The Devaluation of Capital Budgeting in Real Estate Development Firms

Article excerpt

The capital budgeting process in real development firms is a vital part of their regular operations. Developers invest large amounts of money in this process. Their finance departments frequently hire highly paid staffs to conduct studies of proposed projects. Under the best of conditions, capital budgeting for real estate development is a very challenging process due to the long lags in production times that characterize the industry and contribute to the risk of significant forecasting error.

Most real estate development firms practice advanced capital budgeting procedures in terms of the techniques used to evaluate individual projects. These techniques typically include discount cash flow analysis, consider the risk of the project and produce metrics such as EVA, NPV and IRR that can be used to select projects that meet the firm's return requirements. However, agency problems within the firm frequently result in a degradation or complete devaluation of the entire capital budgeting process.

Similar to firms in other industries, many real estate development firms have multiple divisions that compete with each other for scarce resources-mainly capital available for investment. Managers of these divisions have an incentive to convince their superiors to pursue the projects within their division in order to advance their own careers. Hence, division managers may be compelled to "make the numbers work" in order to obtain funding for projects. This process begins when a manager reviews a preliminary analysis of the project and recognizes that the capital budgeting metrics do not meet the firm's minimum requirements for acceptability. In an effort to improve the economic viability of the project, the manager may direct the individuals performing the analysis to reconsider market driven inputs such as costs, absorption rate and sales price. If we can assume that the initial analysis was performed using the best available estimates of these factors, the manager is asking the analyst to ignore market data that have a tremendous impact on the anticipated value of any project. The reliability of any capital budgeting technique hinges on the quality of the data used in the analysis. If data that has been manipulated so that it no longer reflects realistic expectations within the marketplace is used to make capital budgeting decisions, the entire process is devalued and the firm is at risk of adopting projects that will result in decreases in firm value.

In addition to the risk of adopting projects that will not meet the firm's return requirements, capital rationing within the firm may compound the situation. Most firms do not have unlimited capital to pursue projects. Therefore, the managers must select an optimal set of projects in order to maximize the value of the firm. The adoption of projects of dubious quality by one division of the firm means the resources required to pursue the project are not available for investment in other, possibly more profitable, projects. When a sub-optimal set of investment projects is selected, the firm will incur the costs of these foregone opportunities.

The problems described above are not confined to the divisional level. It is possible for firms that are in mature competitive markets to face situations where no or only a limited number of acceptable projects are available for future investment. In this situation, the course of action that would best serve the shareholders of the firm is to liquidate the firm either partially or completely. The firm realizes agency cost when operations are continued and the firm is unable to meet the minimum return requirements. However, the motivation of management to continue the firm's operation at current levels is easily understood. The decision to contract or liquidate the firm would result in many distasteful activities such as the dismissal of employees. It would also likely result in negative financial consequences for the firm's managers at both the firm and division levels. …