Question Regarding IRR vs NPV Calculations for Development Projects

Non-PC Broker's picture
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In a typical levered development project, you have months of cash outflows followed by a number of months of lender contributions and then you'll start your lease up period in which you'll, hopefully, have positive cash flows.

However, when raising capital for a fully-entitled development (I'm talking ~10MM TDC range, so I'm not dealing with Carlyle as an LP here), your investors will be contributing all capital (except for capital calls) at Time 0 (closing). So which way is used when calculating the IRR? Technically, no money is spent until it goes toward paying for project costs, however, it's already out of your investors' pockets and sitting in the bank account. Comparatively, in a value-add acquisition, you have your Time 0 negative outflows, and then all periods after are separate. In most value-add models, I see the outflows treated all-the-same at Time 0, whereas this seems to differ in development models.

Depending on how this is classified in a development model, it can lead to wildly different IRRs. It's not something I had given much thought to until I was getting a 20%+ IRR and 2x+ MOC on a project I'm modeling and then did an NPV calculation and got a negative result at a 20% discount rate. So I compared =-Equity at Time 0 vs negative outflows across months and that's where the difference was; something like a 16% IRR vs a 21% IRR.

So, how is this treated in partnership documents and what's the right way to think about this? The difference is a feasible project versus not-even-close.

Would appreciate input from those who have experience with partnership docs.

EDIT: After writing this out, part of this sounds like a dumb question but I still want your answers. My confusion is largely between NPV and IRR on these projects: so are LPs' using different discount rates? Their OCC is, hypothetically, 20% if that's the hurdle rate they invest at across all projects. Yet, the NPV is all wacky. Or maybe I'm just doing the NPV calcs wrong.

Comments (12)

Mar 17, 2019

it's a great question and frankly one that I think is not spelled out in enough detail in operating agreements. NPV and IRR are virtually in the same family, meaning the IRR is part of the NPV formula...So I think the answer applies to both metrics. Simply, it depends on the investor and how detail oriented they are. I understand your point. If I'm an LP...Technically my capital contribution is out of my pocket and sitting in an account waiting to be deployed. My pref etc. should be based on me being out of pocket that money at day 0...not when the project actually gets around to using it... Depending on how liquid your other investment strategy would be...in some projects equity wouldn't be drawn for 7-12 months from closing. Decent money could be made during that time period.. However, most operating agreements interpret contribution to mean contribution to the project activity...not an escrow or money market account before the project starts. I've spoken with a few lawyers on this topic, and most (while understanding the point Im making) will ultimately side with the aforementioned treatment. With that being said, I've seen a few term sheets (albeit all from smaller family shops nothing institutional) that have language stating no matter how long the equity draw process lasts...my pref/etc. will be calculated assuming 100% of my equity has been drawn by month X (usually see anywhere between 18-24). I think this is a smart inclusion as it's twofold...depending on what month you use and the budgeted Gant Chart, it might get you some extra pref. Also, it protects you against unforeseen delays, by guaranteeing that no matter what the build out time-frame is...you have a guaranteed minimum pref on the project.

Regarding your comment about NPV being negative...im not quite sure you're applying it correctly. Im far from a math engineer...but calculated correctly, if you get an IRR of X% based on a set of cash flows (granted has to have outflow and other req'd parts of npv)...NPV'ing those cash flows with the calculated IRR should ALWAYS return a value of 0.

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Mar 17, 2019

Thanks for the detailed reply. It sounds like my suspicion that the cash outflows are treated on a project-level basis was correct. I'm the developer in this situation, so I'd prefer to not have it all treated as an outflow on Day 0, since that decreases my promote to the tune of a couple hundred basis points. The point about capping the max draw period seems very reasonable, especially for a fully entitled deal.

It begs this question about return thresholds: can you really compare a 15% IRR from a value-add multifamily deal with all positive outflows calculated at Time 0 with an IRR of 21% for an entitled garden multi development with cash outflows calculated across the development period? It seems like apples-to-apples would be closer to 15% to 18% if you assume all development outflows at Time 0, making the spread less attractive. Does what I'm saying make sense? I realize this is an academic question, because if the market treats it one way then that's the way it is.

Regarding NPV: I'm familiar with the math of it all, which is why I was baffled. Yes, IRR = NPV of 0. However, I was always taught that the =NPV() function in Excel was used for positive inflows and then you add the cash outflows back in outside of the function. Thus my formula was looking something like: =NPV(rate,E1:X1)+sum(A1:D1) -- as an example.

