I'm sure you're keen to earn a profit from your development. We all are! And when it comes to securing a lender, they're keen to see you'll be earning a profit too.
But what profit are you talking about? It might surprise you to find out there's multiple ways to calculate profit in a deal, and while you might be talking about an orange, the lender might be thinking it's an apple.
So let's take a look at all the lingo around calculating profits.
Definitions
First up, there's a lot of acronyms used in this space, so let's break down the main two - GRV and TDC.
GRV stands for Gross Realisation Value. Which in plain language means the total sales the project makes. Sell 2 lots for $500k each? Your GRV is $1 million.
TDC is Total Development Costs. This covers all the costs of the development, start to finish. Breaking this down a little further, there are 2 types of costs - hard and soft.
Hard costs are those expenses that come out of your pocket (or at least the project's bank account!). Need to pay the demolition company? That's a hard cost.
Soft costs come out of revenue, so they don't occur until you start selling the project. Need to pay the real estate agent's commission? That gets deducted when settlement occurs for the lot you sold. You don't have to dig into your pocket to pay it.
If you want to understand more about hard and soft costs, you can check out my article "Learning the Lingo: Hard Costs vs Soft Costs" for more information.
At its most basic, the profit of your project is GRV - TDC. In other words, take all the income from sales, deduct what it cost to complete the project, and that's your profit in dollar terms.
As an example - you sold 2 lots for a total of $1 million, and it cost $800k to get there (right from purchasing the property at the start through to paying the agent at the end). Your project profit is $200k.
Now strap yourself in, as this is where it starts to get tricky.
Ways To Measure Profit
Now, if I ask you what sort of margin a developer should make on a project, chances are a lot of you will say 20%. That's kind of the holy grail of development project returns. The thing is, though, 20% as a figure sounds nice, but it's kind of meaningless if you don't understand how it was calculated.
So let's take a look at the three main ways you can calculate the profit for a development.
% Profit on Gross Realised Value
First up, % profit on GRV, also know as the Development Margin. For this one, you take the project profit and divide it by the GRV.
Using the example from above, this would be $200k/$1million. The famous 20%.
% Profit on Costs
Similar name, similar process. Only this time you take the project profit and divide it by the TDC.
For our example, that would be $200k/$800k. Wow, even better - 25%! Don't get too excited though - given that in a profit scenario the sales are always going to be higher than the costs means this profit calculation should always be higher.
But given these first two variations are both called % Profit, hopefully now you're starting to see that when a developer just gives a percentage return for their project, you need to know which one they're talking about.
% Cash on Cash Return
This is also a profit calculation, but the focus here is about what return you're getting on the money you put into a deal.
For investors, this number is really important. If it turns out that their cash-on-cash return is only go to be 5%, they might have to think about whether the risk is worth it. They could get that level of return in less risky ways.
It's also important to you for the same reason if it's your own money in the deal! In both cases, though, this calculation hasn't taken into account the cost of that money if you have to borrow it.
So if you've taken money out of your line of credit, and are paying interest on it, then your cash-on-cash return will be lower.
Back to our example. Let's assume you had to put in $200k of your own money for the project. Given there's a profit of $200k at the end after all costs are paid (including the money you put into the project), then you've doubled your money. Woohoo!! 100% return!
But what if you borrowed the $200k from someone else, and so had NONE of your money in the project? That gives you an infinite return. How cool is that?
If you're interested in delving into the topic of cash-on-cash returns in more detail, then check out my article "Learning the Lingo: Cash on Cash Return"
The possibility of infinite cash returns is one of the most exciting things about learning how to do Low and No Money Down Deals.
Annualised Returns
But I haven't dealt with the other really important part of calculating profits - and the best way to only compare apples with apples.
Once you have a percentage return (and it's your choice whether you calculate it on GRV or profits), you then need to look at how long a project is going to take.
This is my secret sauce! If your return is 20% and the project takes a year - great! But what if it takes 4 years (yes, it happens)? You'd be earning 5% per annum.
And how about if the project is done in 6 months? Then your return is actually 40% per annum.
I think this is the biggest mistake newbie developers make. They don't think about the length of the project. And yet it's one of the most vital factors of all.
It's also one of the best ways to compare different projects. Essentially you're creating a common denominator (time) that is the same for all the projects. You can work out what percentage return a project makes per year, and then pick the one with the highest return.
One final tip - make sure you understand whether your lender is working with GRV or TDC. It can result in a big difference in how much they'll lend you, along with profit calculations.
