Think Value

In residential real estate development, 20% of decisions create 80% of the value and, consequently, the profit. In strategic consulting, a widely used method is creating a value creation diagram to understand specifically where and how investor profit is generated.

Below is a diagram representing our view, derived from years of experience:

Generally, in any business, value is measured by three main components:

• Return on Invested Capital (ROIC);
• Weighted Average Cost of Capital (WACC);
• The growth rate of the organization (Growth), if ROIC > WACC.

In our opinion, in the local residential real estate development sector, ROIC is primarily created in four components:

I: Land Price/Sale Price Ratio

Most brokers talk to us about the price per square meter of land, which is an insignificant figure by itself—the weight of the land in revenue depends on both the K2 coefficient and specific location prices. Moreover, the land contract impacts two important components: 1. The scale of the invested capital in the project, and 2. The portion of sales risks transferred to the landowner. You can find more on this topic here: Cash vs Barter.

II: Strategic Decisions

At the start of the project, significant strategic decisions are made that have a colossal impact on profitability. According to our observations, very few developers manage to make these decisions correctly. By strategic decisions, we mainly mean three directions:

• General Pricing Positioning: The project must match the segment; it needs to be decided whether to go with a skimming strategy, penetration strategy, or a rational value strategy. For example, a penetration strategy is good when the project’s scale is large, completion is planned in a short time, and rapid sales are needed. This strategy does not necessarily imply lower prices; rapid sales can be achieved with relatively high quality and moderate prices, requiring thorough competitor research.
• Project Development Over Time: One of the most common mistakes here is making project development decisions without financial analysis. Different development scenarios affect sales speed (prices), construction costs, and the volume of investment funds. Making this decision verbally often leads to disastrous results. You can read more on this here: Residential Real Estate Project Excel Model.
• Architectural Task: It is critically important to set the right tasks from the beginning and give the architect the necessary business priorities. For example, constraints regarding ergonomics, utility coefficient, room assortment, ceiling height, number of floors, partitions, windows, and facade elements. Naturally, not all these conflicting goals can be achieved simultaneously, but agreeing on priorities in writing from the start means getting the first button right.

III: Efficient Construction

Construction is not difficult; building profitably is. Avoiding overspending, delays, quality failures, and other problems is impossible without modern digital management. Just as it’s easy to boil water gradually, it’s easy to end a project in loss (or not finish it at all) when small mistakes are not connected to the final outcomes. You can read more about this here: MS Project & Profitability.

IV: Profitable Sales

Sales are not difficult; selling profitably is. Developers often perceive the task of sales and marketing as preparing good renderings and beautiful clips. This is important, of course, but the main tasks of sales are to achieve high prices, bring in a lot of money, and manage financial risks. Here, having an effective pricing system is critically important, one that ensures maximum prices, transforms cost risks into prices, and maximizes the profitability of the cash/sales ratio. You can read more about this here: Profitable Pricing in Real Estate.

Lastly, the diagram shows #WACC and #Growth, which are also value measures along with ROIC.

• #Growth: Growth mainly depends on the organization’s access to critical resources such as land, money, and architectural power. It is noticeable that a positive relationship with the state creates significant value. However, many project management cases do not associate with good historical statistics. Although this significantly improves marketing expenses efficiency (e.g., one Facebook page funds 10 projects), management becomes very difficult, and the risk of building financial pyramids increases.
• #WACC: The cost of invested capital should be very high due to the sector’s cyclicality. Accordingly, developers should think of undertaking only those projects whose #ROIC or #IRR will be higher than #WACC, i.e., positive #NPV projects, which are rare in our market.

For example, if we see that the risk-free interest rate today is 4.2%, assume that the sector’s beta is at least 1.7, take a long-term risk premium of 5.5%, and add only 1% for country risk, it turns out that the ROIC of an unleveraged project should be at least 15%. This profit above is real economic profit. However, here we usually only calculate IRR and that too incorrectly. You can read more about this in McKinsey’s article: Tempted by a project with a high internal rate of return? Better check those interim cash flows again.

P.S.

If you are a #builder and need support in any of the areas described above, or if you are a landowner and want an experienced team to carry out a construction-development project o