When I tested it, this doesn't work for multiple cash outflows but the NPV() function alone (i.e., without the sum function) does work when calculating multiple outflows followed by multiple inflows.

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Mar 18, 2019

You are right about the NPV excel issue. I think what might be throwing yours off, is that quick fix of adding the outflow on the backend usually assumes 100% of the outflow occurs at a single period. If you have multiple periods of outflow up front...adding them all together to the NPV isn't technically correct because you have a present value delta during that time frame covered over the various outflow periods.

Mar 20, 2019

The key for the NPV and XNPV functions is that they discount each cashflow you highlight by one period at the rate you specify. So, when using them do not include time 0 in the range since it should not be discounted, add that in separately. Include ALL cashflows after that though.

In the equation you show, some periods will not be discounted back to time 0 so you will get different results than an IRR calculation of the same cashflows.

One solution to trying the keep the IRR up is to have two equity draws. One to acquire the property and one at the start of construction. I am guessing most of the time LP's will only go for this if there is a long interval between the two, or you have a good prior relationship.

Mar 18, 2019

If you have a construction loan, and are going through lease-ups (i.e. no cash flow to cover debt), when/how does a developer pay back the loan? when do they convert construction loan to a perm? anyone know the specifics? thanks.

Mar 18, 2019

Do research on capitalized interest. In the most basic explanation...the lender knows this. So on top of the basic loan proceeds there is also the capitalized interest part of the loan budget...where the lender says "here take this loan money we are giving you and use some of the loan $ to pay the interest on the very loan you are borrowing". From a modelling perspective it becomes inherently circular in nature...but that's the logistics behind it.

Many loan documents will also have required lender reserves that must remain funded up to a certain threshold (usually calculated based on the actual would be debt service of said loan)...in the case of not being able to make a payment, there are a wide variety of items that can occur here...default, cash traps, reserve funding, sweeps, etc....deal by deal at that point.

Mar 18, 2019

Thanks ad hoc!

Most Helpful
Mar 18, 2019
Non-PC Broker:

... Technically, no money is spent until it goes toward paying for project costs, however, it's already out of your investors' pockets and sitting in the bank account. Comparatively, in a value-add acquisition, you have your Time 0 negative outflows, and then all periods after are separate. In most value-add models, I see the outflows treated all-the-same at Time 0, whereas this seems to differ in development models...

Quoted relevant part. Note: I work in acquisitions/development.

  1. In my experience (not a huge amount, so take w/ salt), the time between the cash leaving your investors pocket vs. being spent is very small, and often held in escrow w/ the lawyers. ex/ Buying a property to knockdown lowrise multifamily and build highrise multifamily. Investor + developer decide on equity split, send money to lawyer to make purchase, and remainder gets spent monthly to cover development expenses. When that cash dries up, construction financing comes into play and you start making draws. I can see how for a value-add it might be different though.
  2. Don't fully understand the "all periods are separate part".
  3. My gut tells me that this is for simplicity in modeling certain projects depending on the timeline. ex/ value-add project of 9 months is easier to look at as if it is 1 period. ex/ development project might take 2-3yrs, so timevalue of money actually becomes material in the calc
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Mar 18, 2019

Thanks, and yes it will only take a handful of months before the equity is drawn down.
Regarding #2, you don't fully understand because what I wrote is turgid and redundant :).

My questions have been answered and I cleared up a few small errors in my model, which made a big difference.

I think the only time my reasoning matters is when a deal is really borderline and most of your promote is over some high hurdle, in which case it's best to keep this in mind when negotiating the PPM.

Thx monkey fam

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Mar 18, 2019
Non-PC Broker:

...**I think the only time my reasoning matters is when a deal is really borderline **...

This is likely unwarranted advice, but IMO: be hesitant to engineer a model to make it pass some arbitrary benchmark. There are bigger reasons as to why a deal is tight.

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Mar 18, 2019

It's pretty rare that you would model a deal where it takes more than the first couple months before you start drawing from debt, so this is a pretty insignificant problem.

But the answer is simply that the returns that the deal folks model are always going to be slightly different than what actually happens when the accountants go to calculate returns. Accountants have perfect information - they know the exact day when cash is contributed and distributed. A proforma is just a proforma. Guess what - you're also probably not going to be distributing a nice even stabilized FCF every month either.

    • 2
Mar 20, 2019
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