But that's a topic for another article!
But what profit are you talking about? It might surprise you to find out there's multiple ways to calculate profit in a deal, and while you might be talking about an orange, the lender might be thinking it's an apple.
So let's take a look at all the lingo around calculating profits.
DefinitionsFirst up, there's a lot of acronyms used in this space, so let's break down the main two - GRV and TDC.
GRV stands for Gross Realisation Value. Which in plain language means the total sales the project makes. Sell 2 lots for $500k each? Your GRV is $1 million.
TDC is Total Development Costs. This covers all the costs of the development, start to finish. Breaking this down a little further, there are 2 types of costs - hard and soft.
Hard costs are those expenses that come out of your pocket (or at least the project's bank account!). Need to pay the demolition company? That's a hard cost.
Soft costs come out of revenue, so they don't occur until you start selling the project. Need to pay the real estate agent's commission? That gets deducted when settlement occurs for the lot you sold. You don't have to dig into your pocket to pay it.
If you want to understand more about hard and soft costs, you can check out my article "Learning the Lingo: Hard Costs vs Soft Costs" for more information.
At its most basic, the profit of your project is GRV - TDC. In other words, take all the income from sales, deduct what it cost to complete the project, and that's your profit in dollar terms.
As an example - you sold 2 lots for a total of $1 million, and it cost $800k to get there (right from purchasing the property at the start through to paying the agent at the end). Your project profit is $200k.
Now strap yourself in, as this is where it starts to get tricky.
Ways To Measure Profit
Now, if I ask you what sort of margin a developer should make on a project, chances are a lot of you will say 20%. That's kind of the holy grail of development project returns. The thing is, though, 20% as a figure sounds nice, but it's kind of meaningless if you don't understand how it was calculated.So let's take a look at the three main ways you can calculate the profit for a development.
% Profit on Gross Realised Value
First up, % profit on GRV, also know as the Development Margin. For this one, you take the project profit and divide it by the GRV.
Using the example from above, this would be $200k/$1million. The famous 20%.
% Profit on Costs
Similar name, similar process. Only this time you take the project profit and divide it by the TDC.
For our example, that would be $200k/$800k. Wow, even better - 25%! Don't get too excited though - given that in a profit scenario the sales are always going to be higher than the costs means this profit calculation should always be higher.
But given these first two variations are both called % Profit, hopefully now you're starting to see that when a developer just gives a percentage return for their project, you need to know which one they're talking about.
% Cash on Cash Return
This is also a profit calculation, but the focus here is about what return you're getting on the money you put into a deal.
For investors, this number is really important. If it turns out that their cash-on-cash return is only go to be 5%, they might have to think about whether the risk is worth it. They could get that level of return in less risky ways.
It's also important to you for the same reason if it's your own money in the deal! In both cases, though, this calculation hasn't taken into account the cost of that money if you have to borrow it.
So if you've taken money out of your line of credit, and are paying interest on it, then your cash-on-cash return will be lower.
Back to our example. Let's assume you had to put in $200k of your own money for the project. Given there's a profit of $200k at the end after all costs are paid (including the money you put into the project), then you've doubled your money. Woohoo!! 100% return!
But what if you borrowed the $200k from someone else, and so had NONE of your money in the project? That gives you an infinite return. How cool is that?
If you're interested in delving into the topic of cash-on-cash returns in more detail, then check out my article "Learning the Lingo: Cash on Cash Return"
The possibility of infinite cash returns is one of the most exciting things about learning how to do Low and No Money Down Deals.
Annualised Returns
But I haven't dealt with the other really important part of calculating profits - and the best way to only compare apples with apples.
Once you have a percentage return (and it's your choice whether you calculate it on GRV or profits), you then need to look at how long a project is going to take.
This is my secret sauce! If your return is 20% and the project takes a year - great! But what if it takes 4 years (yes, it happens)? You'd be earning 5% per annum.
And how about if the project is done in 6 months? Then your return is actually 40% per annum.
I think this is the biggest mistake newbie developers make. They don't think about the length of the project. And yet it's one of the most vital factors of all.
It's also one of the best ways to compare different projects. Essentially you're creating a common denominator (time) that is the same for all the projects. You can work out what percentage return a project makes per year, and then pick the one with the highest return.
One final tip - make sure you understand whether your lender is working with GRV or TDC. It can result in a big difference in how much they'll lend you, along with profit calculations.
But that's a topic for another article!
