How a high rate of return can be bad for business
The rate of return can refer to several things. Equity investors pay attention to stocks. The fixed income market is bonds. In capital budgeting and business investment the rate of return most closely corresponds with the internal rate of return or IRR. This is known as the return on a capital project such the construction of new shopping mall, warehouse, seaport, etc. Another term for the rate of return is yield. This is because the yield answers what percentage of return truly occurred on the investment. Many questions about the planning invariably have to be raised.
How large is the local and regional population? What are the demographics? What segments of the population are most likely to benefit from and use this facility? How will this affect traffic flow patterns? Will increased traffic erase any known profits from this capital investment and also create economic strain for the surrounding businesses? How will the sewage and drainage be altered changing the direction of any runoff whether it is rain, freezing rain, sleet, ice, snow, etc? How prone is this facility to fires, explosions, and combustion? These are some of the questions that must be answered when deciding what kind of facility it should be.
The entire square footage, number of stories (floors), and the height of each floor require extensive floor plans with drafted blueprint, excavation, and other applicable steps in the construction process. Whether the approval is for a seaport, large-scale retail mall, business center, and corporate headquarters a lot of variables must be weighed. The decision has been made to construct this facility or place of business. Now it comes time for the burning question. How much money can we make from this project once it is open for business?
The central figure that tells us just how much money the project did get is known as the rate of return, and another term used in the finance field or profession is also referred to as Return on Investment (ROI). This comes from discounting future cash outlays as converted in today’s dollars. The rate of return measures the percentage of return realized after these out flows. This is the percentage earned on cash flows, but does not consider the cost of capital. The cost of capital is not reflected in the internal rate of return; the rate of return just pertains to the outflow of the cash stream in each fiscal (budget) year. The Internal Rate of Return is often overestimated in terms of its yield because it is presumed that the yield is the same on the dollar amount of outlay during each budget year regarding the funding of the project. Alternatively the more conservative yield that does consider the cost of capital is better known as the modified rate of return.
A modified rate of return will take into consideration fluctuations in the actual rate of return from one year to another hence it reflects changes in the yield on the investment.
Still the Modified Internal Rate of Return (MIRR) can be unrealistically high as well. While higher yields appear attractive to the investor, they may also mask mismanagement and complications related to the project whether it is financing, planning, and management decision making. Internal disagreements on the part of management are common, and knowledge about the level of risk may not be immediately clear. Liquidity and transferability (are they fungible) say a lot about the risks and viability of the funding. One cost structure that can add up very quickly is known as floatation costs.
Floatation costs are separate and extrinsic to the interest rate charged on the capital funding and borrowing. This is because they are administrative expenses, and they often get compounded with delays and changes in the business plans including initial blueprint excavations and subsequent construction. Some circumstances can be unforeseen due to extreme weather, but other aspects have to do with mistakes and unanswered questions. More paperwork is costly because more business meetings are required resulting in more delays. While these costs are not a function of the interest (lending) rate they have to be reflected in the overall cost of the financing. The overall cost of the financing is known as The Weighted Average Cost of Capital (WACC).
Depending on the frequency of these delays plus some of the other cost factors discussed The WACC can be upgraded by a few percentage points unmasking more of the true costs associated with the underwriting and budgeting of the project. This heightens the need to be more vigilant to the concern that there may be a default or at least garner a net negative on their investment (this is where outflows of funds exceed the inflows). This is more common than some may think. A construction lot is left abandoned and undeveloped.
Why is the lot not developed, and what are the future plans? This vacant land can exist for months, sometimes years. Changes in the national real estate market are considered macroeconomic because they are measured in aggregate terms. Individual cities have their unique culmination of microeconomic business circumstances. Because of the recent bankruptcy filing in Detroit, this is a very common problem that has only mushroomed especially in recent years. One block has many boarded up businesses while another section of the same neighborhood has many unused lots that are vacant, in some cases due to prior demolitions of the structures.
Detroit is certainly not alone. Other such cities include Cleveland, Baltimore, St. Louis, and Buffalo, NY. There is a precipitous and accelerating exodus of the local population with Detroit losing well over 10% of its population each decade. Commerce has changed altering the job market. Many of these larger cities have not fully asked why this is happening and what needs to be done about it? Where I live in Jersey City this is plenty prevalent and also throughout Hudson County. There are the boarded up buildings and unused lots adjacent to them. Nearby Newark has added businesses, but this largely remains the case throughout many of the neighborhoods in that city. In all of the communities I have mentioned crime and drug use are high with chronic unemployment for many residents and families living within the respective neighborhood. Calls to the police, the ambulance, fire department, and 911 are recurring and routine even during the middle of the day. Developers and businesses know about this.
They are hesitant about developing their commerce in these locations. They would opine that the high rate of crime and unemployment stops them from advancing their projects. There have been and continue to be urban enterprise zones available to have some incentivizing of future business development. A lot of what of what does cause these delays is lack of open mindedness and municipal planning. Not enough research was done about the construction of the structure, plumbing and the impact on sewage, fire codes and safety evacuation plans, and lastly but of course not least the changes in traffic flow patterns. In this phase and portion of the planning it is the zoning laws that require the greatest examination and hence the question becomes are they appropriate and applicable to the proposed project? Poorly coordinated planning in these aspects of a capital project along with lack of transparency, and not enough prior research conducted about the costs and feasibility studies no doubt drive up the costs.
Depending on the repetitiveness, frequency, and longevity of these delays the lending rates may too be augmented. No differently than with an individual mortgage holder a business considered to be high risk will have fewer financing options where the interest rates will be higher. Floatation costs will obviously go up as well. Outside investors who invariably end up as the respective creditors are going to naturally demand a higher yield. Since the risk of default is evidently real and even imminent in some circumstances these investors will want to be compensated accordingly since they are the parties responsible for making the capital budgeting and construction possible. There can be any number of reasons for the delays.
As with almost any assignment turnover is a likely factor. An individual creditor may have personal corruption issues and difficulty with the law. Training might be inadequate. The technology could be poor leading to inaccurate record keeping. The list of possibilities can be endless. Whatever the case is or might be the added costs could plausibly be exorbitant and ongoing. I talked about this in my piece on pension plans how they can be referred to as legacy costs. They are ongoing, recurring, and permanent. Therefore they become compounded, and they accumulate. The reason these expenditures become so costly is that they cannot be reversed and certainly not eliminated. They become a permanent part of the budget.
Loan agreements, property taxes, long-term rental contacts, and leasing terms are among the most common budget items where these expenses are perpetual. It is important for a spectating investor to ask what the cost structure is and how it defines the rate of return. There are many necessary questions to ask when considering the fiscal consequences. What are the rates of return on similar or nearby projects? What is their Weighted Average Cost of Capital culminating the lending rates with the added administrative (floatation) costs? What are the reputations of the creditors? Are they reliable? How will the surrounding community be affected in terms of traffic flow, plumbing, and without question individual residential market (real estate) value? Depending on these comparative measures the high rate of return maybe nothing other than a subversion regarding the lack of certainty and also lack of confidence about whether the respective project should be undertaken.