to the $15 of returns at year’s end – resulting in a net gain of about $10 on your $1 investment. The return on equity (your own invested dollars) is 1,000% instead of 115%, even though the project itself is still only returning 115%. And because you only tied up one dollar in this investment, you can look for more leveraged opportunities for the other $99 you didn’t spend – if they could perform similarly, each $1 earning $10, you’d have about $1,000 at the end of the year, instead of $115. That’s the power of leverage. It’s the reason Mitt Romney could run for president.
Excessive leverage (meaning borrowing a higher percentage of the overall cost) can lead to extraordinary profits, but it also dramatically increases the risk of default. If you can’t make that $5 interest payment, for any reason, the money you invested is lost. This is one reason folks get mad at private equity firms — when the acquired companies collapse, it’s often because they can’t afford the amount of debt the PE firms saddled the companies with. It’s the same principle in real estate, but with foreclosure on the property instead of bankruptcy for a company.
So, you see where I’m going with this cashflow issue. A $100 investment which returns $0 in year one and $121 in year two, and and a $100 investment which returns $10 in year one and $111 in year two will both have a 10% IRR, and both have a future value of $121. But if you have to make an $8 interest payment each year, you’ll default under scenario one. Just looking at the IRR doesn’t show that, but it’s really important stuff to know. Can I make enough to cover my debt service, when each payment is owed? Does the project maintain positive cashflow?
Additionally, you’ll want to know where different portions of that cashflow come from to understand how each affects the overall IRR. How much of my return comes from rent? How much come from selling the property? When you buy a property, you might purchase one with leases in place for the next 5 years – this money is relatively low risk, as it’s under contract. But you’ll also make assumptions about how much you’ll be able to sell the property for – this is much harder to predict than rents you have under contract, and is consequently higher risk. It’s important to know how much of your return comes from cashflows with different risk profiles.
Which brings us to the second major limitation of the IRR metric — it doesn’t tell you anything about risk, only the returns.
Say I come to you tomorrow with an investment projected to have an IRR of 145% over the next three months. Assume there are no anticipated negative cashflow events. Sounds pretty good! Until I tell you that the investment is in stolen iPhones which you’ll have to sell out of the trunk of your car, and you’ll almost certainly get arrested. It’s a risky business.
You might have a property showing a 45% IRR, but without additional metrics, there’s no no way of factoring in that you only have a 50% chance of actually realizing that return. This is where our next key metrics, discounted cashflow analysis and net present value (NPV), come in handy. But I’ll leave the description of those for another time…